Posted on 01/28/2011 5:16:10 PM PST by DeaconBenjamin
Inflation is actually much higher than what the BLS claims it is; something that purchasers of college tuition, pharmaceuticals, or health insurance know all too well.
To give the BLS some credit, they must try and estimate a single rate of inflation that applies to everyone equally. But that is a completely impossible task. An octogenarian living in Seattle on a meager pension and taking lots of prescription medications will have a totally different inflation experience than an 18 year old living in their parent's basement eating Ramen noodles.
But even after spotting the BLS some slack, there are some enormous and glaring errors in their methods that render the official inflation measure hopelessly - and dangerously - inaccurate.
In this article, I am going to reveal how US inflation numbers are badly understated, how this practice short-changes institutions and fixed-income individuals alike, and why this means fiscal and inflationary train-wrecks are the most probable outcome for the US -- and, by extension, the globe.
Why This is Important
As a refresher, inflation in the US is calculated by the Bureau of Labor Statistics (BLS) in a measure called the Consumer Price Index, or CPI. It is used by the Federal Reserve to justify its money printing policies, by the federal government to calculate cost-of-living adjustments (COLA) for the entitlement programs (e.g., Social Security), and to set the interest rate on inflation-adjusted bonds known as TIPS. Indirectly, the CPI influences interest rates, the stock market, and a host of salary and pension negotiations each year. If the CPI is too low, even by a single percent, the impact is in hundreds of billions of dollars.
And from a financial planning standpoint, the impact is just as dire. If you are putting away money for a child for college, the rate of inflation you apply to the tuition has an enormous impact on the amounts you'd need to put away. In eighteen years, a current $40,000/yr tuition will become $66,000/yr at a 3% rate of inflation, but $107,000/yr at a 6% rate of inflation. The same logic and results apply to retirement planning.
Further, the cost estimates surrounding the current health-care debate in the US are founded on inflation projections that draw upon prior CPI readings for their baselines.
It is vitally important that our assessment of inflation be as accurate as possible.
Unfortunately, the CPI understates inflation, which is much higher (worse) than we're told.
Understanding exactly how this is accomplished will help clear your mind and lead to more certainty in your decisions.
Caveat Emptor
Every country fights its last battle, and in the US, unlike Europe, the prior enemy was deflation, which ravaged the land in the 1930's.
Seeking to avoid that fate repeating itself, the US Federal Reserve routinely justifies the continuation of its massive money printing experiment (which goes by the all-too-fancy title "Quantitative Easing") by citing an apparently low rate of inflation, as provided by the BLS.
Here's a recent example of such justification at work:
Recent data show consumer price inflation continuing to trend downward. For the 12 months ending in November (…) inflation excluding the relatively volatile food and energy components--which tends to be a better gauge of underlying inflation trends--was only 0.8 percent, down from 1.7 percent a year earlier and from about 2-1/2 percent in 2007, the year before the recession began.
Chairman Ben S. Bernanke--The Economic Outlook and Monetary and Fiscal Policy
A 0.8% yearly rate of inflation (ex food and energy, of course) that is trending downwards certainly makes inflation sound like a non-issue and supports the idea of dangerous deflation lurking nearby.
Indeed, the Fed is right, after subtracting out the items that are most responsible for keeping everybody alive and comfortable (food and energy), the rate of inflation as reported by the BLS seems to be locked in a mortal tailspin…as long as you only look at the narrow range marked by the red line below:
Well, the average person would be well within their rights to wonder what all the fuss is even about. After all, inflation is now within 0.06% of its ten-year average, and unless you are calculating the trajectory of a newly launched Mars probe, 0.06% is not really that big of a deal. But the Fed is terrified of it.
Backing up this view is the BLS, which provided us with these data for December 2010:
According to the BLS, the average household experienced an exceedingly tame rate of inflation of only 1.5% between December 2009 and December 2010. That is, what used to take $100 to buy in 2009 requires $101.50 in 2010; only a dollar-fifty more. Once we strip out food and energy, the cost index plummets, requiring only 80 cents more than a year ago to buy the same basket of goods and services.
The only problem with this view is that it is utterly, provably, and demonstrably wrong.
I can reveal how with one relatively simple example.
[Note to any journalists reading this. My standing offer to you is this: I will spend as much time as you wish going through this data if you feel that understanding it more completely will help your current or future reporting on the issue.]
Health Insurance and the CPI
As I mentioned in the Crash Course chapter on inflation, there are three major statistical 'tricks' that the BLS imposes on the Consumer Price Index. They are hedonics, which tries to account for improving quality in products over time, substitution, which is the act of switching to lower-cost items when prices surge on preferred items, and weighting.
