Sunday, May 20, 2007

Inflation Reporting Errors?

Good Morning!

First up is an interesting article by Barry Ritholtz, entitled Inflation Reporting Errors, Continued.

It's a little technical, but it meshes nicely with my overall message that the United States government has been playing fast and lose with our national "credit card"[1], and has written checks to big for it to cash[2].

Mr. Ritholtz writes:

Wednesday, we looked at a way to measure actual Inflation: Comparing the "spread" between the Headline CPI data, and that of the Core CPI, we learn that BLS has been consistently under-reporting inflation over the past 8 years. Since then, we have come across two related discussions that shed additional light on the subject of accurate inflation reporting.

Right off the bat, our author makes a serious charge. If Mr. Ritholtz's hypothesis is true, then there are people in government guilty of high crimes worthy of impeachment, indictment, court hearings, and if proven guilty, incarceration.

When Mob Bosses are convicted under RICO statutes, Bosses go to jail. Bureaucrats and politicians that impose a "hidden tax" on the people, therefore defrauding them, are criminals that deserve to spend a lot of years in "Club Fed."

One would hope and pray that this under-reporting is nothing more than extreme incompetence.

Unfortunately, when this article is considered within the totality of evidence that I have presented, it appears that these funny numbers are no accident. Low inflation figures are exactly what the government needs right now.

Now at this point, one might be wondering, why is inflation so important, and why would the government take pains to mislead the financial markets?

Basically, inflation is an increase in the price level of the goods and services we consume. And one of the biggest causes of inflation is when the government increases the money supply in the economy.

A good example of this is what happened in Post World War I Germany in the 1920's[3]:

Before World War I Germany was a prosperous country, with a gold-backed currency, expanding industry, and world leadership in optics, chemicals, and machinery. The German Mark, the British shilling, the French franc, and the Italian lira all had about equal value, and all were exchanged four or five to the dollar. That was in 1914. In 1923, at the most fevered moment of the German hyperinflation, the exchange rate between the dollar and the Mark was one trillion Marks to one dollar, and a wheelbarrow full of money would not even buy a newspaper. Most Germans were taken by surprise by the financial tornado.

"My father was a lawyer," says Walter Levy, an internationally known German-born oil consultant in New York, "and he had taken out an insurance policy in 1903, and every month he had made the payments faithfully. It was a 20-year policy, and when it came due, he cashed it in and bought a single loaf of bread." The Berlin publisher Leopold Ullstein wrote that an American visitor tipped their cook one dollar. The family convened, and it was decided that a trust fund should be set up in a Berlin bank with the cook as beneficiary, the bank to administer and invest the dollar.

In retrospect, you can trace the steps to hyperinflation, but some of the reasons remain cloudy. Germany abandoned the gold backing of its currency in 1914. The war was expected to be short, so it was financed by government borrowing, not by savings and taxation. In Germany prices doubled between 1914 and 1919.

After four disastrous years Germany had lost the war. Under the Treaty of Versailles it was forced to make a reparations payment in gold-backed Marks, and it was due to lose part of the production of the Ruhr and of the province of Upper Silesia. The Weimar Republic was politically fragile.

But the bourgeois habits were very strong. Ordinary citizens worked at their jobs, sent their children to school and worried about their grades, maneuvered for promotions and rejoiced when they got them, and generally expected things to get better. But the prices that had doubled from 1914 to 1919 doubled again during just five months in 1922. Milk went from 7 Marks per liter to 16; beer from 5.6 to 18. There were complaints about the high cost of living. Professors and civil servants complained of getting squeezed. Factory workers pressed for wage increases. An underground economy developed, aided by a desire to beat the tax collector...

... Sellers held back because the Mark was worth less every day. As prices went up, the amounts of currency demanded were greater, and the German Central Bank responded to the demands. Yet the ruling authorities did not see anything wrong. A leading financial newspaper said that the amounts of money in circulation were not excessively high. Dr. Rudolf Havenstein, the president of the Reichsbank (equivalent to the Federal Reserve) told an economics professor that he needed a new suit but wasn't going to buy one until prices came down.

Why did the German government not act to halt the inflation? It was a shaky, fragile government, especially after the assassination. The vengeful French sent their army into the Ruhr to enforce their demands for reparations, and the Germans were powerless to resist. More than inflation, the Germans feared unemployment. In 1919 Communists had tried to take over, and severe unemployment might give the Communists another chance. The great German industrial combines -- Krupp, Thyssen, Farben, Stinnes -- condoned the inflation and survived it well. A cheaper Mark, they reasoned, would make German goods cheap and easy to export, and they needed the export earnings to buy raw materials abroad. Inflation kept everyone working.

So the printing presses ran, and once they began to run, they were hard to stop. The price increases began to be dizzying. Menus in cafes could not be revised quickly enough. A student at Freiburg University ordered a cup of coffee at a cafe. The price on the menu was 5,000 Marks. He had two cups. When the bill came, it was for 14,000 Marks. "If you want to save money," he was told, "and you want two cups of coffee, you should order them both at the same time."

