Nothing Real About It

The US government reported an annualized growth rate of 4.1% in real GDP for the second quarter yesterday.  While some economists dismissed this growth rate as unsustainable, the one that occupies the Oval Office claimed it’s very sustainable.  Both miss the ‘real’ problem.

The trouble with this so-called “real” GDP is that, temporarily or not, there’s nothing to celebrate in the first place.  That is, unless you regard inflation as something worthy of celebration.  In short, “real” GDP is arrived at by calculating nominal GDP and then backing out inflation.  So if nominal GDP growth comes to 5% and inflation to 2%, real GDP is then 3%.  And if nominal GDP growth comes to 5% and inflation to 4%, real GDP is then 1%. Notice here the strong dependence on the rate of inflation.  The same nominal GDP growth gives you a radically different real GDP conclusion depending on your reckoning of inflation.  So if the government underestimates the rate of inflation, it overestimates real GDP.  Although there is a little wiggle room in nominal GDP in the first place, it’s a far harder number than the rate of inflation.  Wolf Richter of Wolf Street gives an excellent analysis of this in The Big Adjustments in “Real” GDP.

I’m going to take it further.  The government clearly has the opportunity to understate inflation, since it publishes the data most economists cite, and particular to this issue, the data that is used to find “real” GDP.  It also has motive; literally trillions of dollars worth.  The government profits from inflation, because its debt is denominated in dollars, and to the extent it can depreciate those dollars it reduces its effective debt.  And since it can create dollars itself through the Federal Reserve, it can transfer value from citizens who hold dollars to itself via inflation, giving it a means to tax without elected representatives having to vote on it and be held accountable by the electorate.

Under pressure from recipients noticing the rapid loss of purchasing power in their Social Security benefits, in 1975 the government began indexing this major portion of its obligations to the Consumer Price Index.  This attempt to be honest with SS recipients put a big dent in the government’s ability to rely on inflation to reduce its SS payments expense.  In 1985, it began indexing tax brackets, so that Congress could no longer raise taxes without a vote by virtue of automatically moving taxpayers into higher tax brackets with inflation.  As measures like these eroded the government’s fiscal benefit from inflation, pressure grew to find ways to reduce the inflation numbers that would be used for these indexing programs. 

Some of these ways were found by the Boskin Commission in 1996.  The Boskin Comission was, according to Wikipedia, “appointed by the United States Senate in 1995 to study possible bias in the computation of the Consumer Price Index (CPI)”.  Realizing that reported inflation was now cutting into the government’s ability to profit from it, which kind of bias do you suppose the Commission was about to look hardest for?  If you guessed the Boskin Commission would find that that “possible bias” caused the CPI to come out too high, with the implication that the CPI should be revised lower, then you will not be surprised to find that’s exactly what it did.  And its findings were couched in economic jargon unlikely to be used on the six o’clock news and understood by the majority of voters.  This was necessary because as every politician and technocrat knows, it’s difficult to grow the fungus of subterfuge under the bright light of broad scrutiny.

We could dig into the technical details of just how the revised CPI understates inflation, but won’t, because they are already widely documented elsewhere and we have yet more fundamental problems to deal with.  CPI stands for Consumer Price Index.  The “I” is not for “Inflation”, but “Index”, and that’s for good reason.  It was not originally designed to be an index of “inflation” in the first place.  It was designed to be – just as the name states – an index of consumer prices.  Specifically, the prices of US domestic consumer goods and services.  Inflation, however, is a depreciation in the general market value of the dollar, and that carries no restrictions as to what things the dollar might be used to buy and sell or who might be doing it.

As you might expect, though, in the long run the prices of US domestic goods and services are going to reflect depreciation in the general market value of the US dollar, so at first blush this might not appear to be much of a problem.  But the key phrase here is “in the long run”, because in the short run consumer prices lag changes in the market value of the dollar.  That is, not only do we have the issue of the CPI having been doctored to understate inflation in magnitude, but that it lags in time as well.  Why?  Because consumer prices just don’t react in real time.  Other prices do, for example things like the prices of stocks and bonds, commodities and currencies, things that are traded tick-by-tick in highly liquid auction markets around the world.  These are the places inflation shows up first.  In contrast, your local grocer doesn’t typically run down the aisles remarking the prices of the goods on his shelves every fraction of a second, or even on a daily basis.  More significantly, the major portion of consumer goods and services prices comes from the wages paid to those who provide them, and wages are notoriously slow to react.  Wages and salaries may be reset perhaps just once a year, or even by multi-year contract.  So the focus on the use of final product and service prices causes such measures to structurally temporally lag actual changes in inflation.

As you may have noticed, we’ve strayed a bit from the real GDP issue, because the government doesn’t use the CPI for its real GDP adjustment.  There are a number of data series in use as inflation proxies.  The Federal Reserve, for example, prefers to use the Personal Consumption Index deflator.  For GDP, the government uses the GDP deflator.  All of them, however, are similar in philosophy.  They view inflation as an exclusively low-frequency phenomenon that exists only over time spans of months, quarters, years and decades, and their measurements exclude by design those prices that react quickly.  The GDP deflator in particular is focused on “final goods and services”, not unlike the CPI.  So, as with the CPI, it must lag.

Consequently, if there is an incipient rise in inflation, then, it will take time to be reflected in most conventional inflation indexes, including the GDP deflator.  So inflation first gooses nominal GDP before it is reflected in the GDP deflator, resulting in a surge of reported “real” GDP.  That’s exactly what happened last quarter, and explains why this surge can’t be readily accounted for by newly resurgent employment or otherwise unmeasurable “productivity”.  This phenomenon is also behind the widespread myth that inflation results from an “overheating” economy.  This takes us full circle back to our original assertion: nothing to celebrate here … this GDP report confirms only a surge in inflation.