Inflation: Lies, Damned Lies, and Statistics

Inflation is one of the most-misunderstood concepts in our economic vocabulary. Here's why.

 

WASHINGTON August 13, 2012 – It is said that there three kinds of things you can expect from politicians: lies, damned lies, and statistics.

When it comes to talk of “inflation,” all three are employed. They are not ,however, exposed because of either a “great media conspiracy” (possible) or because of a public that’s ignorant of how media liars can manipulate the truth.

There are columns here in Talking Sense that address the lies and statistics, columns like GDP: Lies, Damned Lies, and Statistics. Following this column will be an explanation of the jobless rate (please follow my RSS).

“Inflation” is often taught and widely understood as “a general rise in prices,” and it’s reported as a rise in the Consumer Price Index, or CPI.

Prices of hundreds of consumer products like size large wool sweaters, 21” flat-screen televisions, or 225-70x15 car tires, are collected and crunched by governmental bureaucracy, and then these prices are compared to those in previous periods to determine if the CPI is rising or falling.

The index itself is used to compare over longer periods, and across national borders. Every so often, when the index gets embarrassing, it is re-set to 100.

There are several weaknesses in this approach, and huge problems in the misunderstanding of the underlying math. These cause misinterpretations of the numbers, and hence their misuse.

The CPI can be useful, but only when honestly discussed; and honest discussions cannot take place unless the CPI and its shortcomings as a measure of inflation are understood.

Here’s the good news: the collection of data is fairly consistent.

OK, here’s the rest: value and utility are not considered.

The prices of, say, cell phones are indeed collected; but think how much smarter your phone is today than even five years ago. If the price hasn’t changed, the usefulness and capability certainly have.

Or televisions – ten years ago, a true flat-screen TV was a really expensive proposition; today, I see 40” HD brand-name sets for around $300.

The cell phone pricing shows “no inflation,” but it should show a “value increase” or an effective decline in price. Likewise, televisions.

Not so with new cars, gasoline, food.

Anyway, all these price collections give us the CPI; it is what it is, though this number is manipulated (under the guise of “seasonal” or other corrections).

But inflation is not captured by the CPI. I repeat: Inflation is not captured by the CPI.

Inflation is the growth of the money supply and how this is the only thing that can lead to “a general rise in the price level” will be explained shortly. When the government adds money to our economy, through borrowing or “printing” it, this currency allows those who receive it, to “bid” higher for goods and services.

Those who get the new money first, win – they are able to outbid others, before others have the added cash. So, when new money enters the economy, it usually enters through the usual channels – banks and government contractors; lately, it has also been given to Wall Street.

These institutions and wealthy (well-connected) individuals already have the consumer products they need. What do they do with their new money?

They invest it, bidding up the prices of stocks (as one obvious example). When TARP money hit, stock prices rose.

Likewise, “Quantitative Easing” 1 and 2. When the stock market is rising, people tend to think that recovery is on the way. But stocks are not consumer goods, so the rise in stock prices, fueled by easy money, does not raise the CPI.

Reporters (who are ignorant of economics) then conclude that “we have a recovery without inflation.”

Thus, rampant inflation can undermine our economy, long before the CPI identifies it.

You’re still not convinced that growth in the money supply is inflation, and that “rising prices” are not? OK – I’ll give you an example.

Let’s assume that there is an isolated island, where there is a big population – 100,000. Everything is contained on the island – there is no external communication with anyone outside; the system, flourishing as it is, is not influenced by outside trade or capital or immigration/emigration.

On this island is a limited amount of money – 100 million; the per-capita wealth is one thousand. There are no limits on what people can make or sell, and the islanders spend, on average, their entire thousand in wealth.

Of course, after time, some people will end up with more money, and some will have less; but the total amount of money spent will always be the same. Some items will become trendy, and command higher prices; but these will be bought only when something else’s price declines, or goes completely out of favor. More than 100 million cannot be spent – that’s all there is.

Now, some prices will rise, but only when others fall. Prices of all goods cannot all rise – there is only so much money available. So, the CPI on our island cannot change.

Now, if the island’s central bank decides to lend money (by creating it, as our own banks do), more money can become available. When the recipients of the new money go to market, they can pay higher prices for everything, and the CPI can rise.

But note, and this is key, that the CPI, the “general price level”, cannot rise unless there is additional money, through bankers’ largesse or credit in this example; foreign investment would be another, in the hands of the consumers.

The two things that we need to understand about inflation are:

1) That the act of adding money to the money supply is, by itself, inflation, and

2) That the CPI is too limited to depict inflation, and lags too far behind.

Tim Kern taught economics for fifteen years, and discovered that understanding life is easy; it’s recognizing reality that takes practice. He holds a music degree, and later earned an MBA in finance from Northwestern University. He has lived across the US, and now makes his home in Anderson, Indiana.  

Send Tim Kern a message

 


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Tim Kern

Tim Kern taught economics for fifteen years, and discovered that understanding life is easy; it’s recognizing reality that takes practice. He holds a music degree, and later earned an MBA in finance from Northwestern University. He has lived across the US, and now makes his home in Anderson, Indiana.

Contact Tim Kern

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