Priceless: The Myth of Fair Value (and How to Take Advantage of It) (32 page)

How had Zimbabweans managed? The world was left asking that question, and journalists in Zimbabwe found it difficult to give outsiders a straight answer. Zimbabwe’s economy was a shambles, with 80 percent unemployment and rampant starvation. Inflation was the least of the average Zimbabwean’s problems. Those lucky enough to have jobs coped with the money, though. They stoically accepted that their nation’s dollar was about as perishable as milk, with a similar expiration date. Day to day, the ratios of prices remained reasonably steady, even as absolute prices changed.

The first great scholar of hyperinflation psychology was Irving Fisher
(1867–1947), an economist currently experiencing a revival of interest. No less a figure than Richard Thaler has hailed Fisher as a pioneer of behavioral economics. One of Amos Tversky’s last papers treated Fisher’s concept of a “money illusion,” a cognitive trick that comes into play during times of inflation.

Fisher was an unlikely hero-before-the-fact to this crowd. In his 1892 dissertation, Fisher complained of Gustav Fechner’s baleful influence on the profession of economics. “The foisting of Psychology on Economics seems to me
in
appropriate and vicious,” he wrote. For several decades in the twentieth century, Fisher was probably America’s most famous economist. The public first knew him as the author of a bestselling self-help book with the earnest title
How to Live
. A successful inventor, Fisher devised an index card system, a precursor of the Rolodex, and came into a fortune when his index card company merged into Remington Rand (a typewriter company that eventually became the early computer company Sperry Rand). From his perch at Yale, Fisher pontificated on the issues of the day. He was for vegetarianism, prohibition, eugenics, and just about every nutty health regimen under the sun. His daughter Margaret died in 1919 after he allowed a quack to remove parts of her colon in a misguided attempt to cure schizophrenia.

Fisher’s brilliant career came screeching to a halt in 1929. Days before Black Monday, Fisher tried to calm the jangled nerves of investors. The market’s recent volatility, he said, was only a “shaking out of the lunatic fringe.” With the lunatics out of the market, prices were sure to rocket
higher
. “Stock prices have reached what looks like a permanently high plateau.” They hadn’t, and that statement trashed Fisher’s reputation just as the market decimated his index card fortune.

Fisher believed it ought to be possible to predict prices with the rigor of a physicist. He must have been encouraged in this by his doctoral advisor, the reclusive physicist Josiah Willard Gibbs. Just as the volume of a gas can be computed from its pressure and temperature, Fisher aspired to predict prices from supply and demand. His thesis described how to do that, and Fisher went so far as to build a price-generating machine (see page 225). It was a tank of water with a flotilla of half-flooded wooden “cisterns” connected by a system of levers. Adjustments to “stoppers”
and levers fed in data on incomes, marginal utilities, and supplies; then prices could be read off scales. Gibbs must have been pleased. The device prefigured, if not parodied, the direction of twentieth-century economics. (“Press stopper I and raise III,” read part of Fisher’s instructions for the thing. “I, II, III now represent a wealthy middle class and poor man respectively . . .”)

Unlike some of his contemporaries, Fisher was keenly interested in the anomalies that didn’t fit the machine. Fisher’s 1928 book,
The Money Illusion
, is a still unsurpassed epic rant on the subject of inflation. Fisher traveled to Weimar Germany in 1922 to see how average citizens were coping with the nation’s raging inflation. German printing presses were churning out marks to pay its staggering war debts, and prices had increased by a factor of fifty since the war. In a Berlin shop, Fisher picked out a shirt and paid the shopkeeper her quoted price. “Fearing to be thought a profiteer, she said: ‘That shirt I sold you will cost me just as much to replace as I am charging you.’ Before I could ask her why, then,
she sold it at such a low price, she continued: ‘But I have made a profit on that shirt because I bought it for less.’ ”

Of course, the shopkeeper
wasn’t
making a profit in any meaningful sense. She had paid so many marks for the shirt, back when those marks had a certain purchasing power. Between that time and the sale to Fisher, the purchasing power of the mark had decreased. She was charging a markup, but only in marked-down marks.

Fisher’s point was that money is just a tool for getting stuff. When prices are stable, we can act as if money and purchasing power are one and the same. When the purchasing power of money varies, it’s necessary to draw a distinction.

This is how economists think, at any rate. Regular folks, like the shopkeeper, tend to ignore inflation. The peak year of German hyperinflation was 1923, when prices were doubling every two days. A news photo showed a German woman shoveling marks into her furnace. By then, a pile of burning cash generated more heat than the shrinking pile of firewood it could buy. Fisher nonetheless found that Germans managed to live in partial denial. Their mind was on the prices, not on the stuff.

The money illusion is almost always introduced in the context of inflation. Actually, the shrinking dollar, American or Zimbabwean, need have nothing to do with it. The money illusion can occur whenever prices change. Its basis is that consumers pay too much attention to prices and not enough to the buying power that those prices represent. The signifier becomes more important than the signified.

You have just opened a bottle of good Bordeaux for a dinner with friends. The bottle comes from a case you bought on the futures market (before harvest) for the price of $20 a bottle. It turned out to be a very good year. You happen to know (and can’t resist informing your guests) that the very same wine is now selling for about $75 a bottle. How much do you feel the bottle is really costing you to serve tonight?

