Are you brave enough to answer this question?

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Lemonyellowschwin's picture
Lemonyellowschwin
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Are you brave enough to answer this question?

All right folks -- anyone who thinks they are smart please step up to the plate and answer me a question.  (I've been waiting for Chris but he's been busy and I can't wait anymore).

A few weeks ago, Chris made a statement along these lines:  Inflation is a function of the money supply in relation to goods, services AND assets.  He stated that the biggest intellectual blunder that the Fed makes is failing to recognize the ASSETS part in this equation.

 Now, I sense that Chris said something profound, but he is too busy to expound and I am too dumb to figure it out myself.  It has been eating at me.  Will someone please enlighten me?  Why is this such an important statement, and in what sense is it the Fed's biggest blunder?

Thanks.

steff66's picture
steff66
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question
Not saying I am smart and that I am a foreigner makes my english knowledge some what less then others. But the fact that the money value is not connected to anything real. It has no worth of its own. This makes the market vonerable to speculation. The FED in the 80-th disconnected the money value from the goldreserv. Not 100 % sure of the time table. And maybe he refer to the fact that people used to save money and have a buffer. Or they invested in assets that had a real value that could be sold for money. But the fact that people does not save anymore and that they refinance on there property, for consumtion, to the extent that the value now has imploded. And all of this was made possible by the FED lowering the rates and creating the housing bubble. /Steff66
gsti's picture
gsti
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I can't read minds... but
Hi Lemonyellowschwin, I can't say for sure, but certainly in the UK, house prices are not included when calculating inflation. A 5% increase in the price of a house is actually a lot more serious event than a 5% increase on a tin of beans, well for most people at least. So when inflation is being calculated, a huge part of the REAL cost of living for most people is not included. Because we have had this property boom, and it was not considered when calculating inflation, the amount of inflation , which as Chris carefully pointed out is actually about currency we are left with a hugely distorted picture of what our true level of inflation is , the true cost of living and a misguided (although there are other indicators) few of how much money there is. There is also the issue of asset stripping, in a bubble the item in question tends to raise above it's normal value. In a race to be involved people offer more money for the item, and it appreciates in value for a short time, before falling again. Now if you owned a house that went up in value , from 100 to 1000 you may wish to take advantage of that money you made, and mortgage the property for say 700. Now the crash finishes and your property returns to its original value of 100. This is very bad for you, you are in debt without an asset to back up that debt. The whole point of fractional reserve banking is to be able to lend money as needed at source. A crucial part of this is being able to accurately match the value of the asset to the liquid funds. That 700 you took and spend is now in an economy when really it should not be, as you do not have an asset worth 700. This, the government in the UK at least does not take into account.
GeoffreyTransom's picture
GeoffreyTransom
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Lemonyellowschwin
[quote=Lemonyellowschwin]

All right folks -- anyone who thinks they are smart please step up to the plate and answer me a question.  (I've been waiting for Chris but he's been busy and I can't wait anymore).

A few weeks ago, Chris made a statement along these lines:  Inflation is a function of the money supply in relation to goods, services AND assets.  He stated that the biggest intellectual blunder that the Fed makes is failing to recognize the ASSETS part in this equation.

Now, I sense that Chris said something profound, but he is too busy to expound and I am too dumb to figure it out myself.  It has been eating at me.  Will someone please enlighten me?  Why is this such an important statement, and in what sense is it the Fed's biggest blunder?

Thanks.

[/quote]

Hey there Lemonyellowschwin

What was meant by that statement is that if a key destination for new money (e.g. houses/stocks/assets) is left out of inflation calculations, then the inflation rate will be understated. (True iff the non-included things are appreciating more rapidly than the average of things that are included).

Think of all the dollars in existence, divided by ll the possible things on which one canspend those dollars. If the number of dollars is rising faster than the things you can spend them on, then prices (broadly defined) will be rising. If not, then they won't.

But - this is important - the CPI is expressly NOT a measure of the general price level, and changes in the CPI are NOT a measure of the rate of inflation (despite what journalists might think). The Commerce Department  explicitly disclaims the use of the CPI as a measure of the cost of living.

But it is (obviously) referred to ALL THE TIME as such a measure.

