Cyprus and the Money Illusion

A bit late in the day to comment on the situation in Cyprus, but the fiasco provides an interesting example of what behavioural economists call ‘the money illusion’. The money illusion refers to the phenomena that most people, most of the time evaluate alternative outcomes in terms of nominal currency values rather than in the real value, the purchasing power of a currency. The money illusion was pretty central to Keynes’s approach. He argued that workers are more resistant to nominal wage cuts than real wage cuts, with significant consequences for unemployment and recovery from recession. Keynes’s folk psychology has been backed up by research in behavioural economics that provides evidence that individuals judge alternatives using fixed reference points such as nominal monetary values. So workers might well accept below inflation pay rises (real wage cuts) but respond with industrial action or withdrawal of effort in response to equivalent nominal pay cuts. Behavioural economists have connected these tendencies to widespread psychological biases that predispose people to treat losses very differently from gains.

Cyprus provides an example of how strongly people react to monetary losses. It is one thing for savings to lose their real value year on year due to imported inflation and ultra-loose monetary policy. It’s quite another to start knocking digits off personal savings accounts. People might grumble and complain about the former, but it isn’t perceived as directly confiscatory in the way that the latter is. Add to this the indignation that populations across the OECD have felt about the prospect of paying for the mistakes of others, violating a set of pretty basic norms about fairness and moral responsibility. Thus the furious response to the clueless bailout plan for Cyprus. Of course, this should have been obvious to everyone involved – it’s a testament to the disconnection between the worlds that elites and publics currently occupy that it appears not to have been.

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Posted on March 25, 2013, in Uncategorized. Bookmark the permalink. Leave a comment.

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