Thursday, July 09, 2009

Flawed Measures of Inflation

Wall Street Cheat Sheet did an interview with Barry Ritholtz last week, and I thought these several paragraphs from Barry on misconceptions regarding inflation were very well stated and worth reading:

"Damien: If the government hired you and sent you in with a team to work on some of these models, do you think the political pressure would still be there, thus continuing to cause a lot of these problems?

Barry: Well, the pressure would not be on me, but whoever comes after me [laughing]. If they hire me they know what they are getting. They are getting someone who is going to say, “Let’s go back to the Boskin Commission.” The Boskin Commission determined inflation was overstated by one-point-something percent and they came up with some hair brain ways of lowering it. For example, when steak goes up in price and a consumer purchases chicken instead of steak, the economists call that ‘substitution’. Therefore, the Boskin Commission says this substitution doesn’t reflect a price increase in the basket of goods that that consumer purchased. Thus, they say inflation is moderate.

Now, anybody else would look at that and say, “No, you stupid sons of bitches. I was just priced out of steak and now I’m buying the cheaper meat because I can’t afford the more expensive meat.” Anybody with two eyes and a brain should be able to figure that out. Boskin is obviously sheer absolute and unmitigated nonsense. If steak goes up in price, that’s inflation by definition. The fact that I can no longer afford steak doesn’t mean I’m buying something else or there’s no inflation. It means I’ve been priced out of that product!

I hold Boskin indirectly responsible for the whole credit collapse and the entire stock market crash because his lame hair brained rationales for understating inflation gave Greenspan the ability to say, “Well, rates are dangerously low back in ‘01, ‘02, ‘03, but look inflation is contained so it’s really not too bad.” I make that connection in the book [Bailout Nation] in a chapter called ‘Strange Connections, Unintended Consequences.’ The chapter explains how all these weird things took place and they all ended up having extremely bizarre consequences. Boskin is a perfect example.

Hedonic adjustments are another example. I think there is a terrible mistake economists make: they don’t understand technology. They don’t understand the life cycle of a new technology that comes out and there are economies of scale unfolding. For example, when the first plasma screen came out it was $100,000 and eight of them were sold. They cost that much because only eight of them were sold. Then, you build a factory and amortize the cost of the factory, and a few years later you are selling 10,000 of these things a year. Now they are going for $10,000 and $12,000. Then, a few years later you’ve gone from a small factory to a big factory and are selling a million of these a year. At this point plasmas are down to $6,000 a piece.

So, you had the early adopters who were unsure about the technology but bought it. Then you had the later adopters. Fast forward a few years later until finally the item becomes a mainstream product and you have huge factories all over the place. You are cranking out 100 million of these a year and these 50″ plasmas are going for under $1,000. The economists would have you believe this is proof inflation is contained. However, in reality the product cycle is a normal, natural cycle for all technologies and has nothing to do with inflation. This cycle happened with the cell phone, the iPod, PCs, laptops, etc. The cycle doesn’t mean that there is less inflation. The cycle means there is a normal life cycle of a product.

Meanwhile, you’re buying all these goods that didn’t exists 20 years ago. You didn’t have an iPod, an iPhone or a plasma screen. So, you are actually spending more of your discretionary income on all these toys. All the economists listening to this are going to say, “No. He’s wrong. Those are prices coming down. It’s deflationary.” I disagree. This stuff happens with every technology. It doesn’t matter what is going on with the money supply, the deficit, issuing dollars, etc. Every product goes through that life cycle. It’s normal and natural. It sure as hell isn’t deflationary. When something new comes out, you can expect that eventually — as it goes from a limited custom product to a more luxury product, to a more mainstream product, to a ubiquitous product — the economies of scale bring the price down. I don’t believe we can accurately describe that process as deflationary or disinflationary.


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