Monday, October 25, 2010

How We Measure Inflation

I've been talking a lot about inflation lately.  But if you look at the traditional way we measure inflation, the Consumer Price Index (CPI), we are seeing inflation of 1.1% which isn't very much at all.  But like every number and statistic that you hear, you'll learn far more by looking at the methodology that was used to get that number or statistic.

Ostensibly, the CPI is a measure of consumer prices.  That is, an imaginary shopping cart full of goods from many different sectors of the economy (food, houses, cars, clothing, energy, etc.) is brought to the checkout and the price of all those goods is added up.  Then, one month later, the same imaginary shopping cart full of the same goods is brought to the checkout and the price is added again.  By doing some simple math you can figure out what the rate of inflation or deflation is by comparing the change in the price of your shopping cart's contents.  That seems like a very accurate and reasonable way to measure inflation, right?  I think it does.  And that's how the CPI is currently measured.  That's how the CPI was measured before the 1980's.  You see, modern economists and politicians have found some neat new ways to measure the price of those good in the shopping cart.  Let's take a look, shall we?

Alan Greenspan and Michael Boskin argued that changes to the CPI needed to be made for certain items when they became too expensive.  For instance, if the price of steak rose too high they should quit using steak in the CPI measurements and use hamburger instead.  They reasoned that once steak got to a certain price, the consumer would simply eat hamburger instead.  BAM!  Now inflation isn't as high.  Of course, this only shows the rate of inflation measured in terms of maintaining a lower standard of living.  Inflation stayed low on paper but in real life inflation was higher and living standards decreased.

Some years later there was another change that took place.  In addition to substituting cheaper goods for more expensive goods, the CPI started to use geometric weighting.  This means that when the month-to-month (or year-to-year) prices are calculated, more weight is given to prices that are falling, and less weight is given to prices that are rising.  If the price of bread has gone up 10% in the past month, but the price of milk has gone down 10%, then the official CPI measurement will give more weight to milk prices than bread prices, making the rate of inflation appear to be lower than it otherwise would.

More recently, the politicians and economists in charge have come up with a truly amazing new way to measure the CPI.  It's called hedonics, and it shows that these guys will stop at nothing to make inflation appear to be lower than it actually is.  Hedonics adjusts the price of goods for the increased pleasure the consumer derives from them.  That 20% increase in the price of your washing machine?  Well, that isn't going to be included in the CPI because of all the pleasure you get from pushing the fancy electronic buttons instead of turning the loud clicking wheel thing.  When the price of gas goes up due to federally mandated additives, it doesn't raise the inflation rate because the consumer got so much thrill from breathing the fresh air.

I've read that the real inflation rate (measuring CPI with the methods that were in place before all these changes) could be up to 7 or 8% higher than what the official measurements are.  And the Federal Reserve is making decisions based on a 1.1% inflation rate that they want to raise to about 2%.  But because they use such innovative ways to measure inflation, the real inflation rate will have to go up a lot more than 1% in order to get the official number to go up 1%.  I probably sound like a broken record but to me these are all signs that we're heading for an extremely high(er) rate of inflation.

If you're reading this you have access to the internet.  If you're curious about any of this just use the internet to watch the dollar index and commodity prices to see what inflation is doing.  The value of the dollar has been going down for some time and the price of sugar, cotton, corn, etc. has been going up.  When commodity prices (food) go up, and the value of the dollar goes down, you're seeing inflation.  The changes that I've been seeing in these two areas in recent months are significant.

The other day I was talking with someone about what I've been writing and I was told that I'm painting a really bleak picture.  I couldn't argue with that, but I had to clarify that what I'm describing is still the worst case scenario.  But with every passing day, and with every decision the Fed makes, the worst case scenario is looking more and more like the most likely scenario.

Pssst, that's not good.

Monday, October 11, 2010

WWIII: The Currency War

Believe it or not, we're in the midst of a war right now.  It's not Iraq or Afghanistan.  It's a war waged by the major governments of the world to destroy their own currency.  All across the world countries are enacting policies that devalue their own money.  It's a race to the bottom.  Last week, Brazilian Finance Minister Guido Mantega made headlines when he mentioned that a worldwide currency war was brewing, and the winner would be the nation with the weakest currency.

In a normal war countries try to kill the enemy.  In a currency war the countries point their guns at their own citizens and kill them with a currency that loses its purchasing power.  The country that can make its money worth the least is the country that wins the war.  The bad news is that the winner of this war will experience a Pyrrhic victory. The worse news is that America is poised to win this war.

