Friday, November 4, 2016

Inflation: lies and reality

What is commonly referred to as "inflation" should be the general raise of the price of goods, services and assets.
The American Bureau of Labor Statistics defines inflation as "a process of continuously rising prices or, equivalently, of a continuously falling value of money".
As we already saw, the typical gauge for measuring inflation is the CPI, ie the consumer price index.

Unfortunately, this indicator is, to use an euphemism, biased as a minimum. The government has all the interest to keep this metric as low as possible.

Now, the average citizen may be confused: once we are told that inflation, measured by the CPI, should be as low as possible since it is a kind of hidden tax for the population.
This blog was born to help those people, who are not experts in economics, to understand the world we are living in today, from a different perspective. This blog is aimed at helping the family father, and especially those people questioning about the origin of this epochal change that media continuously refers to as "crisis", those people who had to emigrate from Italy to find better opportunities. I am not an academic, I did not study economics in a college, I am an engineer and I like the fact that I study things with my personal lens. I try to explain complex things in an easy way, focusing on what really matters. So, you won't find "conventional"explanation of what inflation is, how money is created, that you can find in all mainstream media (if it was possible...). I follow my ideas, simple as that, and I document my findings. In any case, this approach let me leave Italy, change job, find a house, etc. and I couldn't have done it had I been attached to my previous "economic"convictions.

Note: we have already seen that the real problem with inflation is "who gets the new money first?" dilemma. Nobody talks about this.
Then,  we are told we are in risk of deflation, ie negative inflation, ie the prices are lower today than one year ago, we are told it is a terrible thing because people don't spend today but will wait for the prices to go down before doing purchases.
Note: The real issue here is the capability of a government to repay its debt, but it is a long discussion that we will cover in another post.
So, we are told that a good inflation is around 2% per year. Why exactly 2%? that's the first mystery.

There are many points here that are incorrect as a minimum. And I think it is worth to spend some words to clarify a bit the whole subject. Today we are going to cover a bit the CPI, to give some hints and clues for a curious family father to investigate further in the topic.

The CPI is a gauge that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. "Weighted" average means that, if we consider the ingredients in the basket, some are more important than others when considering the final average. The CPI indicator is reported periodically by the Bureau of Labor Statistics of a country.

Does the CPI make sense?
This is a one million dollar question. To use the words of Steve Seville, "averaging the prices of a car, a potato and a visit to the dentist makes no more sense than averaging the goods/services themselves. Clearly, a car, a potato and a visit to the dentist cannot be averaged."
In other terms, there are things that cannot be averaged because they are completely different. Nevertheless, they are averaged and end up in the CPI index.

Further to that, just suppose you buy a brand new OLED TV screen. How do you compare prices of a new light TV screen, which has bluetooth, internet connection, different display technology that is completely digital against an old analog, bulky, cathode ray tube? Of course it is not possible. Yet, the magical alchemy of CPI calculation does this job. By means of a mathematical approach called "regression", it is possible to turn the price of a thirty years old cathode ray tube into an equivalent today's price. In this way, technology obsolescence is supposed to be taken into account. 
Instead of a TV screen, you may consider a car. Well, it turns up that today's cars, even with all the accessories that were not available thirty years ago, are still cheaper, even without taking into account complex regression models. This is due to technology deflation, on one hand, and to globalization, on the other, since factories have moved outside the developed countries, to lower the cost of labor.

So, a huge variety to be measured by a single metric! the ubiquitous CPI.
It is not over yet. We have seen that in recent years, the prices of houses, stocks, bonds etc have skyrocketed or have recovered from the bottom of 2009. Yet, inflation is low or even negative. How's that possible?
It is possible because inflation, as we said before, is mainly measured by the CPI, consumer price index, so it does not take into account the price of houses, stocks, bonds and land.
We can all agree that, on average, the most important debt you do in your life is the mortgage to buy a house: so, if a house doubles in price, you need to double the mortgage, so to increase the debt and/or the duration of the mortgage. Yet, despite this, which has a tremendous impact on our lives, inflation, measured through the CPI, is not impacted. 
And the CPI is the most important government statistics since it affects a number of public programs and is used as the basic benchmark to set public policy.

You can imagine that all this mathematical alchemy is, as minimum, questionable.

To recap:
  • The government and the Central Bankers consider the CPI as the most important benchmark to steer decisions on monetary policies, fiscal policies, and public policies.
  • The CPI is completely fictitious, and can be easily manipulated. 
  • The CPI does not consider the price of houses, land, or other assets, like bonds and stocks and life insurance.
Now, you can understand that, following this, the CPI does not come even close to measuring the falling value of money. It simply measures the consumer's spending habits. Even better: what the consumer is supposed to spend for a living on an almost daily basis.
So, a house can increase by 10%, yet the inflation rate, measured by CPI, can turn negative, like -0.1%!

You may question: why the hell is the inflation most important indicator, that is CPI, ignoring the raw cost of houses? For the sake of simplicity, let's not consider the land (which is included in the cost of the house) and the stocks and bonds, since they are by definition investments. But the house?
Statisticians argue that a house is an investment in any case, so it is outside the basket of the cost of living index. So, homes are considered like commodities? Maybe this is true for rich people who buy properties across the globe but generally you buy a house to live in it. You buy the furniture, pay the maintenance etc. I do not think you pay the maintenance on a stock or a bond or a bare terrain.

The bitter reality is that if the government took into account the cost of houses, the inflation index would skyrocket: that would create a huge pressure on policymakers, since it would make evident that wages, which have not kept the pace of normal raising prices in the last 45 years even when measured with the standard CPI, would look ridiculous low.
Plus, the Central Banks would be obliged to raise the interest rates...but that's another story that we will cover in the future.

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