Inflation Part 1: How the Government Lies About Inflation

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Inflation Part 1: How the Government Lies About InflationOfficially, inflation today is calculated about 4%. Unofficially, it is over 7%. Since 1997 the government Consumer Price Index (CPI) has manipulated the raw data and significantly underreported inflation.

Recently I watched the 1997 movie “Conspiracy Theory” starring Mel Gibson and Julia Roberts. Before the opening credits have finished rolling, we understand that Gibson’s character is a crackpot cab driver who sees conspiracies everywhere. But our perception changes by the end of the film when we realize for ourselves that some of his theories are true.

For years I’ve hesitated writing about the CPI, computed by the Bureau of Labor Statistics, for fear of being compared with a paranoid character like the one in “Conspiracy Theory.” The message that the government lies to us about inflation and, as a result, quietly confiscates hundreds of billions of dollars from its citizens isn’t the easiest message to swallow. It only goes down when accompanied by a healthy drought of political cynicism.

What’s changed over the past year, however, is that we are closer to the end of the movie. It is clearer now not only that inflation is running rampant but also that the government’s numbers are still ridiculously low. More Americans have come to mistrust official inflation statistics, and therefore they are ready to understand how and why the government skews these numbers and to learn how they can protect their family’s savings.

Take 2007 as an example. Bread price rose 7.4%, gasoline 8.2%, health insurance 10.1%, whole milk 13.1%, eggs 29.2%, but according to the CPI, somehow inflation was only calculated as 4.1%. This year to date we have seen an even sharper rise, which still has barely affected the official numbers.

In 1975 programs such as government pensions, Medicare and Social Security were indexed to inflation. With rising inflation in the early 1990s, public officials realized that entitlement programs made government deficits impossible to control. Politically it was just too difficult to cut spending to this program. It was much easier simply to lower their cost-of-living adjustments.

So a commission of five economists in 1996 called The Boskin Commission studied the CPI and issued a report stating that the index overstated inflation by at least 1.1%. Lower CPI adjustments would not only save money in entitlement programs but also raise tax rates mostly among the middle class. Tax brackets, personal exemptions and the standard deduction are all indexed for inflation. Lowering these adjustments has the effect of increasing the tax paid, with the greatest impact on middle-class taxpayers.

The argument that the CPI was overreported went something like this: In 1970 a mid-priced car cost about $3,500. Today, in 2008, the same size car costs about $25,000. After adjusting for inflation using official CPI data, today’s car costs $4,515 in 1970 dollars.

It certainly looks like inflation has been significantly underreported, even though the government argues the exact opposite. In their 1996 study, they suggested that although it looks like today’s cars are more expensive even in inflation-adjusted dollars and that CPI has been underreported, in fact it is the opposite. They claimed that today’s cars are simply better built.

According to their logic, what we called a car in 1970 doesn’t even qualify to be called a car today. It wasn’t fuel efficient. It had no airbags, no power windows, no power door locks, no heated seats, no tilted steering wheel and no CD player.

The government has decided that the enjoyment you get from all of these extra features is why a car costs more today. Thus you are buying a better model than you did in 1970 and therefore it should cost more. The extra pleasure you get from the car should be measured as your choice, not as inflation.

You can see the problems with these government assumptions. You still need a car today. Apparently, you can’t buy what we used to call a car in 1970. A combination of government mandates and changes in market preference have added features. Rather than being able to take advantage of these improvements simply because you are living in the 21st century, these improvements have diminished the value of your currency.

The official term for this type of adjustment is a “hedonic deprecator.” If the computers available this year are twice as fast, then the government counts that as 50% deflation. You are getting twice the hedonism for the same dollar, so only half the price is reported in the price indexes. It evidently doesn’t matter that you paid the same price. And it doesn’t matter that a computer at the old speed won’t run any of the new software.

Hedonic adjustments are a way to discount any improvements in productivity. Under the old method, when a reserved Federal Reserve kept inflation in check, productivity improvements resulted in every dollar of your paycheck buying more. Now, an unreserved Federal Reserve deflates the value of every dollar. By counting the bonuses from increased productivity, the government does not need to report the real inflation it is causing.

Not everything is more expensive. Clothes cost less, thanks to continued globalization. And communications costs less too, along with many other electronic gadgets. However even these items are used against consumers. In a concept called “creative substitution,” the government CPI numbers did not count electronics when they were expensive but now counts the drop in their price as anti-inflationary.

The government’s argument is that very few people owned a calculator when it cost $100. But now that the same calculator can be purchased for $5 and everyone owns one, it should be counted as deflationary. According to this mindset, the fact that your calculator and cell phone each costs $100 less should more than make up for the fact you can’t afford to buy basic foodstuffs or drive your car.

With food, the government adjustments are a little more imaginative. They assume if the price of beef goes up, you will eat less beef and more chicken. If chicken goes up, you will choose pork. And if pork goes up, you will eat more tofu. They assume that when the price of something goes up, some people creatively substitute something less expensive.

Lacking any standard for a U.S. dollar, we can make two observations: your currency has been devalued, and this devaluing is not reported as inflation. Standard of living improvements due to technological advancements have been withheld from those who are on fixed incomes and those who keep their wealth in dollar-denominated investments.

It was none other than former Federal Reserve chairman Alan Greenspan who in 1966 wrote, “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”

Unreported runaway inflation has made dollars unappealing to hold. This is good for our trade deficit because those outside the United States now want to trade dollars of diminishing value for real goods and services, but it could have detrimental effects on our country and its citizens. Next week we will describe those effects and how to protect yourself against them.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.