The Money Illusion Real and Nominal Values

Dear Readers, the topic for this fortnight’s article is Money Illusion. My aim is to look at how it relates to us in the ultimate sense, the macro-economic sense, and in the technical sense. In my opinion, all of these various aspects need to be examined in order to clarify what exactly it is we’re aiming for, and then, more certain of our aim, we can have more confidence in the outcomes.

As money exerts an inordinately powerful influence over us today [especially amid speculative markets], it’s incumbent on us to better understand it that we might better position ourselves. In approaching it more critically, we can turn what is so often that master/ slave relationship on its head. Much is about perception, and for astute perception you need perspective, and for perspective you need distance.  It’s this ‘distancing’ that allows us to see through some of our perceptions that would otherwise be illusory. Without this distancing, we can find ourselves easily disorientated, with no external points of reference as in a labyrinth, or, in today’s equivalent, down the topsy-turvy shrunken world of a rabbit hole. A self-determined life [if freedom ever meant anything] must largely consist in extricating ourselves [yes, the responsibility is ours] from such illusions, and then having that power of money [for a power it is] restored to its proper function as a means to our own ends.

Besides this ultimate sense of money illusion, there’s also the one we’re perhaps more familiar with, the one to be found in the books of macro-economists. Where the simpler economist will busy himself with the numbers, the macro-economist will also stand back critically. Also distancing himself, he asks what the numbers may mean in terms of their weight and worth. Are all numbers created equal, or are they all relative, and relative to what?  The macro-economist has moved outside the numerical labyrinth to ask what those numbers represent in reality, and in so doing, draws a distinction between nominal and real values that becomes crucial to the idea of money illusion [as Irving Fisher first popularized the term though first mentioned by Keynes].  The illusion consists in con-fusing the nominal values of money [the numbers/ units] with the real value [their capacity to purchase/ purchasing power]. Where this article here will focus more on the macro, and how it relates to Crypto [it always relates to Crypto], the following article to come will look at how this distinction is crucial in a more technical and practical manner when it comes to charting very volatile Crypto currencies.

Most of us are familiar with money illusion through the idea of inflation, with inflation being that insight where consumables across the board are not necessarily becoming more expensive with price rises, but that the purchasing power/ potency of money may have decreased instead. The generally cited reason being that this is due to an inflation of the money supply, or more strictly, an increase of the amount in money in actual circulation that is available to bid for goods. Of course, you could have real and nominal monetary inflation here also if money supply numbers go up [on paper], but actual money in circulation doesn’t - it’s all relative at the coal face. The essential thing to keep in mind in regard to ‘seeing through’ money illusion is to recognize the relativity of available money to available goods [this distinction here between real and nominal monetary inflation is why a hyper-inflationary outcome is as yet uncertain]. There is no fixed point, or fixed measure. The fixed points, what we call the units of the currency, are merely the nominal values – the value in name only. They provide a measurement, a pricing mechanism, that is fine in the short term, but is itself to be further measured by something else due to the fluctuating nature of money over the longer-term. Most often, this measurement is a basket of real goods/ commodities, and it’s this measurement that provides the real value of money; that is, money as relevant to its capacity to buy real things.

Though we are most familiar with money illusion as associated with inflation, it cuts both ways, and can equally apply to deflation. In periods of deflation, workers have found it inconceivable that their wages could be reduced and yet in real terms they might still have the same purchasing power [as prices dropped].  Inflation or deflation, money illusion results from not perceiving the instability of money relative to goods as opposed to just the inflation of it.

An example of this instability, and the money illusion it induces, is the current housing market in many countries. Commentators repeatedly refer to the law of supply and demand as the cause for rapidly rising house prices, whilst at the same time disregarding or diminishing the role that the supply of money [easing of bank lending standards, expansion of credit, creation of money through a double-ledger system/ debt, zero interest rates, speculative mania etc] must play in those ballooning prices.

As illusions by definition involve a distortion of reality, reality has to serve as its corrective. In the field of macro-economics’, real things are placed on one side, while money is firmly placed on the other. Why? Because money, from the macro perspective, is always and everywhere a collective abstraction – money is first an idea that takes form in a currency, where that currency becomes something of a social institution. It’s this ‘network effect’ that provides its potency. If money itself is not considered in this ultimate sense as ‘real’, in the way that a tangible commodity is real, it could instead be considered as ideal [a collective idea/ the network effect]. Of course, the ‘Bitcoiner’ [and I consider myself half a one] may object here and point to a technologically instituted superior form of money that could be classified as a ‘real asset’. The first response to this is that money ‘itself’ is the general idea, of which Bitcoin is a form or currency [water can have a powerful current, with this notion also applied to electricity]. Second, there is still the obvious fact that there’s another partner involved in something of a ‘dialectical process’ – Bitcoin burgeons as a currency [is increasingly monetized/ capitalized] in the marketplace, that is, Bitcoin still requires the collective belief of market participants. This is something that the ongoing and often dramatic process of price discovery in the marketplace attests to only too well. This is no disadvantage for Bitcoin, for it’s inherent to all forms of money altogether – money consists of digits on a screen [or marks in a ledger]. The question really is which digits are the best [become the most potent]. With this established, it is not the most ‘real’ form of currency that interests us, but the most ideal. And in the modern experiment of de-regulated global foreign exchange money markets, where all currencies float, the collective and all-too-human activity of the market will decide the valuations, not some mechanical device or a deterministic cast iron logic. In this world, even currencies themselves are relative to each other, to be bid up or down on a market as if they were commodities. The instability of money is taken to another level.

