Money Illusion In Financial Markets

One disputed issue within macroeconomics is the possible existence of a money illusion. This is mainly discussed with regard to the labor market, where it is discussed whether it is possibly to lower real wages with inflation in situations where this would be impossible with nominal wage cuts.

Yet one interesting question not discussed here is to what extent financial market participants suffer from money illusion? This would perhaps seem implausible. After all, these are the sharp and sophisticated people, the greatest brains in the world, as one observer in this discussion put it. And in a related issue, does the academic finance teachers who taught the financial market participants what they knew perhaps also suffer from it?

The answer actually seems to be a clear "yes" for both groups. Starting with the greatest brains in the world, the evidence seems clear that they do. Why else would government securities be seen as the ultimate safe haven and why would anyone accept the pathetically low yields on U.S. treasury bills, running as low as 0.2%? To quote one of these very sharp and sophisticated people, John Derrick, director of research at U.S. Global Investors:

"You've had a huge flight to quality... people want to own the safest securities at any costs. Yields on very short-term government debt are low but at least you didn't lose money."

Well, people investing in U.S. government securities may not have lost any money, or more correctly any U.S. dollars (although they did lose in terms of most other currencies), but they have lost the only thing relevant for any rational person, namely purchasing power as inflation is running way above short-term yields. The fact that some financial market participants don't seem to care about how they lose purchasing power, but only care about not losing money, is clear evidence that some financial market participants, far from the greatest brains the world, really aren't smart enough to avoid being fooled by such an obvious illusion as the money illusion.

The question is then why they are fooled by the money illusion? Well, the idea that somehow government securities are a safe haven and completely risk free isn't just something which is advanced by people on Wall Street. This fallacy actually has its roots in academic finance theory. For example, in my experience, whenever finance teachers have described the very popular CAPM model for asset pricing, which very simplified says that the return of a stock should be a function of three factors, namely the risk free rate of return, the risk premium for stocks in general and the relative riskiness of a particular stock relative to other stocks, then the return from government securities have always been held up as the real world example of the risk free rate of return. Considering that one of the assumptions of CAPM is that there is no inflation, that example is certainly consistent with CAPM, at least in countries which do not default in the traditional sense.

But while consistent with CAPM, it is not consistent with reality as inflation do exist, and which fluctuates in a way which is not entirely predictable, this means that government securities are not risk free, with the possible exception of the so-called Treasury Inflation Protected Securities. And because finance classes thus teaches the people who later enter financial companies that government securities represent a risk free asset, that is why many of these people now are fooled and see their purchasing power fall.