Inflation Part 2: The Results of Underreporting Inflation

The following is a guest post from Marotta Asset Management. For more on the issue of inflation, see my post titled Inflation and Its Impact on Retirement.

Officially, inflation today is about 4%. Unofficially, it is over 7%. Inflation at this rate causes serious harm to our nation's economy and its citizens.

Since 1997 the Consumer Price Index (CPI) has manipulated the raw data and significantly underreported inflation. This tactic has saved the government hundreds of billions of dollars. Entitlement program recipients find their benefits reduced every year. And middle-class taxpayers are pushed automatically into ever-higher tax brackets.

Instituted by the Clinton administration and willingly continued by the Bush administration, this hidden tax burden transcends the political ideology of conservative and liberal. It threatens the idea of limited government.

As economist Milton Friedman said, "Inflation is the one form of taxation that can be imposed without legislation." John Maynard Keynes agreed. He commented, "The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens." And none other than Vladimir Lenin wrote, "The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation."

Lenin may have intended to grind just the upper class. But in America, everyone ends up as grist for the mill. Average Social Security recipients, that is, retirees, are crushed the most. Technological advances are factored out of Social Security cost-of-living adjustments. Seniors are left to live Amish lives in a digital age.

Productivity and technological advances should result in dollars that are capable of buying more each year. If inflation was being reported accurately, simply putting dollars in the bank would result in a 3% boost in purchasing power. These technological advances are the fruits of capitalism and innovation as businesses develop better products and services. Why should the government deny people the advantages of business innovation by deficit spending and increasing the money supply?

In fact, the CPI is deceptively labeled. The name takes something that government has done to confiscate capital wealth and blames it on businesses: rising consumer prices. But businesses aren't at fault. If the CPI was accurately named, we would call it "Capital Piracy by Inflation."

Instead of seeing their money grow in value, people with dollars in the bank experience the equivalent of an extra 3% tax on their savings. People on fixed incomes such as Social Security experience the equivalent of a 3% reduction in their benefit payments. Like any compounded taxation, the cumulative effect over the past decade has taken its toll. The lifestyle of millions of the elderly has suffered as a consequence.

Middle-class workers aren't exempt either. The alternative minimum tax (AMT), established in 1970, is not even indexed to official inflation. So middle-class taxpayers are pushed higher and higher into a tax intended for the ultra rich. The AMT punishes taxpayers for having children or living in a state with high taxes. Thus being hit with the AMT turns many of the tried-and-true rules of thumb on taxes upside down. Ironically, many of the wealthiest taxpayers are now avoiding AMT penalties entirely. Those with large incomes pay enough tax to avoid the AMT while the middle class is penalized.

There's another concern too. Underreported inflation also masks the current recession. Official first-quarter real gross domestic product (GDP) growth was 0.9%. Current reports suggest that annual economic growth for 2008 will be 2.4%. But if official inflation is at 4% and actual inflation is over 7%, then real economic growth is 3% less than reported. That means growth for 2008 isn't 2.4% but rather -0.6%. If it feels like a recession, don't let official government statistics fool you.

During inflationary periods, finding capital is challenging. No one wants to loan expensive dollars today only to be reimbursed with dollars that are worth less in the future. This situation also makes it difficult for companies to capitalize their businesses. Why risk valuable dollars today to create and expand production when inflation devalues the rewards significantly? So of course businesses are not investing. First-quarter fixed investments were down 7.8%.

We risk a business environment similar to the 1970s. Inflation then caused declining price-to-earnings ratios and hindered small business capitalization. Small businesses are responsible for the majority of GDP and job growth. Inflation slows the economy and increases unemployment. Drastic steps by the Reagan administration were necessary to deal with the stagflation of the 1970s and put the economy back on a secure footing. Our current malaise may require some equally bitter measures.

Historically, people worldwide counted on the U.S. dollar holding its value. We sometimes forget that a stable currency is not a given in every country. In the past, people outside the United States were willing to trade their goods and services for nothing more than our currency's safe store of value. The result has been a trade deficit where our biggest export has been U.S. dollars. About 60% of all U.S. dollars today circulate outside the United States.

But global confidence in the dollar has been shaken recently. Now foreign markets are not committed to holding dollars. They would rather trade those dollars for some of our real goods and services. All those dollars coming home to roost may be good for our trade deficit. But it only exacerbates the problem of too many dollars in this country chasing too few goods and services.

When we have no reliable way to measure the purchasing power of the U.S. dollar, all statistics calculated in our currency become suspect. How can economists or accountants measure anything accurately when their ruler is made of rubber? And if statistics aren't measurable, then business forecasting is impossible.

All of these are serious public policy concerns. But they don't have to block your personal financial goals. Despite inflation rates that are higher than reported, you can still protect your investments from being ravaged. In the final part of this series, we will describe practical ways you can hedge against excessive and unreported inflation and secure and guard a comfortable retirement.

