Inflation: “You can’t hide your lyin’ eyes” The Eagles

Forget the IRS, Benghazi, Justice department, NSA et al. government scandals for the moment, and let’s consider a government financial “scandal” that has been going on for more than two decades. It has an impact on every one of us, whether we are on social security, pay income taxes or are collecting welfare or disability payments. Of course, this scandal is producing NO headlines but is probably costing Americans trillions of dollars in higher taxes and lower benefits. More importantly, it appears to be a very deliberate policy, albeit one that is very stealthy. (Imagine the hysteria generated if the government simply announced it would cut Social Security and raise taxes yet again!) .Of course, the financial “scandal” I am referring to is (Drumroll)……How the government has been measuring the consumer price index (CPI) and the change in this index over the past 20-30 years.

I know talking about inflation is dull enough that it puts most of us to sleep, and I expect you yawned when you read the last sentence. But the reality is that the government has been taking money out of people’s pockets simply by the way it calculates inflation. In addition, it has been overstating the growth in the economy and in real incomes. This is because by understating the rate of inflation the federal government is:
(1) providing less benefits for social security, welfare and other programs than it should to let people keep pace with “real” inflation
(2) effectively raises taxes more than it should as tax brackets that are by law, indexed for inflation do not keep up with the “real” rate of inflation.
(3) showing more real GDP growth than is actually occurring, and showing greater improvement in real personal incomes, because both of these measures are adjusted downward by the government’s understated rate of inflation.

Why would the government want to do this?

Well, it’s pretty obvious isn’t it. We’ve known for years that programs such as social security and other guaranteed and inflation indexed pensions are grossly underfunded and with aging US demographics, benefits would inevitably have to be cut or these programs will default. No politician wants to support cutting benefits even if its 20 years or more from now. However, if we could stealthily cut benefits without requiring a single vote of Congress, well that’s quite a different matter. 

We’ve also known that we need more income tax revenues, and even prior to the recent 2013 income tax increases on the “wealthy”, more than 90 percent of tax revenues came from less than 10 percent of the population. Clearly, a significant middle class tax hike is needed in order to raise any significant additional revenue. Almost no politician, R or D, would ever vote for this. However, with our progressive tax rate system and the tax rate thresholds indexed for inflation, the government’s understatement of inflation means for example that a taxpayer in 10 percent bracket may effectively move to a higher 15 percent bracket and pay more taxes even though in “true” inflation adjusted terms, his income has not increased at all.

Understating the true rate of inflation is also in the government’s interest, because it makes ALL the key economic numbers look better. Real GDP growth and real personal income can be shown to be growing rather than declining and the faux-CPI rate can be shown to be low so the Fed can keep printing money with abandon!

So how is the government understating the rate of inflation? Here is some background:

First, back in the good old days of the 1970s and 1980s and for many decades before, inflation was calculated using the “market basket” approach. This method took the average consumer’s expenditures into account and created a typical market basket on a weighting for each expenditure. For example, in 1980, if the average consumer spent 25 percent on gasoline, 25 percent on rent , 25 percent on clothing, 25 percent on food. If gasoline prices went up 12 percent, rent by 4 percent, clothing by 2 percent and food by 10 percent, then the government would calculate inflation equal to 7 percent. ((12*.25) + (4*.25)+(2*.25)+(10*.25)=7) . Of course, the market basket was considerably more detailed with thousand of products , but the general concept was pretty simple – take the typical consumer market basket and its various weighted products and use it to determine the CPI and the increase in CPI.

However, some economists correctly noted that inflation calculated with this metric was overstating inflation (though only somewhat). They argued that consumers would change their consumption patterns in response to higher prices (e.g. drive less if gasoline prices go up too much, buy less coffee and drink more tea when coffee prices spike, or buy more hamburger when steak prices rise). This is referred to as the”substitution effect” by economists. Second, economists also recognized that inflation was an imperfect measure because the value or “quality” of products changes in some cases significantly over time (e.g. desktop computer in 1990 versus today is of very different “quality”).

To deal with these issues, the government (or more specifically the Bureau of Labor Statistics(BLS), developed models that simulated the substitution effects and adjusted CPI downward for “quality” improvements. In principle, this sounds fine but in so doing they overcompensated substantially for these factors:

