Ok, I am off to the US Open Tennis tournament for the day in Queens, NY. Courtside. Of course I will be thinking about the housing market the entire time in nominal terms (read on) with plenty of topspin.

The assumption that people think rationally about their money, ergo housing, has been tested a lot over the past decade. The phrase money illusion, is the idea that people think of money in nominal, rather than real (adjusted for inflation), terms. There are distinct camps of economists at either end of this concept with probably more against the concept of money illusion. Here’s an example given in wikipedia:

people generally perceive a 2% cut in nominal income as unfair, but see a 2% rise in nominal income where there is 4% inflation as fair, despite them being almost rational equivalents.

Of course, my own illusion is that I always have a lot more than I actually do. I suspect this phenomenon is called insulated by reality. In the real estate brokerage business, a case could be made for an agent who has a great month of sales, and then multiplies it by 12 and feels they had a great year. Pure illusion, but it helps them get through the day, I suppose.

In reference to housing, if your mortgage rate is fixed at a low rate, and inflation falls, your borrowing costs rise. Its enough to make me take stock of my nominal lifestyle.

but I digress…

An argument for the validity of the concept of money illusion, is the fact that nominal prices are slow to react to changes in inflation. In society, there is a lack of understanding by the consumer and the media ( and appraisers), as well as little understanding in contracts and law about the differences in nominal and real prices.

Here’s some interesting discussion on Money Illusion from the University of Copenhagen.

A striking example comes from the housing market. Housing prices have risen sharply in several countries, and booms followed by busts are common in housing markets. Money illusion in the guise of a confusion of nominal and real interest rates may be partly to blame. When inflation is low, monthly nominal interest payments on mortgages are low compared to the rent of a similar house.

Housing prices therefore seem cheap, causing illusion-prone buyers to buy rather than rent which, in turn, causes an upward pressure on housing prices when inflation declines. However, decreasing inflation also increases the real cost of future mortgage payments. Investors who base their decision on the salient low nominal mortgage payments but ignore the less visible effect of inflation on the future real mortgage cost are prone to an illusion.

The concept of money illusion is controversial because of the strong belief that people ultimately behave rationally when it comes to their personal wealth. I find this hard to believe, having gone through the latest housing boom and there was limited rational behavior. Here’s a research paper on the subject [pdf]. Its over my head, but the abstract was interesting.

One Response to “Rational About Housing = Money Illusion = Racquet”

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