Comments

[fathersez]

Many Governments seem to like understating inflation rates. maybe it looks better on their report cards.

I have not looked at this from the view point of subtle taxation. Pretty devious it seems.

[aaktx]

I think the govt is going to underreport inflation so TIPS will not pay well.

[Lord]

I think a lot of this is the failure of our terminology. All the discussion of whether we are in recession or not, for example, when what is important to people is growth per capita. Since that is already negative, people are less well off even if we aren't in recession. I don't doubt inflation is lower than the 70s because pay hasn't increased, but that doesn't make things easier, in fact it makes day to day living tougher since cost increases can't be made up. What we measure has become less relevant to what we experience.

[Lord]

The other effect is how these are distributed. Previously luxury goods increased in price with the increase in income among the upper 1%. Often these are investments rather than consumption and don't even count as inflation. Now it is commodities and necessities, so the median consumer feels the change much more acutely. Many probably experience much higher rates as these form much higher percentages of their budgets.

[LotharBot]

Would be a good argument, were it not based on the false conclusion from the previous article that inflation is 7% rather than 4%. FMF, you should link to the rebuttal so people can get the whole picture.

[Matt]

If you find this to be credible, then I don't find you to be credible. I'm unsubscribing my RSS feed.

[Noah]

I'm sure you'll be missed. But for the rest of us, why don't the naysayers post some links or data on why this line of reasoning is so flawed?

[Jim]

Noah, the main gripe has to do with the 7% inflation rate that the Marotta folks appear to be pulling out of the air.

[Jennifer Lynn]

The argument of understated inflation may be being pulled from Shadow Government Statistics (http://www.shadowstats.com/) by economist John Williams. I've seen Mr. Williams' material before on CNN and in the NYTimes, which led me to his website a few weeks ago.

He's quite bearish on the American economy and has written extensive series on what he refers to as misleading 'shadow stats' of the government, all of which are available online for public viewing.

Consumer Price Index:
http://www.shadowstats.com/article/56

[Stephen]

Eh whatever, we're still no Zimbabwe

http://www.boston.com/news/world/africa/articles/2008/05/21/zimbabwe_inflation_now_over_1_million_percent/

[Rod Ferguson]

So we're only a little bit pregnant?

[Jim]

Its not good to incorrectly estimate inflation. True. It has not been shown with any factual data that the CPI is incorrect or underestimated.

"Lenin may have intended to grind just the upper class. But in America, everyone ends up as grist for the mill."

I hardly think that allegedly underestimating inflation makes for a reasonable comparison to communist Russian economics. That kind of comparison really erodes any legitimacy your point has.

I look forward to the rebutal.

Jim

[----------]

(1) Marotta starts the article off with ultra-conservative political scaremongering, which is really neither here nor there. I'm not going to debate whether inflation really threatens the idea of limited government, but the invocation of communism seems to be an absurd scaremongering, namecalling tactic.

(2) Marotta claims that "if inflation was being reported accurately, simply putting dollars in the bank would result in a 3% boost in purchasing power". That is an idiotic statement. Changing the methodology for reporting a statistic does NOT change how much money your local bank will pay in interest in your savings account. Bank of America currently pays less than 1% interest, why would that change with a CPI edit? Answer, it wouldn't. Of course Marotta's statement here also begs the question -- if this CPI manipulation is really there, how come Marotta is smart enough to see it when nobody who runs a bank is smart enough to realize what's going on? After all, Marotta is saying that if banks understood what he did (say if the CPI was telling it to them) they would be offering savings accounts with 10% (TEN PERCENT!) interest. This kind of lunatic claim discredits the author IMO.

(3) "Why should the government deny people the advantages of business innovation by deficit spending and increasing the money supply?" This is another example of Marotta using inflation/CPI as a smokescreen -- an excuse to try to talk about his political ideology, which is still really not part of this discussion (and doesn't really belong on a personal finance blog).

(4) "People on fixed incomes such as Social Security experience the equivalent of a 3% reduction in their benefit payments." Somehow I suspect that increasing everyone's nominal social security payments is NOT compatible with Marotta's political philosophy.

(5) Next, the discussion on the AMT is another distraction. Marotta continues to push a political agenda -- which unsuprisingly suggests decreasing taxes and increasing government entitlement payouts so everyone's happy -- but this is not really germane to the rest of the discussion. I will continue to ignore his political rants.

(6) Inflation, if underreported, would mask the official recession indicator (real GDP growth), but that begs the question that I first rebutted about whether the CPI really understates inflation or whether Marotta simply should buy some meat to go along with his dairy products.