• The use of the “substitution” effect is not an accurate portrayal of cost of living. The problem inherently is that the BLS assumes that substitution does NOT involve a “loss” to consumers when in most cases it clearly does. (e.g. switching to hamburger from steak involves a loss in consumer welfare which is not captured by the BLS in its measures). Thus. for most consumers, the substitution effect adjustment will result in an understatement in the increases in “their” cost of living over time.
• Second, the “quality” adjustments are ONLY used to adjust prices downward. For some products that’s OK , but not so for others. (Can anyone argue that the “quality” of a plane flight has done anything other than get worse over the past 10-20 years?).
• Third, quality adjustments made by the BLS assume that ALL consumers want them. But in fact, many do not. For example, suppose I pay $1000 for computer with x gigabytes of memory, but the computer companies eliminates this model and instead gives me 1.2x of memory with this new computer costing $1100. The BLS measure of CPI would NOT calculate 10% inflation for this item but something much less or maybe even a price decline due to the higher “quality”, even though I may NOT want or even need the additional memory.
• Fourth, some of the data used by the BLS is simply wrong or weighted incorrectly (or is subject to an INCREDIBLE amount of quality adjustments). As Peter Schiff, President of Euro Capital reports in his article “Inflation Propaganda Exposed” in January 2013:  “Another stunning example is found in health insurance costs, which is a major line item for most families. According to the BLS we can all breathe easy on that front because their “Health Insurance Index” increased a mere 4.3% (total) in the four years between 2008 and 2012. Interestingly, over the same time, the Kaiser Survey of Employer Sponsored Health Insurance showed that the cost of family health insurance rose 24.2% (5.5 times faster). But even if the BLS had reported higher costs, it wouldn’t have made much of a difference in the CPI itself. Believe it or not, health insurance costs are assigned a weighting of less than one percent of the overall CPI. In contrast, the Kaiser Survey revealed that in 2012 the average total cost for family health insurance coverage was $15,745, or almost one-third of the median family income.”

The bottom line is that the CPI is no longer an accurate gauge of the true cost of living increase that consumers face each year. As Schiff notes: “Finally, all of these changes take the CPI away from what it originally was intended to do , which is to calculate how much my cost of living goes up for my market basket of goods given the price increases of these products”. For this, we need to go back to a simple cost of living increase formula using something much closer to the fixed market basket approach used in 1980.

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So how much is the government understating the inflation rate? …A LOT, based on the available evidence.

First, there is Shadow Statistics, an organization which has spent a number of years collecting an analyzing data (summary data and graphics are available on their website at  shadowstats.com) on inflation and other macroeconomic statistics. Their conclusion is that real inflation (using the market basket approach) is increasing at roughly 3 percent per year faster than the reported CPI if one merely goes back and uses the methodology employed in 1990 (which is closer to the fixed market basket approach). In other words, between 2009 and 2013, while official CPI has grown by about 2-3 percent per year on average , Shadow Stats estimates about 5-6 percent inflation using the 1990 BLS methodology. Using the 1980 BLS methodology (which is a pure fixed market basket approach), Shadow Stats estimates even higher inflation on the order of 8-10 percent during this same period.

Second, in the previously noted Peter Schiff article, Schiff evaluated price increases in a basket of  20 randomly selected goods (e.g. milk, electricity, prescription drugs, new car, bread, eggs, gasoline, beer etc.) from two 10-year periods—1970 to 1980, and 2002 to 2012—and compared them to the reported government CPI during those periods. The results are pretty astounding. Schiff’s inflation measurement from 1970 to 1980 outpaced the official government measure by only 5 percent, (117 percent versus 112 percent) which was probably due largely to his statistical sampling error of the 20 goods he selected.  However, in the more recent 2002-12 period, there was a much bigger difference. Schiff’s measurements showed a price increase of 52.1 percent from 2002 to 2012, compared to the CPI figure of just 27.5 percent. Schiff’s measurements outpaced the government’s by almost 100 percent in the last decade! Using another 20 randomly selected goods, the numbers again showed drastically understated inflation by the government in this more recent period.

Finally, I did a bit of my own analysis of inflation statistics using available commodity price statistics and commodity indices and several other major consumer goods for which I had some anecdotal information. The results shown here for the last 4 years (2009-2013) were even higher than I thought they would be:

1. Commodity Metals (Both precious and non-precious)- 13% per year
2. Commodity Fuels (oil, natural gas, gasoline, diesel etc.)-17% per year
3. Commodity Food and Beverage (grains, meats, milk etc)-7% per year
4. Commodity Agricultural Raw Materials (lumber, wool etc)-12% per year
5. Commodity Price Index (weighted of above four)- 14% per year
6. Rents (Nationwide average)—6% per year
7. National Minimum Wage–9% per  year
8. Base price of a Ford F-150, the best-selling US passenger vehicle–7% per year
9. Family Health Insurance—6% per year

In other words, a 2% CPI inflation rate doesn’t pass the laugh test. We are more likely already at 5 or 6% inflation (and maybe even higher). Yet, this low 2%inflation number is the basis that Bernanke, Krugman and other neo-Keynesians are using to argue for continued money printing at a record rate in the US (as well as running large budget deficits for many years out into the future) . “No inflation, no problem” seems to be the mantra. However, I continue to believe that this strategy is lunacy!!! In the end, we are going to end up with very high inflation with very negative consequences for the US and world economies. Also, as noted above, we are already seeing greater inflation particularly in commodity prices. 

However, don’t expect the government to ever change the CPI back to the older and more accurate methodologies which would give us a true cost of living index. After all, no one wants to tell the Emperor he has no clothes.