Tuesday, May 13, 2008

Kevin Phillips, Bad Money and the Consumer Price Index

It's always a real ego boost to be quoted twice in a bestselling book. Kevin Phillips did me the honor by noting my revulsion over the Labor Department's Consumer Price Index.

I'll be straight with you: the CPI goes beyond the government's expedient fabrications on the economic conditions of everyday Americans. The index is a bald-faced whopper on a scale of Pecos Bill and Paul Bunyan. It's so mythological in scope that just about any Disney movie is
much more credible.

The CPI grossly understates the largest expense for most Americans: home ownership costs. Instead the blind stat-lovers at the Bureau of Labor Statistics embrace a goofy measure called "Owner Equivalent Rent," that is, what would your home cost if you rented it out? It gets better. The government uses the CPI for the basis of cost-of-living increases for Social Security, so older folks on fixed incomes are getting hosed. What about rising property taxes, home maintenance or even adjustable-rate mortgages? Taken at look at your utility bills lately? The government doesn't want to know about it. Its "core" CPI even strips out food and energy, which, as you know are rising at double-digit clips with no end in sight.

Although the government can certainly cap what it pays seniors getting Social Security, the monthly expenses of the elderly keep going up. Did you know that Medicare only covers about 40 percent of out-of-pocket medical care for those over 65? There are large gaps in coverage, not to mention dental care and a host of things that aren't covered. And with fewer and fewer companies paying defined-benefit pensions -- it's a 401k world now in W's "ownership society -- it's unlikely that the CPI measures anything important about the true cost of living.

So when Kevin Phillips noted my ire over this phony stat, I was happy to see it in his bestselling Bad Money, an indictment of the financial system and how debt is this huge anchor weighing the whole system down. Will it collapse under the huge burden of personal, corporate and government debt? We know that the Medicare and Social Security system have run up trillions in unfunded liabilities, that is, nobody has socked away the money to cover future payments.

We also have no way of knowing how derivatives, or what Warren Buffet calls "financial weapons of mass destruction" are poised to wreck future havoc with the thousands of debt securities the government and corporate sector have floated in the last decade.

While Phillips's book sounded the alarm on not only the rising level of debt on every level, it highlighted the inability of elected government officials to act on this unfolding fiscal nightmare.

To me, one of the greatest fiscal lies foisted on the American people is the pretension that anything has been done to cover the future liabilities for Medicare and medical expenses in general. The Medicare program alone may be bust within 10 years unless some major program cuts or tax increases are put in place. No candidate dares to step within 10 feet of this issue, Ironically, a single-payer national health program, wouldn't even begin to fix this problem.

On the personal finance front, it's clear that people are leveraged to the hilt and tapped their home equity just to pay everyday bills. What's left over is financed through credit cards. Want an explanation of the housing bust? People had to borrow more than ever to buy homes, so Wall Street stepped in with even more flexible credit terms called option, or interest-only adjustable mortgages. Even less well-heeled Americans with no credit rating to speak of got a piece of this action. The 21st Century American Dream: Easy terms, no downpayment, pay later -- or never.

If the government wanted to do something useful, it should publish a consumer retrograde index. This gauge would measure how much people are falling behind. It's simple: Subtract personal income growth (or declines) from the increase in household expenses. I want to see some negative numbers out there, because after inflation and taxes, most families are in the hole these days. Wage growth hasn't kept pace with the cost of living in this century.

With home values dropping -- 75% of home prices across the country dropped this year -- there's no home equity to prop up falling real wages. The stock market is just about where it was before the credit crunch. If we're heading into a recession or facing stagflation (stagnant economic growth with inflation), forget about Wall Street bailing anyone out. They have problems of their own these days.

This whole economic drama is called falling behind. My index would also account for how much more employees have to pay to cover lost benefits. In an ownership society, corporate America has phased out the guaranteed defined benefit pension for the unguaranteed 401(k). You fund it. You pay the expenses. You learn about investing. If you come up short at 65, tough luck.

Now corporate chieftains and MBAs who are walking away with record pay packages are whittling away at employer-provided health benefits. Some 6 million lost health care coverage from 2000 to 2007. Certainly this raises the cost of living for these families in some measurable way. This is my last shout-out for now on what's happening with the Consumer Price Index. Make it honest or make it fly away like the dodo.

Here's Kevin's Huffington Post piece, headlined "Washington's Great No Inflation Hoax" (May 8)

Billionaire California bond manager Bill Gross calls it "a haute con job." Bloomberg News columnist John Wasik describes it as "a testament to the art of economic spin." More and more shoppers and consumer simply disbelieve it.

