Money illusion- how a flaw in the human brain makes our lives easier

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Part of the HR remit is to organise and distribute salary adjustments.  Aside from steps to give real benefits (i.e. merit increases and bonuses), part of what we need to do is increase employees’ pay to keep up with inflation.

The inflation adjustment

Without getting into the weeds of modern economics, our economies are mildly inflationary by design, with inflation generally sitting between 1-3%.  This means (except for situations the economy has slipped the reins of the central bank) the cost of living goes up 1-3%, so to keep our employee’s real income the same, we need to increase their pay by the same amount.

Money illusion

When by design or happy accident, the employer benefits here from money illusion.  Money illusion is a cognitive bias that occurs in economics- that we view money by its nominal value rather than its relative value.  To put it simply, it’s why people see a 10% increase in pay during inflation of 12% as better than a pay decrease of 2% during deflation of 2%.  To put it more simply, we look at the numbers and think big is better, rather what they mean.

Acceptance of pay adjustments

This is very handy when it comes to pay increases.  People will be more accepting of increases that aren’t real increases to their income (e.g. 2.5% when inflation is 2.5) because the number is bigger, and we like bigger numbers.  We will even accept numbers that are actual decreases in real income (e.g. 3% when inflation is 3.5%). 

Is this fair?

It’s an interesting question worth considering. Is it fair that people get a false sense of acceptance?  Are they (and we, because it applies to us as employees too) getting duped?  Personally, I land on the conclusion that overall it’s not unfair, except where organisations intentionally try and shave off 0.1-0.5% off to make some savings.

Pay isn’t just about the money.  It’s also a sense of worth- how much we get paid is tied to our ego and sense of self-esteem.  It’s why taking a pay decrease is an ego hit. Getting an inflation adjustment that feels like a pay increase gives people a boost of self-belief. 

Overall, its two illogical cognitive flaws (seeing an inflationary adjustment as an increase, and pay rate as a proxy for value to the world) working in tandem to provide a small sensation of contentedness, if not happiness.  Is this right?  Maybe, but it’s not a bad thing.

The deflationary world

Governmental monetary policy that aims for small inflation makes our lives easier.  But they can’t always control the economy.  For example, the early 2020s saw higher inflation (outside of central bank preferences) across the OECD, in part due to US fiscal stimulus packages during lockdown. 

But in some rare cases, the economy can slip into deflation- where prices go down.  This is a nightmare for HR- because we need to get people to accept pay decreases.  Yikes.   

Fortunately, these are very rare- Japan went through a period of deflation in the 1990s but overall it’s very rare.  Crypto currency however is deflationary by design, so let’s hope that doesn’t become currency.

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