[R-G] [BillTottenWeblog] Numbers Racket

[Bill Totten]

Why the economy is worse than we know

by Kevin Phillips

Harper's Magazine Report (May 2008)


Almost four decades have passed since the United States scrapped its
last currency ties to precious metals. Our copper and nickel coinage
still retains some metallic value, but not nearly enough for the purpose
of currency tampering - the historic temptation of inflation-plagued or
otherwise wayward governments, including, at times, our own. Instead,
since the 1960s, Washington has been forced to gull its citizens and
creditors by debasing official statistics: the vital instruments with
which the vigor and muscle of the American economy are measured. The
effect, over the past twenty-five years, has been to create a false
sense of economic achievement and rectitude, allowing us to maintain
artificially low interest rates, massive government borrowing, and a
dangerous reliance on mortgage and financial debt even as real economic
growth has been slower than claimed. If Washington's harping on weapons
of mass destruction was essential to buoy public support for the
invasion of Iraq, the use of deceptive statistics has played its own
vital role in convincing many Americans that the US economy is stronger,
fairer, more productive, more dominant, and richer with opportunity than
it actually is.

The corruption has tainted the very measures that most shape public
perception of the economy - the monthly Consumer Price Index (CPI),
which serves as the chief bellwether of inflation; the quarterly Gross
Domestic Product (GDP), which tracks the US economy's overall growth;
and the monthly unemployment figure, which for the general public is
perhaps the most vivid indicator of economic health or infirmity. Not
only do governments, businesses, and individuals use these yardsticks in
their decision-making but minor revisions in the data can mean major
changes in household circumstances - inflation measurements help
determine interest rates, federal interest payments on the national
debt, and cost-of-living increases for wages, pensions, and Social
Security benefits. And, of course, our statistics have political
consequences too. An administration is helped when it can mouth
banalities about price levels being "anchored" as food and energy costs
begin to soar.

The truth, though it would not exactly set Americans free, would at
least open a window to wider economic and political understanding.
Readers should ask themselves how much angrier the electorate might be
if the media, over the past five years, had been citing eight percent
unemployment (instead of five percent), five percent inflation (instead
of two percent), and average annual growth in the one percent range
(instead of the three to four percent range). We might ponder as well
who profits from a low-growth US economy hidden under statistical
camouflage. Might it be Washington politicos and affluent elites,
anxious to mislead voters, coddle the financial markets, and tamp down
expensive cost-of-living increases for wages and pensions?

Let me stipulate: the deception arose gradually, at no stage stemming
from any concerted or cynical scheme. There was no grand conspiracy,
just accumulating opportunisms. As we will see, the political blame for
the slow, piecemeal distortion is bipartisan - both Democratic and
Republican administrations had a hand in the abetting of political
dishonesty, reckless debt, and a casino-like financial sector. To see
how, we must revisit forty years of economic and statistical dissembling.


A Short History of "Pollyanna Creep"

This apt phrase originated with John Williams, a California-based
economic analyst and statistician who "shadows", as he puts it, the
official Washington numbers. In a 2006 interview, Williams noted that
although few Americans ever see the fine print, the government "always
footnotes the changes and provides all the fine detail. Nonetheless,
some of the changes are nothing short of remarkable, and the pattern
over time is what I call Pollyanna Creep." Williams is one of the small
group of economists and analysts who have paid any attention to the
phenomenon. A few have pointed out the understatement of the Consumer
Price Index - the billionaire bond manager Bill Gross has described it
as an "haute con job", and Bloomberg columnist John Wasik has dismissed
it as "a testament to the art of spin". In 2003, a University of Chicago
economist named Austan Goolsbee (now a senior economic adviser to Barack
Obama's presidential campaign) published an op-ed in the New York Times
pointing out how the government had minimized the depth of the 2001-2002
US recession, having "cooked the books" to misstate and minimize the
unemployment numbers. Unfortunately, the critics have tended to train
their axes on a single abuse, missing the broad forest of statistical
misinformation that has grown up over the past four decades.

The story starts after the inauguration of John F. Kennedy in 1961, when
high jobless numbers marred the image of Camelot-on-the-Potomac and the
new administration appointed a committee to weigh changes. The result,
implemented a few years later, was that out-of-work Americans who had
stopped looking for jobs - even if this was because none could be found
- were labeled "discouraged workers" and excluded from the ranks of the
unemployed, where many, if not most, of them had been previously
classified. Lyndon Johnson, for his part, was widely rumored to have
personally scrutinized and sometimes tweaked Gross National Product
numbers before their release; and by the 1969 fiscal year, Johnson had
orchestrated a "unified budget" that combined Social Security with the
rest of the federal outlays. This innovation allowed the surplus
receipts in the former to mask the emerging deficit in the latter.