For less-than satisfactory reasons, the BLS only weights healthcare at 6.5% of the CPI, although it represents 17.6% of the total GDP. That's a big problem, because healthcare is the biggest and most consistent source of inflation over the years.
[Note: This next section has been extensively edited from its original content to reflect new understandings and information. See comments below for the context for these changes. Briefly, based on a conversation with a BLS employee I had incorrectly assumed that 'health insurance' reflected the total cost of health insurance. It does not. It is only meant to reflect changes in the retained earnings ratio of health insurance companies. I truly dislike making errors and seek to correct them publicly and completely whenever they occur.]
Medical care as a CPI component rather oddly excludes all government expenditures for healthcare (primarily Medicare and Medicaid) and does not count the rising costs of health insurance to businesses. After subtracting out these expenditures only 6.5% remains from the 17.6%.
It turns out that in its attempt to capture health insurance the BLS splits it into two cost streams, one which goes towards paying for health care and the other which goes to the insurance companies. The first cost stream is allocated to the medical care components listed above while the insurance company component is contained within the 'health insurance' subcategory. But it's all done by what is described as an 'indirect method.'
Here's the official explanation
The weights in the CPI do not include employer-paid health insurance premiums or tax-funded health care such as Medicare Part A and Medicaid. Currently, the index employs an indirect method for measuring price changes for health insurance premiums.
Under this indirect method, the medical care index will not be affected by changes in policy characteristics, such as modifications to policy benefits and utilization changes. The approach implicitly assumes that the level of service from individual carriers is strictly a function of benefits paid.
Measuring Price Change for Medical Care in the CPI
By this method, the rising costs of medical care should feed into rising health insurance costs, which will then be captured in the medical care CPI. Also, we might note that the part in bold implies that changes to insurance policies such as rising deductibles and copays, both very significant portions of the current experience for most people, will, perversely, cause the CPI for medical care to drop because less money will be registered as going towards medical services and commodities. You pay the same amount to the health care company for insurance, but less is paid out because you have to shoulder a bigger portion via deductibles and co-pays and, presto!, less money is recorded as being paid out and so inflation is apparently less. I still need to vet that thought process with the BLS to be sure I've got it right, but the way things are worded, that's the only way I can interpret it.
The cost of health insurance itself, has apparently been steadily falling for the past three years something that will be news to anyone whose premium's have vaulted up:
Because most private health costs are paid by insurance claims, it stands to reason that the medical care CPI should track the rise in health insurance over the years. That is, if the methodology for tracking health insurance costs works, and those costs are properly allocated into the CPI, then both should give roughly the same answer over time.
But they do not.
Where the CPI for medical care purports a 52% increase over the 1999 - 2009 time period, health insurance premiums have risen by 131%:
In just those two errors, underweighting healthcare and the inexplicable gap between health insurance increases and the medical care CPI, by my calculations the BLS is understating inflation by at least three percent, and possibly more.
If three percent does not strike you as a lot, go back and re-read the example about college tuition I provided in the sixth paragraph of this article.
Conclusion (to Part I)
For the reasons above, inflation is much higher than proclaimed. Yet we are being told, on a near-daily basis, that the massive money printing and deficit spending activities of the Federal Reserve and federal government, respectively, are not stoking inflation. At least, 'not yet.' Since the Fed uses the CPI as a key indicator in its decision making, the big risk here is that Bernanke will not begin to turn the wheel on the monetary supertanker until after it is too late.
Anybody engaging in any form of long-term financial planning - be they individuals, pension trustees, or budget setters - needs to be aware of the flaws and limitations of the official US inflation measure.
All COLA increases based on the CPI are too low. Any health care policy analyses that rely on the CPI (which is most) will vastly underestimate the true costs and are doomed to trap the nation in a regime of rapidly rising costs and deficits.
We are risking much by systematically understating inflation including our reputation, market confidence, and even the dollar itself.
I truely love the exclusion of food and gasoline, which I purchase every week with my household budget. But let’s make sure we include the HD TV.
Exclude the cost of everything except dirt and all is rosy.
There is inflation. Why we can’t afford a house or car without borrowing.
Do do we have deflation or Hyper-inflation?
The worst of BOTH worlds. The decreasing buying power of the American consumer — which causes deflation, which ORDINARILY would counteract decreasing buying power — is being offset by a collapsing dollar, which ORDINARILY would improve trade balances.
I've never figured this out: if you don't like the figure that excludes those things, then why don't you pay closer attention to the figure that does?