(7) "During inflationary periods, finding capital is challenging. No one wants to loan expensive dollars today only to be reimbursed with dollars that are worth less in the future." Funny, then why are interest rates on bonds WAY lower over the past 12 months? I guess you can add all bond investors (Bill Gross et al) to the list of people not as smart as Marotta and unable to realize all of this double-secret inflation.

(8) "Inflation slows the economy and increases unemployment." Actually, unemployment and inflation are negatively correllated, that's macroeconomics 101. In periods of high inflation, you will find lower unemployment than in periods of low inflation. Inflation also tends to coincide with high economic growth rather than low. I'm not claiming a causal link here, just stating a statistical fact.

(9) "In the final part of this series, we will describe practical ways you can hedge against excessive and unreported inflation and secure and guard a comfortable retirement." Let me save you some time. Marotta will recommend precious metals, other commodities, and the companies that produce them. He has actually in the past claimed that small-cap mining companies in foreign countries are less risky than 3 week treasury bills, so this is not going to be a suprising revelation. In reality, if you expected high inflation not captured by CPI, these kind of companies would still be extremely risky investments, because your personal expectations are sometimes wrong. The financial world does not always behave in a predictable way. And since if you live in the USA, all of your expenses are dollar-denominated, every investment you make in a foreign currency increases the amount of risk you are exposed to. You may see exceptionally good or exceptionally poor returns. When it comes to his suggestion to invest in commodities, remember that if you invest in a total stock market index fund, you reap benefits from long term economic growth and have a solid long-term inflation hedge by owning the companies that sell all the goods that are increasing in price. In commodities like gold, you do not see the same kind of upwards long-term trend. If you bought gold at the end of 1980, over the first 20 years of your investment, you would have lost 50% (!!) and recieved no dividend or interst income in the meantime. You would just be 50% poorer, before even accounting for inflation! Or you could have invested in the stock marked via the S&P 500 and realized 2460% return on your investment over the same time period. What has the rate of return on gold or oil been over the last 100 years? How does that compare to equities? These are all questions you should ask yourself before you follow Marotta's advice and abandon an inexpensive indexing strategy for a HIGHLY SPECULATIVE combination of bets on commodity prices and currency futures that entails relatively high expenses and fees even if you don't do what his clients do and pay him $10,000+ to "manage" all these gambles for you.

Disclosure: I'm currently invested in practically every large public company in the world, a bunch of smaller companies in the USA. I am not short the US Dollar, but I did bet on black when I was in Vegas last month.

[rwh]

If inflation is really 7%, then why is the 10 year treasury note currently yielding 3.94%? Wouldn't the collective market demand a much higher yield if it believes we are in, or heading into a period of higher inflation?

[Rod Ferguson]

1 - I think you read too much into the beginning; he mentions something Lenin said, as well as Friedman and Keynes – all that relate to inflation. I also will not debate the idea that inflation threatens the concept of limited government; if you know your history and the foundations of the Federal Reserve, you’ll have already made up your mind.

2 - You are confusing interest rates with purchasing power. Banks are somewhat immune to the inflation game, as an increase in the money supply effectively starts with them.

3 - I concur with you here.

4 - Now who is using a smokescreen to mask their political ideology?

5 - Actually, the AMT debate has been going on for a while, and there is some legitimate concern about the phase-out point. I do agree that it’s probably going to be a non-issue, though, as I’m sure Congress will raise the limit once enough people are feeling the AMT pain.

6 - As has been said before as well – that all depends on what your definition of inflation is.

7 - My take on this diverges from both of you; it depends on the capital and the investment. During inflationary periods, some investment (usually asset-based, foreign or inflation-protected) has no trouble finding capital at all. It’s a side effect of the whole “flight to safety” mentality that people with cash in capital amounts engage in during unstable times.

8 - Yeah, the Phillips Curve; that only applies to the short term. Only the market cheerleaders are thinking this downturn will be short and shallow.

9 - I agree with your summary, but disagree with your main point. EVERYONE should ALWAYS do their own due diligence. Nobody should take anyone’s word about a particular investment or industry or strategy. To invest in something that you know nothing of dangerous and will almost guarantee you a loss. That said, these other areas Marotta may be referring to (I agree he’ll probably recommend metals, commodities and the companies that make them, but he hasn’t yet so I’ll wait for him to do it) have long been out of favor; many investors don’t think of Agribusiness as a worthwhile investment, or even know what copper-cathode mining is. Being exposed to these ideas gives people the chance to do research into them and perhaps grow their wealth a bit faster than inflation. That alone is worth mentioning them, and that is what these personal finance blogs are about – to teach people the things they can do with their money.

[Jenny]

These posts are getting tiresome. Any actual discussion of financial or economic concepts is secondary to political diatribe. Makes it hard to take any part of it seriously.

Also, if you could employ a proofreader that would be super.