 

The methodological shortcomings of the CPI are not a 'blunder' by the Fed - they are there deliebrately (the CPI methodolgoy was overhauled by none other than that shameless hack Greenspan).

The agency that produces the CPI requires that the methodology downweights anything with sharply-rising prices, and overweights anything with deflating prices (e.g., consumer electronics). 

House prices don't enter directly into the CPI - they enter via the (highly corruptible) measure of 'owner equivalent rents' and/or imputed rent. Stock and bond prices don't enter at all.

The CPI pretends to try to capture the change in the prices of a representative basket of consumption goods - in other words, a set of FLOW variables.

{In fact there are a lot of things about the CPI methodology that explicity PREVENT it from doing what I just wrote - hedonic adjustment, chain-linking and substitution effects - but those are just government chicanery designed to hold down reported inflation, thereby reducing the rate of growth of index-linked obligations like pensions}.

If the prices of STOCK variables (capital/assets) are to be included, then there is a requirement to make the units consistent.

It's for this reason that the CPI methodology pretends to try and capture the change in the price of the flow of services from housing as part of the basket, rather than the price of the underlying asset.

How much of a house do you buy each month? It's certainly not the whole thing: I would certainly make the case that instead of assuming owner equivalent rents, the housing portion of the CPI should be calculated as

 

((1-a).d.P+ a.R)

where

  • a is the proportion of households that rent;
  • d is the depreciation rate for houses;
  • P is the price of a house (more accurately, the price of depreciation-amelioration) and
  • R is the rental price of housing.

Instead, there is an appeal to an 'equivalence theorem' - that for a given house, the 'housing service' produced by a rented house is the same as that provided by a house you own (wrong on so many levels) and therefore that owners can be assumed to face the same monthly costs as renters.

(note that even in my formulation, mortgage rates/payments don't enter into it: that's because a mortgage payment is strictly equal to "rent on an identical house, plus the price of a call option over capital appreciation on the house" - payment for a flow, plus the purchase of a stock variable).

 

At the end of the day, the CPI is just another number produced by government, and ought not be trusted - similar to unemployment numbers, GDP growth... pretty much any number produced by politicians or their appointed lackeys. Understanding how it works will not change your life - because the basket of goods it tracks is not constant, and will never bear any relationship to any basket consumed by anybody who actually exists.

Whenever trends start to show the failure of the political machine, the methodology is changed. This happened with the CPI, unemployment and GDP... all changed under Clinton. The CPI was changed when it was realised that CPI indexation of pensions resulted in a demographic time bomb: using the pre-Clinton methodologies the CPI is running at a minimum of 9%, unemployment is about 12.5% and GDP growth has been negative for half of Shrub's time in office (that's why the economy 'feels' like it's 1975 when according to the stats its more like 1999).

And I haven't mentioned the CES Birth-Death model, which magics workers out of thin air every month to give the non-farm payroll numbers a boost...and adjusts them away in later revisions once nobody is looking at thm anymore.

Cheerio

 

 

GT

France

gsti's picture
gsti
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Joined: Jul 21 2008
Posts: 60
Nice

Thats a very good explanation and commentary GT,

Thank you

Lemonyellowschwin's picture
Lemonyellowschwin
Status: Platinum Member (Offline)
Joined: Apr 22 2008
Posts: 547
Thanks, but I still don't get it

Geoffrey and Others:

 Thanks, but I guess here's what I don't get:  When I think of "Assets" I think of things like houses and buildings and stocks.  And when I think of Chris's statement, I am thinking about changes in the supply of money relative to the supply of services, goods AND ASSETS. 

Now, I get how the CPI, etc. are untrustworthy and all that.  But I am looking at Chris's statement as if he is talking about the SUPPLY of assets not being factored into the equation.  And I am wondering how the SUPPLY of assets is really changing unless we are talking about things like a slowing in new housing, new commercial buildings, new companies, etc.  Notice I haven't talked about the price of assets, I've talked about the supply of assets.

 So, can Chris be saying that when the Fed increases money supply at a time when less goods and services are being produced AND at a time when less assets are being created, that the odds of an inflationary recession go up?

 Do you see what I am saying? 

Thanks!

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