(a) Nothing (since you paid for it years ago and might not even remember the price)

(b) $20 (since that’s what it cost originally)

(c) $20 plus interest

(d) $75 (since that’s what it would cost to replace it today)

(e)
Negative
$55 (since you’re getting a $75 bottle of wine for only $20)

In 1996 Richard Thaler and Eldar Shafir posed this question to a group of wine collectors subscribing to a wine newsletter. Many must have encountered this kind of situation before. There were no “right” or “wrong” answers, of course. Thaler and Shafir were only asking how much it
feels
as if the wine costs. The exact wording: “Which of the following best captures your feeling of the cost to you of drinking this bottle?”

Economists almost invariably side with answer (d). Wine you drink right now costs whatever it would take to replace it right now. How much you paid for it way back when is a nice story to tell over dinner . . . but price history is bunk.

Option (b) might be natural to an accountant. FIFO and LIFO methods of valuing inventory use the price paid. This makes sense because a retailer knows the price paid. She doesn’t necessarily know the current market value, and it may not be worth the effort to determine it.

Answer (a) says that price history is not only irrelevant but possibly forgotten, and (e) turns the history-is-bunk argument on its head, resulting in a
negative
cost for perfectly good wine! Both economists and accountants would throw their hands up at that. Yet (a) and (e) were the most popular answers, garnering 30 and 25 percent of the responses. Only 20 percent of the wine lovers chose the economists’ answer, (d). The vast majority were haunted by the ghost of prices past.

One reason that nominal-dollar amounts are so hard to deny is that we’re bombarded with them. “Common discourse and newspaper reports often manifest money illusion, even in familiar contexts and among people who, at some level, know better,” Eldar Shafir, Peter Diamond, and Amos Tversky wrote. Try thumbing through the
Guinness Book of World Records
. It’s full of money records—the highest-paid athlete, the record auction price, the most expensive meal, etc., etc. Few of the entries attempt to adjust for inflation. Yes, Andre Agassi earns more simoleons than Arnold Palmer ever did. You still have to wonder who was wealthier,
really
.

The
Guinness
editors are hardly worse than
The New York Times
or
CNN. Look at almost any news chart of money values over time. Not many adjust for inflation, even in the smartest media. Perhaps the press-release affection for superlatives has something to do with it. “The largest donation to veterinary medicine programs ever” makes a snappier lead than “the eighth largest donation, in real terms.”

What causes the money illusion? The simplest answer is that it’s too much trouble to do the math. That can’t be the whole story, though. Researchers have grilled math-savvy students with “easy” questions in which the relevance of inflation or changing prices is made bonehead-obvious and is readily computed. By and large, those students still fall victim to the money illusion.

Shafir, Diamond, and Tversky surveyed a diverse group at Newark International Airport and two northern New Jersey malls. One trio of questions concerned “Ann” and “Barbara,” two employees of publishing firms. One year, during a time of no inflation, Ann got a 2 percent raise. Another year, during a time of 4 percent inflation, Barbara got a 5 percent raise.

One group was asked who was doing better “in economic terms” after their raise, Ann or Barbara? The majority picked Ann. This is the “right” answer. The raise increased Ann’s buying power by 2 percent. Barbara’s raise was only about 1 percent in real terms because of inflation.

Now for the interesting part. A second group, randomly chosen from the same population of New Jersey travelers and shoppers, was asked who was
happier
after the raise. Most chose Barbara. A third group was asked who was more likely to leave her job. They favored Ann (meaning that Barbara was more likely to stay). The overall theme was that $$$ = happiness = actual dollars
not adjusted for inflation
.

The answers to the first question indicate that the participants were able to allow for inflation. They tended to do so when prompted by the phrase “in economic terms” but not otherwise. The authors attributed this to “multiple representations.” There are two ways of mentally representing money, one based on actual dollars and another based on buying power. Practically everyone knows that the first way is “wrong” whenever there’s inflation. But both representations command attention and both affect decisions, sometimes unconsciously. This suggests that the money illusion may be a form of anchoring. The nominal dollar amount is an anchor, and adjustments (for inflation) are usually insufficient.

Average folks are the true victims of the money illusion. Their employers use inflation to cut their wages and call it a “raise.” Labor negotiators pat themselves on the back for the “victory.” They put their savings in savings accounts, real estate, bonds, and annuities that have little or no real return. The government taxes “profits” on their houses and savings that aren’t profits at all.

Not that the money illusion is always bad. A 2008
Los Angeles Times
piece observed that “California’s run-up in housing prices after 2000 actually helped open the real estate market for minorities by diminishing fears that their arrival in a neighborhood meant home values would decline.” In any event, the money illusion must be reinforced by lifelong conditioning. All too often, our society is a crazy Pavlov’s dog experiment in which money is the bell. After much repetition, we salivate over the hollow symbol, not the meat.

My dog is worried about the economy because Alpo is up to 99 cents a can. That’s almost $7.00 in dog money.

—Joe Weinstein

Put yourself in the place of the head of a computer company’s Singapore division. It’s 1991, and you’re negotiating a contract to sell computers to a local (Singapore) company for delivery two years hence. You currently sell the computers for $1,000. By the time of delivery in 1993, prices in Singapore are expected to be 20 percent higher. Of course, that’s a guess. There are two ways of structuring the deal.

Contract A: You agree to sell the computer systems (in 1993) at $1,200 apiece, no matter what the price of computer systems is at the time.

Contract B: You agree to sell the computer systems at 1993’s prices.