The presses of the Reichsbank could not keep up though they ran through the night. Individual cities and states began to issue their own money. Dr. Havenstein, the president of the Reichsbank, did not get his new suit. A factory worker described payday, which was every day at 11:00 a.m.: "At 11:00 in the morning a siren sounded, and everybody gathered in the factory forecourt, where a five-ton lorry was drawn up loaded brimful with paper money. The chief cashier and his assistants climbed up on top. They read out names and just threw out bundles of notes. As soon as you had caught one you made a dash for the nearest shop and bought just anything that was going." Teachers, paid at 10:00 a.m., brought their money to the playground, where relatives took the bundles and hurried off with them. Banks closed at 11:00 a.m.; the harried clerks went on strike.
Now, long time readers of this blog will note that the state of the American economy is very close to the state that Germany was in. Not exactly the same, but similar.

Inflation, if unchecked, is bad.

Markets are so worried about inflation, economists, traders, and other finance guys live and die by data indicating whether or not inflation is increasing or decreasing.

If it were shown that inflation is increasing to unmanageable levels, then the stock, bond, futures , and commodities markets would of course be adversely impacted, and shake investor confidence that the United States is able to pay its massive multi-trillion dollar debts and liabilities that have been accumulated over decades.

The government would then find that it's "credit card" is over the limit, and would be "canceled", as a matter of speaking. It would then have to make painful decisions in order to finance its defense, security, social, and other liabilities. Not to mention that financing our massive future liabilities would become exponentially difficult.

All of this would mean political suicide for quite a few government types from both political parties. Heads would roll, figuratively (or maybe literally), for the citizens would demand accountability in the face of a very unpopular cocktail of massive tax increases and cutbacks in spending for services. It would get real ugly, real fast.

And if our government is desperate enough to conspire (there's that word again![4]) to falsify inflation data, and to thereby mislead investors and the public at large, then the situation is probably much worse than We the People are able (or willing) to contemplate.

Turning back to the Inflation Reporting Errors post, we find that:

... Since then, we have come across two related discussions that shed additional light on the subject of accurate inflation reporting.

The first is via PIMco's Bill Gross. In his monthly commentary, Gross observes:

"A bigger threat to asset markets however, comes not from slower economic growth in the short-term, but inflationary pressures towards the end of our secular timeframe. Note first of all the increasing influence of non-core food and energy prices in G-7 nations over the past few years as illustrated in Chart 5 for the United States. Since 1967, average differences in headline vs. core inflation have essentially been zero, despite distinct periods of cyclical variation. Now, however, with globalization so dominant and Chinese/Asian appetites for oil, soybeans, and iron ore amongst other commodities so voracious, it’s hard to envision an extended period of lower headline U.S. increases. This may bias more central banks to begin considering headline numbers in their policy decisions like Japan and the ECB do already."

Gross is referring to the Core/Headline spread we referenced Wednesday. Wednesday's graph was a bit complicated, and the chart below makes it far easier to understand the changing relationship between the Core rate of CPI inflation, and the actual Headline CPI:


As you can see, since 2000 the Core has been under-stating inflation for some time now. And, the amount it is off by has widened dramatically. The gap between core and headline is now greater than it was in the early 1980s, and -- hard as it may be to imagine -- we are only slightly off the spread of the terrible 1970s...

There you have it:

Another piece of the puzzle falls into place.

Do yourself a favor and read the rest of the piece. It's very informative, and all the way relative.

And remember... its not about knowing everything, its about knowing where to look to get the answers. The imminent financial collapse will not be forecasted by the Journal.

Don't sleep.


LtRand said...


There is a big problem though with going to gold at this point, and we have an American reference to look upon.

In our colonial times we had fiat paper money, and the colony governments controlled the issuance to match the level of trade so that they wouldn't have inflation. When the crown forced the gold standard on them, the immediate effect was squalor because there was not enough gold available to back the dollars in circulation, and that was a big part of why we went to war. They forced the gold standard on us so that they could use our commerce to reflect a larger economy so their central bank would give them more loans.

We could go to a gold standard, but the only way we could avoid a massive economic collapse from it is to eliminate the deficit, draw in the cash reserves to the bank until we no longer had fractional banking, and then bought gold with the money in the reserves to replace the paper backing.

Yes, a crash is coming, it's how we handle it that will tell if we survive.

Kumogakure said...

Rand, it's hard to say if we as a country are ready for what's coming.

I don't have much in the way of confidence but, I hope I am wrong about that.

I think a mixed commodity backed system, such as gold, silver and platinum, would serve our needs. It would help put a cap on all the money printing that our lovely Fed is engaged in.

I'm a finance guy, so I really don't mind businesses making a profit, or the government borrowing money, cause that's the nature of business.

What I don't like is all the damn irresponsible drunken sailor type spending, on useless wars like Iraq (there I said it!!) and even more useless programs such as VAWA and other feminist pork.

But, we won't do anything to change our ways until its too late, most likely!!


LtRand said...

Let's not forget that our current federal government will spend 9 trillion dollars. By the time the baby boomers are all retired, and before a significant number die, we'll owe 11.1 trillion in just social security a year.

To give these numbers some perspective, our current economy is estimated to be around 11.1 trillion dollars.

On the upside, unless we massively immegrate large numbers of people, there will be more workers leaving the workforce than will be entering it, which is good for the worker who wants wage increases, and another reason why we need to fight off immigration.