Wikipedia’s definition of money illusion is good:

In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value). This is a fallacy as modern fiat currencies have no inherent value and their real value is derived from their ability to be exchanged for goods and used for payment of taxes.

The key here is that behavior changes in accordance with the nominal numbers used as economic signposts in an economy. This is one reason why governments are often accused of manipulating their economic statistics in order to present a more regime-friendly face (see here and here).

The parallel of money illusion to unemployment rate illusion is that a higher posted rate of unemployment can have a serious negative impact on consumer confidence and personal consumption (think balance sheet recession). All else being equal, higher unemployment rates mean lower confidence and consumption. So, a lower unemployment rate is a better unemployment rate as far as incumbent politicians are concerned.

Now, you don’t have to be a conspiracy theorist and think that the government is deliberately suppressing the unemployment rate to understand what I am about to say. You just have to understand economic cycles in the context of the note from David Rosenberg today.

What I am talking about is the second paragraph of a quote I highlighted (bolding added):

But in a nutshell, to be calling for a 12.0-13.0% unemployment rate is meaningless except that it is very likely going to be a headline grabber. The most inclusive definition of them all, the U6 measure of the unemployment rate, which includes all forms of unemployed and underemployed, is already at 17.5%. The posted U3 jobless rate that everyone focuses on is at 10.2% (though if it weren’t for the drop in the labour force participation rate, to 65.1% from 66.0% a year ago, the unemployment rate would be testing the post-WWII high of 10.8% right now). The gap between the U6 and the official U3 rate is at a record 7.3 percentage points. Normally this spread is between 3-4 percentage points and ultimately we will see a reversion to the mean, to some unhappy middle where the U6 may be closer to 15.0-16.0% and the posted jobless rate closer to 12%. This will undoubtedly be a major political issue, especially in the context of a mid-term elections and the GOP starting to gain some electoral ground.

Let me put this quote in unemployment rate illusion terms:

  • People pay attention to the posted U-3 rate of unemployment. Right now it is 10.2%, which is high.
  • However, it could be much higher – 10.8% – because a lot of people aren’t getting counted. They are dropping out of the labor force and artificially suppressing the labor force participation rate. This will change when recovery takes hold as a better economy brings back those discouraged workers.
  • It’s even worse than that because, U-6, the most comprehensive rate of unemployment is sky-high at 17.5% and much higher relative to the posted rate than is normal. Even if U-6 declines to 15-16.%, using a normal gap to the posted rate gets you a posted rate of 12-13%. Nothing has changed, discouraged workers have re-entered the labor force. It is unemployment rate illusion.
  • If people see 12-13% in 2010, they will be floored, angry, and looking for someone to blame. As Democrats control Washington, they will get the lion’s share of the blame and lose big time in 2010.
  • Making matters worse, this is the kind of shock that causes people to put their checkbooks away and go home for the night a.k.a sending us into a double dip recession.

This is a case where unemployment rate illusion is definitely not a good thing.

What to do? 

Well, if you’re the President, you have to under-promise and over-deliver. President Obama has been doing exactly the opposite. Of course people are going to be angry when you promise 8.0% unemployment and instead we get 10.2%. Right now, Obama should be talking about 13% unemployment.

Moreover, Obama needs to throw his weight around. He should be telling people publicly, “my policy team is telling me that if we don’t get what we want through Congress, this fragile and unsatisfactory recovery will crumble and we will see 13% unemployment or much worse. And it will be the Republicans fault that this happened.”

Then he should turn to the Republicans and say, “give me everything I want or the economy will crumble and I will make sure you get the blame.”  Remember, that’s what Hank Paulson did and it worked brilliantly (a 777-point implosion in the Dow helped). What is the Republicans’ BATNA (best alternative to a negotiated agreement)? Nothing.

If you’re a Republican you should continue on the same course. Obama shot himself in the foot in January and February by not taking the Hank Paulson approach. Now, you get to label him a ‘socialist’ or anything you want. And you get to tell people that stimulus is budget-busting pork designed for the Democrats’ union buddies that doesn’t work and bankrupts America. It’s been working so far. Given the fact employment is likely to rise to a post-Great Depression high, why wouldn’t you continue on the same path? Don’t fix what’s not broken.

…coming soon to a TV screen near you.


Life of Illusion – Joe Walsh