Why on Earth would a country want to devalue its own currency?  That is such an easy question to ask because the premise makes absolutely no sense.  But the answer is actually quite complicated.  That's because modern economists have figured out a way to make it seem like a weaker currency is advantageous to a nation.  Of course, this is complete nonsense.  A weak currency is the result of bad policies that politicians love.  And if an economist can make it seem as though the terrible results of bad policies are actually desirable, well, that economist will probably get a job in the White House on the President's economic staff.  An economist who states otherwise (and speaks in terms of truth and common sense) isn't allowed in that elite club.

There are two reasons why a weaker currency would be desirable.  First, it helps the nation export more goods.  When your money isn't worth very much, it makes the goods you produce considerably cheaper to purchase.  When the price of goods is low, the amount of exports goes up.  Second, and this is related to the first point in a way, a weak currency leads to more jobs.  When the dollars that you pay workers in is worth less, it's more affordable to hire workers and the economy can create more jobs.  Politicians love this.  Debase the currency, raise exports, create jobs, get elected again.  On paper, everything works out perfectly.

Now, you might be thinking that this is what we need right now.  If a weaker dollar will create jobs then a weaker dollar we need.  But let me ask you something.  What's so great about a job?  There are very few people who work because they love labor so much.  Everyone in Soviet Russia had a job.  Every slave in early America had a job.  Seriously, the unemployment rate for black people in America during slavery was basically 0%.  There is nothing great about having a job.  The reason jobs are desirable is because having a job is a means to an end.  You earn money at your job and can use that money to buy stuff you want or need.  But by making that money worth less, which is what happens in a currency war, the people with jobs lose the ability to buy stuff with the money they earn.  Selling goods and having jobs become a means unto themselves and little attention is given to the fact that there are obvious negative effects of currency devaluation: diminished purchasing power and lower living standards.  Individuals see jobs as a means to an end.  Governments see jobs as an end in and of itself, and a devalued currency is the means to that end.

Way back in the 19th century, before economic models developed their current levels of sophistication, the goal of a government's economic policy was to bring prosperity to its citizens.  In other words, they tried to raise the general level of material comfort, while at the same time reducing the amount of toil and work needed to reach that end.  Unfortunately, due to the blather spouted by modern economists, success is no longer measured in those terms.  A country's currency used to be viewed much like a company's stock price.  The reliability, competitiveness, and growth of a national economy usually translated into a strong currency. This system made sense and it worked.

Countries that offered the most fertile soil for investment capital, or that made products other countries wanted, would attract funds from abroad. Demand for the currency of these “blue chip” countries (which was needed to invest or buy locally) would inevitably push up the value of the currency. And so, much as shareholders of successful companies are rewarded by higher stock prices, citizens of successful countries were rewarded with stronger currencies, with which they could buy more goods and services both domestically and internationally, raising their living standards.

But all that has changed in recent years. With a strategy that seems to be taken from the playbook of Sam Walton, governments now look to gain a competitive edge by lowering the cost of their exports. To do this, they have adopted a beggar thyself (as opposed to beggar thy neighbor) policy of habitual currency debasement. Although such a move may benefit those who buy the products, it is a burden to the country’s own workers who, like Wal-Mart employees, have to get by on lower wages. While the markets like a low-cost provider, this is not a niche that everyone can, or should, fill. Some will compete only on price, but more successful ventures will compete on quality and innovation. For every Kia there is a Mercedes Benz.  Nearly every country on Earth is attempting to compete by lowering the price of their goods and no thought is given to producing higher quality goods or developing innovative production techniques.

When a government debases its currency in order to gain sales overseas, the nation earns less for the goods that it exports. As a result, its comparative advantage is ruined, and its citizens consume less as a result. In other words, as a nation’s currency declines, its citizens are forced to work harder for less.

If a department store decided to have a sale in which all of its merchandise were marked down 50%, it will surely sell a lot more stuff.  However, it would earn a lot less than if it had been able to sell its goods without marking them down.  This is how currency debasement works.  Similarly, one way for the unemployed to get work is to accept lower wages.  Workers will sell a lot more of their labor if they accept 50% pay cuts.  But are they better off as a result? Relative to being unemployed, the answer is yes, but they would be much better off being employed at full pay.

As I pointed out earlier, the fact that America holds the world's reserve currency makes it easier for us to have a 50% off sale.  It also makes it easier for politicians to print money and inflate the currency at ridiculous levels.  Politicians love easy solutions so I'm convinced that extremely high inflation is on our horizon.  America is going to win the race to the bottom.  And eventually we're all going to be casualties of war.

Wednesday, October 6, 2010

Kittens, Bar Rafaeli and football. Oh yeah, the dollar collapse that will destroy our economy too, I guess...