Both records are there.
Unfortunately, the ability to understand this is not present in the majority of the semi-literate American population.
And if you point these FACTS out to a liberal, you are sprayed in the face with spittle as that liberal hurls ad hominum insults at you, all the while shaking his fist at you, you racist.
Why don’t they ever mention how products are shrinking while prices increase. A “half-gallon” of ice cream is now 1.5 quarts.
That is right. I really have to check the price per ounce. We have one dairy product manufacturer who packages in 1.75 quarts. Now that really messes with my mind.
Most intriguing.
The five-pound can of coffee has gone the way of the dinosaur.
Soon a one-pound sealed package of bacon will be only a memory (many packages are now 12 oz.).
I think they are required to take into account changes in quality and quantity, but what do you think the chances are that the pure technicians are left alone to make objective disinterested decisions?
Remember just because you are not paranoid, does not mean they are not out to get you.
INFORMATION COSTS AND HEDONICS
We are living in the greatest era of falling prices in the history of man. Our lives are being transformed by this phenomenon year by year, yet most of us take the change for granted. We barely notice it. Yet we would wonder what is wrong if it ceased.
Falling prices, you say? What falling prices? Where is there any sign of this.
Right in front of your eyes. Literally.
You are probably reading this on a computer screen. It is full color. It is thin and lightweight. It is probably 17 inches -- maybe larger. If it wears out (which it won't for years), you will replace it for a monitor that costs less than you paid for this one.
What would you have paid for it five years ago? What would you have paid for it a decade ago? Nothing like it was available ten years ago.
Earlier this week, I wrote a brief article that included a series of funny YouTube videos ridiculing taxes. One was British. One was Canadian. One was American. It took me about five minutes to write that article and embed the videos on a page. I posted the page on my site by clicking a button. Anyone on earth who follows my posts can read that page. He can click each video and enjoy the fun. See for yourself.
How could I have done this six years ago? YouTube did not exist six years ago. You can verify this on Wikipedia, which did not exist eleven years ago.
Are you getting my drift? That which we take for granted today is revolutionary. Much of it did not exist during the dot-com bubble. It appeared after that Federal Reserve-created bubble had popped.
WIKIPEDIA AS THE MODEL
You can consult an encyclopedia with 17 million free articles. Here is a list of the languages available.
Only 3.5 million are in English, but there is translation software a click away that will translate most of the others into readable English with one mouse click. They are then readable.
It is not just that the intellectual division of labor keeps these entries updated and corrected. It is this: nothing can stop you from consulting them. The governments of the world might like to stop some of them from being posted, but they cannot do this. In any case, there are too many online articles to evaluate. Government bureaucrats cannot keep pace with the rate of change.
How do we compare Wiki and its many imitators with what was available in 2000? Nothing like them existed in 2000. They are all free. We cannot compare the "Encyclopedia Britannica" with Wikipedia. I bought a digital version of Britannica a few years ago. I used it only once. I shall not use it again. A few thousand articles written by lone scholars are not worth paying for. There has been a quantum leap in the production of encyclopedia articles. That which is free has completely replaced that which has a price tag.
You want price deflation? You've got it.
How can we measure this? Whatever a standard encyclopedia on a disk was in 2000, Wikipedia is orders of magnitude greater today. We would need a log-scale graph to compare their content. Yet Wiki is free. That is price deflation of 100%.
DEVISING A PRICE INDEX
Let's say that you were hired by the Bureau of Labor Statistics to compare encyclopedias at the end of 2000 with those at the end of 2010. You are asked to calculate the cost of information. You go to the "Encyclopedia Britannica" in 2000. There were about 15,000 articles. Do you calculate cost per article? Go ahead. Put 15,000 as the denominator. Do you calculate Wikipedia's cost per article with a denominator of 3.5 million or 17 million? Remember, there is translation software that did not exist in 2000. Is a translated article worth (say) 70% of an English language article? Or maybe only three-fifths? It does not really matter. The numerator is zero.
It will be zero next year and the year after. Then what? How should you calculate the price effects of (say) 7 million English-language articles with 3.5 million, when they all cost zero? This is not a trick question. It is a real-world question.
If the numerator is zero today, and it will be zero in ten years, but the supply doubles, is that relevant? Of course it's relevant. You get twice as much for free. I reply that the price has not fallen. It is still zero.
"But," you reply, "we have to do something with that doubled supply. We can't just pretend there has been no change. More is better than less, right?"