The subject of this scorn is the federal government's vaunted Consumer Price Index or CPI. Americans are now beginning to understand that this indicator has its own share of gimmicks not unlike a sub-prime mortgage or the six pages of fine print that accompanies your credit card agreement.

Some of these CPI ingredients -- product substitution weightings, "hedonics" (price reductions for added product quality or satisfaction), and use of owner's equivalent rent (instead of home ownership costs) -- have a comic aspect suitable to mockery by Bill Maher, Stephen Colbert or Jon Stewart. But in a larger sense, they're not remotely funny. That's because the federal minimalization and misrepresentation of inflation, pursued statistically over the last 25 years, has been the main buttress of Washington's over-favorable and self-serving portraiture of the U.S. economy.

Distortions aplenty have followed. Some of the most pernicious include the shortchanging of federal pension and Social Security obligations and cost of living increases, a parallel shortchanging of cost-of-living increases in wage contracts tied to the federal CPI, the suppression of equitable interest payments on bank accounts and certificates of deposit, and the camouflaging of weak U.S. economic growth through inadequate adjustments for inflation. The benefits to the executive branch in Washington jump out -- huge annual federal savings on Social Security and pension outlays, as well as on the amount of interest paid on the federal government's multi-trillion-dollar debt. Some $250 billion a year could be involved.

If many individuals are losers, many businesses and financial institutions have been winners. Minimal cost-of-living increases favor corporations, while low interest rates make money cheaper to the financial sector. In particular, the gargantuan $10 trillion increase in financial-sector debt since 1994 could become unmanageable if mounting inflation forced borrowing costs up to 8% or 9%. And it is axiomatic regarding equities that when rates rise in the bond market, that competition usually undercuts stock market values.

In short, there have been three big gainers from understatement of U.S. inflation: the federal government, wage-paying businesses and the institutions and markets of the swollen U.S. financial sector. But skeptics have a weighty counter: Okay, it's easy to understand how they all might profit from understating inflation. But if the understatement is patently false, how can they hope to get away with it?

In fact, the belief by many conservative U.S. economists that inflation is under control, despite global indications to the contrary (including soaring commodity and energy prices), has a major ideological component -- their fidelity to monetarist economic principles (that only money supply expansion can create inflation) and to the Efficient Markets Hypothesis (that markets process all available information, so that if inflation were serious, markets would have reacted already). As late as January, monetarists on the Federal Reserve Board, notably Chairman Ben Bernanke and colleague Frederic Mishkin, believed in the new-version CPI and argued that U.S. inflationary expectations were safely "anchored."

Financial economists and money managers generally agree. A late April survey of 120 U.S. institutional money managers by Barron's, the financial weekly, found that on average, they predicted a CPI inflation rate of 2.72% in December 2008 and just 2.79% in December 2009. Elsewhere in the world, central bankers and politicians are worrying about another wave of commodity inflation akin to that in the 1970s, but U.S. money managers take comfort in the Efficient Market Hypothesis and in the wisdom and sanctity of the CPI.

Critics, by contrast, smell a potential disaster. Oil is up over 80 percent in the last twelve months. The New York Times' consumer reporter, W.P. Dunleavy, wrote on May 3 that his own groceries now cost $587 a month, up from $400 a year earlier. That's a 40 percent increase. Reports in the financial press make frequent reference to foreign investors who distrust the U.S. dollar because they calculate true U.S. inflation at 6% to 9% including food and energy.

California economist John Williams, who runs an organization called Shadow Statistics, contends that if Washington still used the CPI measurements applied back in the 1970s, inflation would be in the 10 percent range. My own analysis, set out in much more detail in an article in the May issue of Harper's, comports with that of the cynical foreign investors.

Therein lies the danger. If the current inflation rate is really 6-9 percent instead of the 2-3 percent claimed by government and most U.S. money managers, then Washington's official estimates that the economy still grew at a rate of some 0.6 percent in the first quarter of 2008 become nonsense. Subtracting a 6-9 percent inflation rate from nominal GDP growth would identify an economy that was deteriorating and shrinking, not growing. Concerned foreign dollar-holders would become even more concerned.

In theory, a vigilant Congress might want to hold hearings, but in practice I suspect not. Democratic presidents (notably Bill Clinton) have been involved in the numbers game along with Republican administrations. Neither party has clean hands. Far more likely that any serious investigation will be mounted clandestinely by central banks or sovereign wealth funds in places like China, Singapore and Saudi Arabia as part of their ongoing study of just how much longer they can continue to support a deteriorating U.S. dollar. It is not a happy prospect.

Kevin Phillips's new book Bad Money: Reckless Finance, Failed Politics and the Global Crisis of American Capitalism was published by Viking in April. His article on untrustworthy government statistics ("Numbers Racket") appears in the May issue of Harper's.

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