Since I started writing this blog thing I've gotten some positive response from people who tell me how much they enjoy it.  So I want to take the time and say thanks to both of you that read my ramblings.  The other people who have brought it up to me have expressed concerns, most notably that politics/economics is much too complicated and boring to waste their time reading about, especially during football season.  Well, I want everyone to know that I've heard your criticism and I am going to take some steps to make these posts more enjoyable to a larger audience.  I'm not a good enough writer to make these topics interesting and fun, but I do know how to link to pictures and other websites.  So as you're reading this just know that there will be some extremely uncomplicated and entertaining links scattered about.

I know reading that paragraph was probably difficult, so here, take some time to enjoy this picture of Israeli supermodel Bar Rafaeli

Now, onto the topic at hand.

I wrote last time about how the trade deficit coupled with the fact that our dollar is the reserve currency of the world has lead to a huge number of dollars that we printed, sent overseas and because they're not coming back we see no inflation.  I'm going to try to expand on this inflation idea but focus more on our domestic policy this time.  I think that this is the most important issue facing our country right now and it's not going to be very long before we start seeing a currency in shambles.  I'll try to explain why I feel this is a very real possibility.

Right after I show you this clever Calvin & Hobbes cartoon strip!

 Since the recession started, the Fed has increased the money supply by $2 trillion and lowered the interest rates to 0%, which is what they call "Quantitative Easing".  The Fed recently hinted that they were going to do another round of Quantitative Easing.  In an effort to prop up an economy that is trying to crumble, the Fed is printing money and giving it to banks at historically low interest rates.  This is being done in an attempt to give banks incentives to lend to businesses and consumers.  The reason we're not seeing the inflation that should come with an extra $2 trillion is that the banks aren't lending the vast majority of that money.  The dollars are just sitting in the banks, and since they're not reaching the economy we don't see the inflation.

WOW!  Have you guys seen the 2010 Lamborghini?!

Now these dollars aren't going to sit in the banks forever.  At some point we'll start to inflate another bubble and it'll send false signals through the economy and banks will feel like it's safe to lend again.  Or maybe the Fed will take interest rates from the current 0% into negative territory to further incentivise banks to get the money into the economy.  Once enough of those dollars enters the economy, we'll start to see real signs of inflation.  This is where the Fed will have to time their actions almost perfectly in order to keep inflation from getting out of hand.  What can they do to keep inflation under control?  Well, they have to suck back those dollars that they pumped into the economy.  This is done by raising interest rates.  Banks don't lend as much when rates are high, the money starts flowing back to the Fed and they remove the money from the economy.  The tricky part is that the Fed has to time this out perfectly.  Raise rates too soon and you lose any positive effect of pumping those dollars to banks.  Raise rates too late and you'll be chasing inflation and it'll get out of control.

This is essentially what we did in the 1970's.  Back then we had inflation at about 12% and a weak economy.  In order to fix the mess, the Fed had to raise interest rates to 20% for an extended period of time to get inflation under control.  That was a difficult move because it kept people from borrowing money which in turn stalled economic activity.  But back then we were the world's largest creditor nation.  Today we're the worlds largest debtor nation.  This brings with it a whole host of problems, the most notable one is the damage that is done once interest rates start to rise.

Remember this hilarious scene from the hit movie Armageddon?  HAHA, that Affleck is so lovable and goofy.

Ok, so let's say for the sake of argument that the banks start lending and the dollars start to hit the economy and inflation starts to go up more than the Fed is comfortable with.  Fed chairman Ben Bernanke said that he would combat the inflation with higher interest rates, as is historically done.  The problem with that is that we have a lot of debt.  And a lot of that debt is financed with short term treasury bills because the interest rate is so low.  When the Fed raises interest rates, and those loans are reset, the government's payments on the interest of those loans is going to go through the roof.  We just did the same thing when people bought homes with adjustable rate mortgages.  When the rates went up, people suddenly couldn't afford their house.  Right now we pay about $200 billion every year on interest alone.  That's because the interest we pay is at 0.3%  If we see interest rates go up to even a modest 4 or 5%, we're going to be paying an astronomical amount of money just on interest, not to mention the principle.  What if the Fed has to raise interest rates to 10 or 15% to combat inflation?  Remember, with all the Quantitative Easing that the Fed did, they DOUBLED our money supply.  In the 1970's they added less than 15% to the money supply and got 12% inflation and 20% interest rates.  If you passed 3rd grade math you can see what a mess this is.

Hey, have you seen this adorable clip of cats running in a wheel?  How cute!