So, you propose a modification of the formula. You insist that there has to be an implicit price adjustment based on doubled output. The price per article remains the same -- zero -- but there has to be an implicit reduction of price. Otherwise, the public will be misled. People will think that things have not gotten better, when in fact things are twice as good. Well, not really twice as good. The next 3.5 million articles will be on less important topics. There is a declining rate of return. Economists say that the marginal value of each additional article falls.
Now what should you do? Things are obviously better by 3.5 million articles. But how can we estimate how much better? There is no theoretically valid answer. We cannot come up with a formula that estimates the collective value of those extra 3.5 million English-language articles. We cannot scientifically measure the subjective valuation of any reader, let alone all readers. That newly posted article on your brilliant career may not be worth much to the rest of us, but you will surely be ecstatic -- if it's nice. You will be outraged if it isn't. How do we measure the marginal value of that article? We can't.
Yet we have to say something relevant. After all, 7 million articles are better than 3.5 million. We just do not know how much better.
So, you will have to fake it. You have to do something that reflects the newer, better state of affairs. Even if you use some simplistic formula -- "articles cost half as much apiece" -- meaning half of zero, this still conveys a more accurate picture than if you say that nothing has changed: zero is still zero.
Do you agree so far?
HEDONICS
There is such a formula. The Bureau of Labor Statistics applies it. The rest of us really don't know how it works. Face it: we don't know much about how anything works.
The important thing is this: the formula does not change. We can see the trend, even though we cannot be sure if the formula is accurate. The fact is, no formula is accurate. But a formula that acknowledges that 7 million at zero price is better than 3.5 million at zero price is better than a formula that doesn't.
A hedonics formula says that improvements in quality count for something. Yes, we can always reply: "Count for how much?" The statistician replies, "I don't really know, but something." He is correct. If there is no implicit deflationary formula that reflects the fact that we are getting more than before at zero monetary price, then we cannot begin to understand economic history.
BETTER AND BETTER
In a free market economy, there is constant competitive pressure to improve quality. The history of the free market social order is a story of small improvements in most things offered for sale, interspersed with major improvements that change everything. Think of electricity, automobiles, medical care (Salk vaccine for polio), and on and on. Our world today would be barely recognizable to a person transported through time from 1900. Similarly, the world of 1900 would not be recognizable to someone living in 1800.
Late last year, I interviewed the grandson of President John Tyler. I would also like to interview his brother. John Tyler was born in 1790. Think of his world at age 20 compared to our world at age 20. The economic world of Jesus at age 20 would have been more recognizable to John Tyler than our world.
Because of the fractional reserve banking system, our world is constantly dealing with rising prices. Because of rising prices due to monetary inflation, this increased physical output due to capital investment and innovation is concealed. This element of concealment is more than mere increases in physical output. It is also due to improved quality.
I used the example of Wikipedia, because it is so spectacular. Also, we can compare the number of articles with conventional commercial encyclopedias. I found that the Wiki articles are far better than the articles on Microsoft's Encarta. So did everyone else. Microsoft abandoned Encarta in 2009. It had 62,000 articles when it finally was killed. How do I know this? I read about it on Wikipedia. http://en.wikipedia.org/wiki/Encarta
CRITICS OF HEDONICS
What astounds me is this: there are journalists out there who insist that the hedonics implicit deflator is some kind of scam by the Bureau of Labor Statistics. This is another way of saying that the increased output of free market social order should be ignored. The critic is saying this: "If we cannot see a price change, no change happened." Or, put another way, going from no entries on Wikipedia in 2000 to 17 million in 2011 did not lower the cost of information in the United States. After all, free is free. The numerator did not change.
Maybe you think I am exaggerating. Maybe you think that nobody could be this dense intellectually. You would be wrong. You do not factor in what I like to call the Brett Arends school of financial reporting. Mr. Arends writes for the "Wall Street Journal." In an article posted on January 26, he wrote this.
Or consider the case of Apple computers. We all know Macs are expensive. And we know Apple doesn't discount. The cheapest Mac laptop today costs $999. A few years ago, it also cost $999. So the price is the same, right?
Ha. Not according Uncle Sam. Using a piece of chicanery called "hedonics," Uncle Sam calls this a price cut. His reasoning? You're getting more for the money. Today's $999 Mac is lighter, fancier and faster than last year's $999 Mac. So the government calculates that the "real" price has actually fallen.
How's that work in the real world? Try it. Go into your local Apple store and ask for 50% off thanks to hedonics. (If you do, please, please video the exchange and put in YouTube. We could all use a good laugh.)
Instead, the government is worrying about deflation, partly because of all the "cheap" MacBooks out there.
