The Blind leading the Blind

April 23, 2011

The financial crisis in 2008 exposed a disturbing trend; many of the economic variables we measure now-a-days are out of date. In fact they are becoming part of the problem. Vast changes have taken place in the economy in the past few decades. There is the obvious impact of globalization, which has put massive downward pressure on the price of manufactured goods, internationalized companies, supply/ distribution chains and markets; and least we forget there has been massive growth in nontraditional intangibles, which now constitute 80% of economic value in post-industrial economies. Unfortunately conventional economic modelling and metrics tend to ignore all these changes. The numbers we use to manage our economy today still assume we’re generating “factory-type” industrial production in isolated national economies.

Consider, GDP statistics, for instance, they simply don’t measure all the asset growth in modern economies.  According to a University of Maryland study, GDP calculations (as well as normal accounting practices) continue to exclude the intangible component of new asset capital. According to the authors, undocumented intangible investment in the US economy is over US$3 trillion per year. They concluded that if intangibles were factored into conventional data the US domestic savings rate, far from being negative, is actually positive. The US trade deficit is smaller than the numbers suggest, and US GDP is growing more rapidly than experts are telling us. The statistical discrepancy in GDP alone is a whopping 52%.

But GDP is not the only area of concern. There are major fault lines emerging in monetary theory and inflation as well. Conventional wisdom seems to be that inflation has been kept well under control in recent years. But what if we’re measuring the wrong things, maybe; just maybe, we don’t really know what’s happening with inflation at all!

Federal Reserve chairmen, like old military generals tend to ignore changing realities; preferring to fight the latest war with the tactics and tools that made them successful in the past. The last time the US experienced a significant inflationary period was during the 1970’s when CPI (consumer price index) rose at an annualized rate of roughly 8%.   Gaining control of the inflation during the period meant “tough love”, hard monetary medicine was imposed by the Federal Reserve in the United States. Interest rates were driven up to unprecedented levels to fight persistent CPI inflation – causing great pain for business and homeowners.

The major lessons of that inflationary period are generally considered to be the following. One, union power and COLA’s (cost of living adjustments) played a major role in driving up prices. Two, 70’s inflation itself was less a monetary phenomenon that a cost-push phenomenon driven by wage growth that was believed to exceed productivity growth.

Whatever the truth of those lessons, they are now ‘givens’, realities governing Reserve Bank thinking in the US and around the world (including the Bank of England). The disturbing truth is this; during the past few decades the definition of inflation migrated from its historical meaning, a debasement (devaluation) of the currency stimulating a general rise in prices (i.e. a greater supply of money chasing a fixed number of goods); to any general rise in prices (defined by the CPI) full stop. In other words monetary authorities began to over-focus on rising consumer prices, the derivative ‘effects’ of inflation, rather than the primary ‘causes’, the complex sources of money growth in a modern economy.

If we revisit the inflation picture from a more traditional monetary viewpoint, we see a different reality than the rosy picture presented by the Fed. The Fed has defined a variety of monetary aggregates including M1, M2, and M3.  The narrowest definition, M1, includes the transaction deposits of banks and cash in circulation.  M2 adds savings accounts, small time deposits at banks, and retail money market funds.  M3 adds large time deposits, repurchase agreements, Eurodollars, and institutional money market funds.  In March 2006 the Fed discontinued tracking M3 because, it said, M3 does not convey information about economic activity that is not already embodied in M2.

Many pundits believe that the Fed stopped monitoring M3 in 2006 because the numbers were going ‘off the charts’. M3 measurement, never very precise, was creeping into forbidden territory, beginning to factor in broad money categories including bank and nonbank credit growth, even wandering into the realm of the so called shadow banking sector where credit was exploding. Officially inflation is (and has been) under control. Unofficially, all that credit growth resulted in massive monetary inflation, and as a consequence the system is now deleveraging massively on the deflationary side to the cycle. Unfortunately (or perhaps fortunately) this kind of inflation/deflation has become detached from CPI in part because of the impact of globalization, which has stabilized prices while credit exploded in the period up to 2008 and is now imploding. The Fed missed (or misrepresented) it all.

Things to Think About

  1. According to this logic, monetary policy has become detached from CPI inflation, so the standard treatment that the Fed would naturally employ to fight inflation in 2011, which is ramping up fast, might not work. If things get out of hand, it will take a larger dose of interest rate medicine to reign in costs than many officials are willing to admit. And even that might not work!
  2. This lack of clarity in metrics and economic modeling means we don’t see the real picture.  Apart from under valued GDP performance and fuzzy logic on inflation we’re still using the stock market as a measure of the health of the economy, when we know it can be wildly out of touch with reality. So, keep your own council and prepare for bumpy ride these next few years.


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