Lets Be Real

"Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened.”  - Winston Churchill

We are reaching a point in time when government economic statistics increasingly look like some kind of alternative universe.

With the prices of energy, health care, tuition, food, and so much else rising steeply, does anyone still really believe that average prices are going up at only around 2.5%? With spending out of control, entitlement spending rising as far as the eye can see and taxes being cut, does anyone really believe that the budget deficit is well contained?

It no longer makes sense to accept published statistics at face value. Fortunately, with a little common sense and access to web sites like John Williams “Shadow Government Statistics”, it is not too difficult to find out what is really going on at planet earth.

It turns out that many statistics have been “adjusted” for many years. It seems that every time the data methodology changed, the CPI was a little less than we thought before, growth a little higher, and the budget deficit just that little bit more manageable. Cumulatively, however, an enormous gap has opened up between what the statistics are saying and what we see with our own eyes.

A reality check has become a matter of urgency. What we find is that in many ways the economic world has been turned up side down over the last two decades, but economic statistics are trying harder and harder to pretend it didn’t happen.

Inflation

Inflation is one of the most important economic variables, and perhaps also the most misunderstood. Not only is the Consumer Price Index (CPI) a highly abused statistic, it is really only a symptom of inflation, not inflation itself.

I do not intend to go through all the changes in methodology over the years in calculating the CPI. This has been done better than I could by John Williams on his web site. I will, however, refer to some of his conclusions.

I hope that the chart below demonstrates clearly what is happening, just by comparing a few variables over recent decades and seeing their progression. This chart shows gold, the CPI, and the S&P 500. In addition it also shows 2 indictors of money supply. M2 is most likely too narrow a definition and so bank loans have been included as well.

What we see is the enormous difference between the growth in the CPI and bank loans, with the other variables falling somewhere in between.

US M2, bank credit, S&P's 500 stock market index and the US$ gold price

Source: Thomson Financials, Bloomberg, Federal Reserve Bank of St. Louis; own calculations. - The series were indexed, with 1960-Q1 = 100. - The shaded areas represent recession periods as defined by the NBER.

The key issue in measuring the economy is the huge discrepancy between the CPI and money supply, and which measure you believe is the appropriate measure of inflation. If you believe in the CPI then everything looks just fine. Whether you have invested in gold or the S&P 500, you have comfortably defeated inflation over time with your investments. However, the world is turned upside down if you use bank loans as your measure. This means that almost certainly you have underperformed and most likely you are not keeping up with the fall in purchasing power of the dollar.

There are 2 key points to make on this issue. The first is really the simplest, but the one that seems the most overlooked - the correct definition of inflation. The price of any variable is, of course, determined by supply and demand, and money is no different than anything else. As obvious as this is, people tend to forget that inflation of the currency is therefore linked directly to supply of that currency. There really should not be any debate about this. The correct definition of inflation is the growth in money supply, not some average price index that, as we will see, produces an almost entirely unreliable index.

The second point is that the calculation of any price index is a highly hazardous mechanism. What should be included in the index? What should the weightings be? How should this be changed over time with the changes in spending behavior?

Anyone who regards the CPI as an accurate measure of inflation needs to understand the following as a matter of urgency:

1.     If the calculation methodology of the CPI had not been changed since the early 1990s the CPI would currently be around 3% per annum higher than is currently stated.

2.     If the calculation methodology of the CPI had not been changed since the early 1980s the CPI would currently be around 7% per annum higher than is currently stated.

3.     What this means is that instead of the CPI currently rising at around 2.5% per annum the original calculation would give a calculation of around 9.5% per annum.

4.     This difference cumulatively applied over the years means that social security benefits are now about 50% below the level they would otherwise have been had there been no changes in calculation methodology. This deficiency is, of course widening further every year.

5.     If you are still using the CPI as a measure of inflation the likelihood is that you are enormously underestimating inflation, and, by the way, you are using the wrong definition of inflation anyway.

Calculating the growth of money supply also has its problems, and a range of monetary measures have been produced in an attempt to estimate different definitions of money. However, at least by attempting to calculate money supply we are using the correct definition. Bank lending may not be a perfect measure, but it has clearly been a major part of money supply for an extended period of time, so at least it provides a reasonable indication.

Bank lending has been growing at around 11% over the last 5 years, so this suggests that the original CPI calculation may not be too far off as a measure of where inflation really is. So being slightly conservative it is reasonable to assume that the average inflation rate over the last few years has been around 10%, just to deal in round numbers.

Think about what this means:

1.     As nominal GDP growth has been in the 7% range, being generous, and again using a reasonable round number, this means that the economy has been in a recession for most of the time recently as economic growth has averaged less than inflation.

2.     Many investments are finding it difficult to keep up with inflation.

3.     Cash, even before allowing for taxes, is losing purchasing power on a consistent basis.

The question most people raise is how can this be so when the stock market is making new highs? Surely this is a sign the economy is doing just fine. Well this is only true if you measure the stock market in terms of depreciating dollars. While the world has historically become accustomed to being on the dollar standard, this is becoming an increasingly unreliable measure, as a natural consequence of the ongoing excessive supply of currency that the rest of the world has, so far, been absorbing.

The chart below shows the S&P 500 in terms gold. But a similar chart can be found by using any of a range of real assets as a benchmark.

This chart shows that measured in this way the US stock market has been in a persistent down trend and it is currently near the low of the downtrend. So looked at in the right way, as I see it, the stock market is indeed reflecting a weak recessionary economy.

What Now?

With only the exception of Ron Paul, who is widely regarded as a long shot, there is still no sign of any change in economic policy at a political level. Indeed the likelihood is that the inflation policy could even accelerate in the near term as offsetting higher and higher levels of debt requires more and more inflation. While this is clearly unsustainable it remains current policy.

The tragedy is that the current sequence of events has been played out so often throughout history. This is hardly a new or unique set of circumstances:

"This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them."

Human Action – Ludwig von Mises (1883 – 1973)

Summary

While no one can forecast the future, we all need to recognize where we are today. Economic statistics have become highly misleading, so investors need to reconsider the indicators they use to measure economic developments.

Being real today applies not only to our assessment of the economy but also to our investment choices. Appropriately chosen real assets need to form a sizeable part of any allocation. Also, without any substantive changes, we must continue to assume that disguised inflation remains the real economic policy.

 

Notice

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