My daughter owns a 2005 Mac. It is slow. It is barely functional. So, I bought her a new PC for Christmas. It cost $500. It is vastly more powerful than the 2005 Mac. But so is the 2011 Mac. The Mac Air is a dream machine.
Mr. Arends' version of rhetoric is to ask us to try to get a discount Mac -- today's Mac -- based on hedonics. But you can surely get a discount on a 2005 Mac. My daughter will sell you hers for only $800. And if you are dumb enough to pay that much, I will put your story on YouTube, as he suggested.
Here is my challenge to Mr. Arends. I challenge him to find a YouTube video posted in January 2005 describing the 2005 Mac.
Problem: there was no YouTube in January 2005. The site did not exist.
But, in the world of Brett Arends, YouTube would not be in the hedonics formula. After all, YouTube is free today. It was free in January 2005, since it did not exist. Conclusion: there has been no economic change. After all, zero is zero. Right? We should compare numerators with numerators. Forget about denominators: the products. They are irrelevant. Price is all that matters: numerators.
He went on.
The second reason to treat the official inflation figures with some mistrust is that they look backward. They register what just happened, not what's about to happen next.
OK, so the prices of many things haven't risen. Yet. But if the laws of economics mean anything, they will have to. Why? Because costs are rising.
The laws of economics supposedly teach that rising costs produce rising prices. They do? Since when? He is operating in terms of pre-1870 classical economics: a cost- of-production theory of retail pricing. It is as if the marginalist intellectual revolution of the early 1870s had never occurred. It is as if Jevons, Walras, and Menger had never written.
Consumer prices are set by consumers competing against each other in a huge auction process. Producers compete against producers. The outcome is an array of prices. If the prices of raw materials are rising, this is because buyers are forecasting increased demand by future consumers -- demand that it will be profitable to meet. So, manufacturers bid against each other, while raw materials sellers compete against each other.
The marginalist revolution explained rising materials cost in terms of expectations by manufacturers. Rising costs do not lead to rising prices. Rising costs are the outcome of an auction process that is based on the expectation of rising demand. Arends has causation backwards.
In any case, it is not the job of the Bureau of Labor Statistics to register future consumer prices, factoring in rising raw materials production prices into the Consumer Price Index, which measures changes in -- memo to Arends -- CONSUMER prices.
He goes on:
Sooner or later this is going to show up in your supermarket, or at the mall, in higher prices.
Really? What if there is a double-dip recession? What if there is a contraction in Chinese consumers' demand for goods because of the phenomena described by the Austrian theory of the business cycle: monetary inflation followed by monetary stabilization? What if the forecasts are wrong? Then consumer prices will fall, and raw materials factors also will fall.
Rising raw materials prices may be a good forecasting tool some of the time, because entrepreneurs who are paid to forecast prices have bid up raw materials prices. But -- another memo to Arends -- the price of food is not subject to the BLS hedonics formula. The BLS does not assume that there are significant improvements in food quality that justify implementing the hedonics formula in this sector of the economy.
He has moved without telling the reader from the realm of digits -- Mac computers -- to the realm of raw materials. To put it simply, he has criticized the hedonics formula, which applies to "electrons," as if it applied to "atoms": food. He has dismissed the hedonics formula, calling it "chicanery." He is inescapably also calling into question the real-world effects of constant attention to quality that the free market encourages through the system of profit and loss.
I remind him and anyone else who follows his line of reasoning: "You can't beat something with nothing." If the BLS formula is chicanery, then which formula isn't? Show that this rival formula enables us to better understand the extraordinary improvements in quality and the historically unprecedented decline in costs in the realm of computers and digital communications.
My advice: forget about the weakness of the formula. Pay attention to the trend. In matters digital, the trend is down. With respect to the cost of information, the trend is down.
CONCLUSION
To get some idea of what Mr. Arends is ignoring, read my article on Moore's law and the other parallel laws that are transforming our world. Output in the realm of silicon and fiber optics is now doubling every 12 to 24 months in two dozen fields. This is transforming our world as never before.
These changes will create a new world -- hopefully brave, but unquestionably new. The BLS is trying to deal with this statistically. If it did not, it would be ignoring the most important development in the last 4,000 years.
Let's here it for hedonics! More free Wiki articles, more free YouTube videos, more free LewRockwell.com articles, more free books in Mises.org's Literature section. At zero price, I want more, more, more. I am not insatiable -- my time has value -- but I want lots of producers trying to meet my demand. Give it a shot, guys! See if I overload.
Probably because smaller package sizes are accounted-for in the inflation figures.
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