Money illusion is a longstanding concept in economics that has enormous significance for you if you’re a saver, investor or entrepreneur. Money illusion is a ruse performed by central banks that can distort the economy and destroy your wealth. Let me explain.
The above edited excerpts (and those below) are from an article* by James Rickards as posted on internationalman.com under the title Beware the Money Illusion Coming to Destroy Your Wealth which can be read in its entirety HERE.
The impact of money illusion can apply to:
- wages and prices,
- dividends and interest,
- asset prices of stocks and bonds.
Any nominal increase has to be adjusted for inflation in order to see past the money illusion and it all boils down to the fact that people ignore inflation when deciding if they are better off.
Why do central banks such as the Fed pursue money illusion policies? Read on…
Central bankers use money illusion to transfer wealth from you — a saver and investor — to debtors. They do this when the economy isn’t growing because there’s too much debt. Central bankers try to use inflation to reduce the real value of the debt to give debtors some relief in the hope that they might spend more and help the economy get moving again.
Money illusion has four stages:
- In stage one, the groundwork for inflation is laid by central banks but is not yet apparent to most investors. This is the “feel good” stage where people are counting their nominal gains but don’t see through the illusion.
- Stage two is when inflation becomes more obvious. Investors still value their nominal gains and assume inflation is temporary and the central banks “have it under control.”
- Stage three is when inflation begins to run away and central banks lose control. Now the illusion wears off. Savings and other fixed-income cash flows such as insurance, annuities and retirement checks rapidly lose value. If you own hard assets prior to stage three, you’ll be spared but, if you don’t, it will be too late because the prices of hard assets will gap up before the money illusion wears off.
- Finally, stage four can take one of two paths.
- The first path is hyperinflation, such as Weimar Germany or Zimbabwe. In that case, all paper money and cash flows are destroyed and a new currency arises from the ashes of the old.
- The alternative is shock therapy of the kind Paul Volcker imposed in 1980. In that case, interest rates are hiked as high as 20% to kill inflation… but nearly kill the economy in the process.
Right now, we are in late stage one, getting closer to stage two.
- Inflation is here in small doses and people barely notice.
- Savings are being slowly confiscated by inflation, but investors are still comforted by asset bubbles in stocks and real estate.
Be nimble and begin to buy some inflation insurance in the form of hard assets before the Stage Three super-spike puts the price of those assets out of reach.
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