JANUARY 2012                                                                       Download PDF Version

The Money Illusion or Really Keeping Up                                                                            

In the early part of the 20th century Irving Fisher, the most celebrated economist of his time and the creator of the debt deflation theory, wrote a book called The Money Illusion. In this work he wrote the following lines:

“The dollar seems always to be the same but it is always changing.  It is unstable.  Important problems grow out of this fact – that units of money are not stable in buying power.  It is a money illusion.”

Source: Irving Fisher, pg.3 “The Money Illusion”: Lune Capital

This quote and the arguments stemming from it explore the vital difference between nominal and real price returns. This issue is now more important than ever for investors to understand, both at the theoretical level and also how it relates to the practical allocation of their portfolios. 


The above graph and table illustrate the issue well. The black line on the graph is the nominal return on the Dow Jones index since 1970. It shows that whatever you invested in 1970 by 2011 you would have received a return of 16.2x on your money. However, it also shows that inflation over the same period ran at an annual average rate of 4.8%, and this means that the real return on your 1970 investment was actually only 2.7x. This return is no longer the headline-grabbing and ‘illusionary’ double digit multiple but must be seen as a truer reflection of the increase of wealth.

It is instructive and chastening to look at the real returns for the other major markets:

So looking at the above table we see some impressive looking nominal returns getting cut down to size when inflation is taken into account. Since 1970 an investor would have made 3.2x in Germany, 3.2x in China, 2.7x in the USA, 1.2x in Japan and 1.1x in the UK. The performance of the UK and Japan is particularly telling - the UK has had annual inflation only slightly under the average growth rate of the FTSE while the Nikkei has delivered better real returns because of the persistently low level of inflation.


Over the last 40 years, other than in Japan, inflation has been our ever present companion. Our outlook for the next 10 years is that inflation will remain at raised levels (3-5%) and interest rates will remain low (0-2%) - therefore we will experience negative real rates of return. It seems clear that this is the ‘exit strategy’ that the Fed and the Bank of England has chosen, and we would expect the ECB to fold their cards and follow suit..

To put this into an historical context, Japan, since the late 1980s, has experienced debt deflation caused by credit crisis. On 31st May 2003 the then governor Ben Bernanke addressed the Japan Society of Monetary Economics and offered the following advice:

“Price level gap is the difference between the actual price level and the price level that would have been obtained if deflation had been avoided…a successful effort to eliminate the price level gap would proceed roughly in two stages.  During the first stage the inflation rate would exceed the long term desired inflation… call this the ‘reflationary’ phase of policy.  Second, once the price level target was reached, the objective for policy would become a conventional inflation target.”

Source: “Some thoughts on Monetary Policy in Japan.” - May 31, 2003. Japan Society of Monetary Economics : Lune Capital

Although Japan did not follow ‘Reflation Ben’s’ advice the Fed now certainly is and is conducting this policy of ‘reflation of inflation’ and we re going to experience an inflation rate that ‘would exceed the long term desired inflation’.


Below is another table which shows the lack of inflation that is present in a range of areas - these are expressed as multiples with inflation taken into account and are from 1970 to 2011:

Anecdotally we can probably also think of a number of other areas where there has been very little inflation or actual deflation. For instance international telephone calls and all areas relating to technology and computing.

But are these the areas that we really want our money to keep up with? For what specific purpose, as an investor, do you want your portfolio? This is a personal question and will differ among individuals. However, I would suggest for the majority of people reading this newsletter they will want their money to keep up with private education and private healthcare. Certainly I would want to be able to provide the same education to my children or grandchildren and/or ensure I was able to provide for myself in old age.

If we again use me as an example, the 5 years of my education between the ages of 13 and 18 cost a total of c.£35,000. The same education at the same school for the same time period would now cost closer to £150,000. If we use a year’s tuition at Harvard in 1970 this would have cost $4,070 and in 2011 it costs $69,282; this is a nominal increase of 17x and a real increase of 3x. The research is currently ongoing on healthcare, however, I would anticipate the results would be in the same range.

An investor must therefore decide what they want to keep up with and then invest accordingly. In the table below we list at a number of assets that have shown the ability, since 1970, to keep up with the sustained level of inflation exhibited by education and healthcare:

Allocations into the assets above should be viewed as important core holdings that will allow investors to make real returns and meet their objectives. Investors will experience increased volatility and therefore should increase their time horizons and accept these condition in order to keep up.


  1. The developed western economies are in the process of ‘reflating inflation’.

  2. Impressive nominal returns must be translated into ‘real’ returns after inflation has been taken into account. This is particularly the case in the reflation stage.

  3. Assets and investments that have historically provided ‘real’ returns may increase the volatility of a portfolio, therefore a client will need to increase their time horizon.

These conclusions will have a profound effect on a number of asset classes and investment funds, and we have already outlined our views on a number of these. In order to provide clients an easier access to the best ‘real’ return allocations Clarmond is also examining the launch of a specific fund and we will keep everyone up-to-date as these plans develop. 

Please do not hesitate to contact Christopher Andrew:

Christopher Andrew
Tel: +44 20 7060 1400



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