The Bank Of Japan (BOJ) says it is looking for consumer spending to stay on a recovery path, focusing on the relatively small increase in nominal wages rather than the steep slide in real wages. Goldman believes the BOJ’s view is founded on money illusion; and crucially, expect the positive effects to be clearly outweighed by the negative impact of lower real wages, and on a net basis see consumption falling. Simply put, once people wake up to the illusion of money, its impact will also fade.
Via Goldman Sachs' Naohiko Baba,
Can the BOJ rely on “Money Illusion”? (Spoiler Alert - No!)
Nominal wages have finally edged into positive territory after more than 18 months of Abenomics. However, prices have spiked on cost-push inflation driven by yen depreciation since mid-2013 and on the consumption tax hike in April 2014 (from 5% to 8%). As a result, real wages were still in negative territory (-1.4% yoy) even as of July, when the outcome of the successful spring wage negotiations should have been almost fully factored in. With the Household Survey also showing real disposable income down 5% yoy in July, we see an increased risk that the consumption tax hike will weigh on consumption over the long term, extending its effects beyond the initial surge and subsequent fallback in demand.
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The BOJ says it is expecting a virtuous wage-price cycle to materialize in the near future. It is focusing on the relatively small increase in nominal wages rather than the slide in real wages and is looking for consumer spending to stay on a recovery path. We believe the BOJ’s view is founded on money illusion. In this report we use Japanese data in the period when nominal wage growth was accompanied by inflation to analyze whether money illusion was in effect, and if it was, how significantly it impacted on consumption.
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Money Illusion
Money illusion refers to people’s belief that their purchasing power has increased when their nominal wage has risen even though their wage in real terms has not changed because of inflation, encouraging them to spend more. Money illusion often occurs when it takes time for people to recognize the true value of their real income because they are insufficiently informed about inflation, or when people are irrational and base their spending behavior on the nominal income they receive.
Under conventional economics, which posits that real consumption is determined by real income, the effects of (1) a 10% increase in nominal income amid 5% inflation, or (2) a 5% increase in nominal income amid zero inflation should entail the same effect on real consumption because the growth in real income is the same at 5% in each case. Where money illusion exists, however, consumer spending rises more in case (1) owing to the higher nominal income growth. Conventional economics has generally taken a negative view of money illusion2, but recently behavioral economists in particular tend to see people’s preferences and behavior being more strongly influenced by palpable nominal values than by real values. This suggests that such bias could exert a significant macroeconomic impact from time to time.
It is important to distinguish between inflationary and deflationary phases when considering the effects of money illusion. In an inflation environment, even when nominal income growth is completely offset by inflation, such that real income remains constant, people will still focus on how their nominal income has risen and spend more than is consistent with their real income. In a deflationary environment, however, people tend to be excessively concerned about a drop in their nominal income and curb their spending by more than is necessary although their real income remains constant because prices are also falling. Given that Japan is currently experiencing inflation accompanied by nominal income growth, our analysis requires examination of historical data from similar phases.
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In conclusion:
The BOJ says it is looking for consumer spending to stay on a steady recovery path, focusing on the relatively small increase in nominal wages rather than the steep slide in real wages. We believe the BOJ’s view is founded on “money illusion”.
Money illusion refers to people’s belief that their purchasing power has increased when their nominal wage has risen even though their wage in real terms has not changed because of inflation, encouraging them to spend more. However, the implications vary depending on whether the economic environment is inflationary or deflationary. As such, we needed to test for money illusion using a sample period when both nominal income and prices were rising in Japan.
We see the following implications for Japan’s current economic climate. Wages have recently edged upward after a long hiatus, but with inflation rising at a faster pace, real wages are still in negative territory. We believe the money illusion may come into play to some extent, with consumers perhaps increasing their spending a little as they welcome a rise in their nominal wages no matter how slight. However, we expect the positive effects to be clearly outweighed by the negative impact of lower real wages over time, and on a net basis we accordingly see consumption falling.
The recent climb in nominal wages is the result of the successful spring wage negotiations - the first time in years in Japan. This is good news and we can understand why the authorities are keen to trumpet it as a success story. In making an assessment of the economy, however, we sound a note of caution about overplaying the positive effects of a small increase in nominal wages in an inflationary climate. We believe the outlook for consumption should focus on the more negative effects of declining real wages. In addition, once people wake up to the illusion of money, its impact will also fade.
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But don't worry because - according to Japanese media - despite a total collapse in wages, Abe's approval rating spiked 13 points to 64%!!