And so insofar as we are concerned with the price of Bitcoin, it is a currency in a global marketplace. Given that there is so much available money on the sidelines [looking for that return], it’s hardly surprising to see prices moving exponentially as money/ capital flows into it. The exponential moves then correct exponentially on an over-heated market. Rinse and repeat, and you continue to see price move inexorably up. This may seem an obvious point, but it’s one worth highlighting as people can get ‘used to’ a certain nominal level or range [money illusion]. If one did get used to a certain level, then it may become difficult to envisage another level/ range up as a likely possibility. For example, a thousand-dollar move currently would be nothing like a thousand-dollar move a while back – one may get overly excited about it, and then not see the realistic range actually within striking distance [more of this in the next article].

Laboring under money illusion, a market participant may find an increase in real values as relative to what came before almost ‘unthinkable’, or outside the range of possibility. When it does happen, there is shock, surprise [horror for some], and on the transmutation into ecstasy, you have the beginning of a mania [see ‘Could Bitcoin Really be a Bubble’ article]. But much of this would really [remember, money illusion and real values] only be a variant of money illusion. Remember, all is relative when it comes to the numbers, and especially when it comes to an exponential amount of money available on the sidelines.  Accordingly, it’s perfectly reasonable that price will move exponentially, and especially so when you also take into account market dynamics and the insights of behavioral economics. Once this distinction between nominal and real value is established, an equitable move up in real terms would have to compare percentages, and thus be on the logarithmic scale. Such a rise would be met with more equanimity and more rationality [business a usual]. This in contrast to those still laboring under money illusion, where the exponential rise of one or two thousand dollars/ units, as perceived on the linear scale, looks astronomical. Here is another example of money illusion, and the prime reason for that phenomenon known as FOMO. This recent spike in Bitcoin [to near 29K] is a good instance of this – nominally, it looks incredible [9K about the previous ATH!]. But in real terms, it is commensurate with the previous spike to 14K. In real terms, it is so far business as normal.

Figure 1. BTC on the linear scale
Figure 2. BTC on the logarithmic scale

The other thing to keep in mind with the parabolic spikes to new nominal highs is whether that price point is sustainable. Where the trader is going to be interested in the temporary volatility, the hodler/ investor should be taking it all with a grain of salt, for [unless it is different this time] price spikes and corrects in super-speculative markets. For the investor, it’s the solid price of the trend underneath the frothy evanescent price that warrants more attention.

Figure 3. Long term trend

In terms of the long-term trend [the logarithmic growth curve channel], price is currently at a crossroads – will it continue to track to the top of the curve or correct to a more sustainable level that would take the eventual cyclical peak to an even higher price?

Where [as in Figure 1 above] the nominal price of a unit through illusion can have a distorted impact on psychology on both the individual and the collective market [in terms of price and in terms of relative value to other assets], it makes sense to look at the over-all market cap [capitalization] of Bitcoin as a corrective to this illusion. It is now not the price of a bitcoin [arbitrary given the arbitrary number of units that Bitcoin has been divided into] that is comparable to another asset, to say that of an ounce gold. Rather, it’s the total market cap of Bitcoin relative to the total market cap of Gold that becomes of more significance here. Looking at long-term charts, Gold is capitalized [price is relatively even], whereas Bitcoin is in the process of capitalization [it’s market cap is in a process of radical growth]. Whereas Gold has seen currencies come and go, current currencies are presently seeing Bitcoin come. And if investors in the mass perceive Bitcoin to possess the monetary properties of Gold, then they will gain exposure to it just as they would to gold. This increasing perception and normalization of Bitcoin as digital Gold will be the driver of its expanding market cap, and this is what ‘mass adoption’ would mean [see ‘Mass Adoption’ article].

Of course, markets are not always rational, and the speculative episodes will help drive this process forward at an even more rapid pace – most will buy simply because they see price going up with a speculative frenzy/ mania ensuing that eventually exhausts itself [see ‘Could Bitcoin really be a Bubble’ article]. But for those focused on the real values, that can compare the way in which the speculative episodes might play out, that have a macro understanding of a nascent currency being capitalized, that perceive the irrational exuberance of a mass market, there will be no alarms and no surprises. It will be bitcoin as normal, they’ll ride the wave up, and look for an opportune exit, for there is no wealth but life [Ruskin] with money the means to an end, which has to be for both the investor and the trader, the conversion of it at some point into real assets.

This article has looked at the illusory nature of money to be found in focusing solely on the numbers. In digging beneath the appearances, one is better able to get a sense of the reality. The essential point here is that money is more like a dynamic force than a static set of units.  Just as time/ duration itself is not the measurement of it as split up into hours and minutes, so too is it with money. Money itself, an almost ethereal force, comes and goes, ebbs and flows, and if, like the sea itself, it’s just the means to take us to our destination, we’ve always to keep one eye on the ends to which our monetary journey is taking us.

Having outlined the nature of money illusion, and the necessity of using real and relative values as opposed to nominal values, the next article will focus on charting exponential volatility as it relates to a Crypto-currency. It will seek to outline, in a more practical sense, how exponential and seemingly incomprehensible moves in Crypto are amenable to rational analysis, and with analysis prediction. This will be due to that focus on the real values, the real moves and proportionate real corrections that lie behind the numbers. Until next time, stay safe out there.

Further Reading:

The Money Illusion, Irving Fisher

The Nicomachean Ethics, Aristotle