Tuesday, December 16, 2008

Gaming the Inflation Numbers

Is inflation good or bad? Most consumers and businesses would say inflation is bad. By distorting prices, inflation makes financial planning for the future difficult, it squeezes family budgets, wrecks business plans, and destroys savings. The government, at least in principle, agrees that inflation is bad and one of the duties of the Federal Reserve is to “fight inflation” by tinkering with interest rates.

But there’s a problem with this good versus evil story line. Inflation actually has beneficiaries with a vested financial stake in seeing it continue. For example, debtors benefit from inflation. People who borrow money during periods of inflation get to pay back cheaper dollars than the ones they spent. Homeowners benefit from inflation because no landlord raises the rent. That means as a homeowner’s income increases, the fraction of income needed for housing decreases. Most people who own homes are also in debt because of the home, so they get duals benefits from inflation.

But, the biggest beneficiary from inflation is the federal government itself. The same institution that controls the money supply and purports to fight inflation benefits from it. Actually, the government benefits most from stealth inflation. If the real rate of inflation can be hidden, the government realizes all the benefits from inflation without having to bear the same costs that everyone else does.

The federal government benefits from inflation because it is the largest debtor on the planet. No other institution measures its debt in trillions of dollars. Not only is the debt enormous, it is projected to go on forever. Vague proposals to balance the budget are lame attempts to end the growth of debt, not the debt itself. Inflation makes the national debt manageable. Without inflation it would be mathematically impossible for the federal government to meet its financial obligations.

In fact inflation is an ideal two-headed quarter for the government. Devaluing the currency is a means of taxation without the need to pass a law raising taxes. The government cheapens the dollars it owes and collects more money through the effect of tax bracket creep. At the same time, rising prices create an illusion of wealth while purchasing power falls. But much of the mathematical magic of inflation would go away if the government were honest about reporting inflation rates.

For example, the government issues inflation-indexed bonds that pay a variable interest tied to the inflation rate. Increases in entitlement spending on such a programs as Social Security are based on the inflation rate. The idea that the government can “stimulate” the economy by lowering interest rates only works if you can convince lenders that the inflation rate is low so they don’t need a high rate of return just to break even.

So how does the government pull off this deception? The problem is no one agrees upon a definition of inflation. CEOs of large corporations will say that their ever increasing, stratospheric compensation packages are necessary for a prosperous company. Of course these same executives will fight raising the minimum wage on the grounds that such an action is “inflationary.” It is rather convenient to label your rise in income as deserved and label someone else’s as delusory.

So it is with the federal government. It can tinker with economic data to underreport inflation so that it reaps the benefits but doesn’t have to pay the costs. In Jim Jubaks December 5, 2008 column: “Fake Inflation Numbers Mask Crisis” he explains some of the techniques the government has used in recent decades to disguise inflation.

For example the government started using “hedonics,” a technique that reported a $100 increase in the price of a car as $0 if in the judgment of the government the “usefulness” of the car increased by $100. An increase in the power, safety, or other features would qualify as increasing its “usefulness.” Never mind that the car does essentially the same thing—take its driver from point A to point B.

The government also started to make “substitution” adjustments to its inflation numbers. If the price of steak goes up, the government assumes consumers will substitute chicken and not pay more for food. Therefore food prices are not actually rising. Got the logic on that one? Of course some government official has to decide what substitutions consumers will make and those decisions are subject to a later change.

According to Jubak the result of fudging the inflation numbers is that the Fed should have been raising interest rates to fight inflation instead of lowering them and allowing the housing bubble to develop. Of course the Fed could accurately report the money supply figures that would give a much better insight into real inflation. While there are disagreements on what inflation is, there is common agreement that printing money to circulate without a corresponding increase in economic activity will cause inflation. But in 2006 the Fed stop publishing broad measures of the money supply focusing on more narrow measures instead.

According to the Fed, the cost of collecting the additional data outweighed the benefits the data provided–a rather convenient cost/benefit analysis to make.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy


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Government Deception said...

well they can game anything under the sun.