The bottom line is that there are really only 2 options for the government to take when it comes to the debt we owe to foreign nations.  We can either default on the loans and not pay them back, or we can inflate our way out of it.  Let's take a look at each option, shall we?

...After this awesome picture of fireworks.

Let's say our fearless leaders (whoever they are when this mess unfolds) default on the debt.  They tell China and Japan "Sorry guys, we're not paying this.  We cannot afford it at all and we're gonna screw you over".  Now this would actually be the better long term option.  It's extremely difficult to do in a political sense though.  First, nobody likes to tell their lenders that they aren't paying back their loans.  Second, it makes the nation look week and good luck trying to get those countries to cooperate with us on anything.  Third, and most importantly for America, it means we lose our premium credit rating and are forced to pay MUCH higher interest on any money we borrow.  Since we're planning on running deficits measured in trillions of dollars for at least the next decade, and since so many Americans love the perks of deficit spending, it would be political suicide to default on the loans and be forced to balance the budget overnight.  That's the worst part about this course of action (from a political standpoint anyway), it happens very quickly and whoever makes that tough decision will not be able to pass the blame on to someone else.

So the easier course of action is to inflate the currency, because it happens relatively slow and allows politicians to pass the blame.  It's also, of course, the worst option since it essentially brings us to the same destination in a far more destructive way.  Instead of raising interest rates to sufficient levels in order to keep inflation under control, we'll simply keep them low to protect our debts and let the value of the money decline.  This also helps us pay our debts because we can borrow $1 trillion now, then make that money not worth as much, and when we pay it back we're paying far less than we borrowed in terms of what those 1 trillion dollars are actually worth.

The problem is that, with inflation, the price of everything we buy goes up.  Pretty soon we're paying more for the necessities like food and clothing and spending less on the products that are keeping our economy viable (I'm using that word very loosely).  70% of our economy is based on consumer spending.  Once we stop consuming because of inflation, the government will try to prop up the consumer with stimulus packages and business bailouts and more deficit spending (printing and borrowing money) all in an attempt to keep us spending money on stuff.  It's exactly what the previous administration did and what the current one is still doing.  Obama likes to remind us that it was the failed policies of Bush that got us into this mess.  He's absolutely right.  The problem is that he's repeating those mistakes and at a much higher level.  Keep Americans buying for as long as possible.  Keep the country drunk on credit and debt and convince us that this phony economy pipe dream is real.  Assure us that we can have it all forever and we can borrow our way to prosperity.  Oh, and pray that when the system eventually crumbles you're out of office and the next guy gets all the blame.  Bush nearly made it.  I don't think Obama will get that close, especially if he picks up a second term.

I'm sorry, I went a long time there without taking a much needed fun break.  I bet that was painful.  Hopefully not as painful as this though

But anyway, once our lenders see our currency depreciate, there is no way they'll want to lend to us anymore without higher interest on the loans.  It will become increasingly difficult to finance our debt.  But again, instead of doing the wise and prudent thing (stop running huge budget deficits because credit dried up) that would lead to political backlash (voters complaining about their government checks/programs going away), our fearless leaders at the time, whoever they might be, will decide to finance our debt by simply printing the money.  You want your social security check?  Sure, we'll just print the dollars.  The retired federal employee wants his nice pension and benefits package?  Sure, we'll just print the dollars.  You're out of work and want the unemployment benefits for another year?  Sure, we'll just print the dollars.

Eventually this set of policies can lead to an extremely high rate of inflation that becomes harder and harder to fix.  But fear not America, because we'll have fearless politicians to fix (make worse) the problem (that they created). When prices start to rise our fearless leaders will find someone else to blame, probably the greedy business owners who are only raising prices to pad their huge bank accounts.  So we'll get price controls on things like food and clothing, but that will only lead to shortages of food and clothing.  We'll get wage controls, but that will only lead to higher unemployment.  Every solution to a problem will create another problem that cowardly politicians will combat with a terrible solution that creates more problems.

This kitty does the YMCA.  Isn't that precious?

And all the while, the countries over in Asia will be going through a transformation of their own.  They currently think that they need America to consume their products.  That's why they keep lending to America long after it became obvious that they wouldn't ever be paid back.  But after Americans stop consuming their goods, they could let the value of their currency gain in value.  Suddenly the people who worked hard to make those goods can afford to consume those goods.  Their standard of living will go up as the standard of living in America goes down.  The world will realize that humans have an unlimited amount of demand for products that make their life better.  Americans don't have a monopoly on that.  When our ability to monetize that demand goes away, there will certainly be humans on this planet who will fill that void.

One more of Bar Rafaeli.  Because seriously, that woman is simply gorgeous.