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Inflation/Deflation II: Is The Answer How We Measure?   (January 9, 2007)

In one school of thought deflation/inflation can be measured by one simple yardstick: is money supply expanding or contracting? But the real world offers another measure: prices. The rise (inflation) or decline (deflation) of consumer prices is calculated for us, courtesy of the Bureau of Labor Statistics.

Here are the numbers used to figure the CPI (Consumer Price Index) (taken from the Bureau of Labor Statistics abstract titled why inflation as stated in CPI doesn't match your reality:)

Expenditure category
Food and beverages         15.7
Housing                         40.9
Apparel                           4.4
Transportation                17.1
Medical care                    5.8
Recreation                      6.0
Education/communication  5.8
Other goods & services     4.3
Total, all items               100.0

I have commented at length elsewhere on the obvious distortions inherent in this basket, chiefly that rising mortgage rates and property taxes play no part in measuring housing costs--that number is based on "equivalent rent," meaning what you'd pay in rent for your house. This effectively negates the cost of homeownership for the 69% of the population who "own" their own home (soon to be 64%, as the 5% on the margins fall into foreclosure). Here are the entries should you want more:
Why Inflation Appears Low (June 2005)
The Housing - Inflation Connection (April 2006)
After the Bubble: rents and Housing Values (May 2006)
Why Post-Bubble Rents Matter (June 2006)

Let's speculate on how a combination of deflation and inflation might effect the CPI. Let's say a recession takes the U.S. economy by the throat in 2007, and builders continue pumping out more housing nobody wants to buy until they finally go bankrupt. Given the low demand (people moving back in with their parents, etc.) and rising supply (thousands of vacant houses and condos) rents might drop 10% nationally, which would by itself cause the CPI to register a 4% decline. Deflation!

But let's further suppose high oil prices (Kuwaiti and Saudi super-giant fields are already in permanent decline, don't forget) and a disasterous crop or two in the world's breadbaskets (note how weird the weather is getting, so don't tell me this isn't possible) cause food prices to leap 10%. Recall that grain, like oil, is priced on the margins; prices are set by the last couple million barrels or tons of supply and demand, not the first 95%.

Since food and beverages are 15% of the CPI, a 10% rise kicks it up only 1.5%. But wait a minute. Rents may have dropped, but 69% of the citizenry don't rent. So the benefits of dropping rents don't accrue to them at all. Meanwhile, they are paying higher food prices.

Next, let's admit that medical costs are grossly understated by the CPI's 5% allotment. Since medical/healthcare (what should be called sick-care, since so little is spent on health) is 16% of the GDP, maybe it should be 16% of the CPI. Let's assume that these costs continue their usual 10% rise annually. In the CPI as figured currently, this 10% increase only adds a .5% to the overall CPI. So a family with limited or no coverage, or serious medical expenses even after co-pays, is paying out thousands of dollars more than in previous years, but the CPI barely registers a blip.

You see the point. Rents could drop even as food and medical expenses soar, and the CPI would register a 2.5% decline. See how meaningless this statistic becomes in terms of' measuring deflation and inflation? Two-thirds of the population are not paying less for housing, and they're paying a lot more for food and healthcare, yet they're told by the media and the government that they're living in a deflationary economy.

The folks who ardently believe inflation and deflation are merely matters of money supply forgot basic economics: supply and demand set prices. Put another way: you can print or create more money, or print less money, but you can't print more oil. When oil supply falls beneath global demand, prices will rise, regardless of whether M2 or M3 money supply is shrinking (deflation, according to theory). Ditto for grain. You do have to eat, and where you get the money to pay for food is not the market's concern. Demand for grain and oil are not as elastic as theory would have it, and history shows that shortages of both appear quite regularly, with the result predicted by supply and demand: prices skyrocket.

That's called inflation, because you're getting the same product and paying more money for it. Money supply has nothing to do with it.

The point: statistics do not reflect the realities of rising or falling prices, so we should be careful before announcing either "deflation" or "inflation." A small example: every European knows that prices rose when the euro currency was established. yet "official" statistics say prices didn't rise. Was the euro inflationary? Well, you got the same cafe au lait but you paid more for it.

Frequent contributor Aaron K. sent in a cogent description of the "Japan carry trade" which I reprint here as one of the most concise I've ever read. Here are some links to previous entries on Japan's staggering debt:

Japan's Runaway Debt Train (2001)

Tale of Two Debts: Japan and the U.S. (October 2006)

Here's Aaron's commentary:
Great piece on Japan. All those things you discuss are surely factors in Japan's condition. But I must say there is one important thing you missed.

That is the zero-interest rate policy (ZIRP) since 1994-1995 and total lack of capital controls. These things spawned the now-infamous carry trade, allowing worldwide investors to borrow yen to leverage up and speculate elsewhere. More on this in a second.

But another important aspect to this policy was to drain most productive liquidity *out of Japan*. In other words, the "smart money" left Japan because the basis of returns for the country (set by interest rates) essentially became zero. Think about it: if you were a Japanese investor and faced with ZIRP, where would you put your money? Answer: if you're dumb, in postal bonds yielding 1%; if you're smart, overseas.

As an exacerbating factor, as you say, business conditions are sclerotic domestically, as a matter of other aspects of policy. A double-whammy: there's nothing attractive to invest in domestically, and a low basis for returns to boot.

Back to the first point: the effective flooding of this liquidity abroad--outside Japan.

It is no coincidence that this started in 1995, which was the starting point of the US stock market bubble. At that time also initiated as a formal policy was the Plaza Accord--the strong dollar. Not only did most of Japan's innate liquidity flee its borders, but foreigners additionally borrowed in yen to leverage up and carry trade, and then virtually all of this expanded money supply was poured into the US markets (yielding 5-6% as a basis at the time). Happily, the Fed had just spent 1990-1994 loosening banking controls, most notably the reserves requirement (which essentially became optional), allowing even more liquidity to bloom inside the US. The US mega-bubble was born.

That's where Japan's missing liquidity (and much more) went.

It is unlikely this delicate setup will be repeated, but with the US as the "deflationary" party: the Eurozone is the most likely contender to play the role of the US economy, but the Europeans don't seem to be too keen on allowing broad money to multiply totally unchecked.
Thank you, Aaron, for this excellent description of the carry trade and its pernicious affect on the U.S. economy.

For more on this subject and a wide array of other topics, please visit my weblog.


copyright © 2007 Charles Hugh Smith. All rights reserved in all media.

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