Richard Nixon, besides continuing the unified budget, developed his own
taste for statistical improvement. He proposed - albeit unsuccessfully -
that the Labor Department, which prepared both seasonally adjusted and
non-adjusted unemployment numbers, should just publish whichever number
was lower. In a more consequential move, he asked his second Federal
Reserve chairman, Arthur Burns, to develop what became an ultimately
famous division between "core" inflation and headline inflation. If the
Consumer Price Index was calculated by tracking a bundle of prices,
so-called core inflation would simply exclude, because of "volatility",
categories that happened to be troublesome: at that time, food and
energy. Core inflation could be spotlighted when the headline number was
embarrassing, as it was in 1973 and 1974. (The economic commentator
Barry Ritholtz has joked that core inflation is better called "inflation
ex-inflation" - that is, inflation after the inflation has been excluded.)


In 1983, under the Reagan Administration, inflation was further finagled
when the Bureau of Labor Statistics decided that housing, too, was
overstating the Consumer Price Index; the BLS substituted an entirely
different "Owner Equivalent Rent" measurement, based on what a homeowner
might get for renting his or her house. This methodology, controversial
at the time but still in place today, simply sidestepped what was
happening in the real world of homeowner costs. Because low inflation
encourages low interest rates, which in turn make it much easier to
borrow money, the BLS's decision no doubt encouraged, during the late
1980s, the large and often speculative expansion in private debt - much
of which involved real estate, and some of which went spectacularly bad
between 1989 and 1992 in the savings-and-loan, real estate, and
junk-bond scandals. Also, on the unemployment front, as Austan Goolsbee
pointed out in his New York Times op-ed, the Reagan Administration
further trimmed the number by reclassifying members of the military as
"employed" instead of outside the labor force.

The distortional inclinations of the next president, George H W Bush,
came into focus in 1990, when Michael Boskin, the chairman of his
Council of Economic Advisers, proposed to reorient US economic
statistics principally to reduce the measured rate of inflation. His
stated grand ambition was to move the calculus away from old
industrial-era methodologies toward the emerging services economy and
the expanding retail and financial sectors. Skeptics, however, countered
that the underlying goal, driven by worry over federal budget deficits,
was to reduce the inflation rate in order to reduce federal payments -
from interest on the national debt to cost-of-living outlays for
government employees, retirees, and Social Security recipients.

It was left to the Clinton Administration to implement these convoluted
CPI measurements, which were reiterated in 1996 through a commission
headed by Boskin and promoted by Federal Reserve Chairman Alan
Greenspan. The Clintonites also extended the Pollyanna Creep of the
nation's employment figures. Although expunged from the ranks of the
unemployed, discouraged workers had nevertheless been counted in the
larger workforce. But in 1994, the Bureau of Labor Statistics redefined
the workforce to include only that small percentage of the discouraged
who had been seeking work for less than a year. The longer-term
discouraged - some four million US adults - fell out of the main monthly
tally. Some now call them the "hidden unemployed". For its last four
years, the Clinton Administration also thinned the monthly household
economic sampling by one sixth, from 60,000 to 50,000, and a
disproportionate number of the dropped households were in the inner
cities; the reduced sample (and a new adjustment formula) is believed to
have reduced black unemployment estimates and eased worsening poverty
figures.

Despite the present Bush Administration's overall penchant for
manipulating data (for example, Iraq, climate change), it has yet to
match its predecessor in economic revisions. In 2002, the administration
did, however, for two months fail to publish the Mass Layoff Statistics
report, because of its embarrassing nature after the 2001 recession had
supposedly ended; it introduced, that same year, an "experimental" new
CPI calculation (the C-CPI-U), which shaved another 0.3 percent off the
official CPI; and since 2006 it has stopped publishing the M-3 money
supply numbers, which captured rising inflationary impetus from bank
credit activity. In 2005, Bush proposed, but Congress shunned, a new,
narrower historical wage basis for calculating future retiree Social
Security benefits.

By late last year, the Gallup Poll reported that public faith in the
federal government had sunk below even post-Watergate levels. Whether
statistical deceit played any direct role is unclear, but it does seem
that citizens have got the right general idea. After forty years of
manipulation, more than a few measurements of the US economy have been
distorted beyond recognition.


America's "Opacity" Crisis

Last year, the word "opacity", hitherto reserved for Scrabble games,
became a mainstay of the financial press. A credit market panic had been
triggered by something called collateralized debt obligations (CDOs),
which in some cases were too complicated to be fathomed even by experts.
The packagers and marketers of CDOs were forced to acknowledge that
their hypertechnical securities were fraught with "opacity" - a
convenient, ethically and legally judgment-free word for lack of honest
labeling. And far from being rare, opacity is commonplace in
contemporary finance. Intricacy has become a conduit for deception.
Exotic derivative instruments with alphabet-soup initials command
notional values in the hundreds of trillions of dollars, but nobody
knows what they are really worth. Some days, half of the trades on major
stock exchanges come from so-called black boxes programmed with
everything from binomial trees to algorithms; most federal securities
regulators couldn't explain them, much less monitor them.

Transparency is the hallmark of democracy, but we now find ourselves
with economic statistics every bit as opaque - and as vulnerable to
double-dealing - as a subprime CDO. Of the "big three" statistics, let
us start with unemployment. Most of the people tired of looking for
work, as mentioned above, are no longer counted in the workforce, though
they do still show up in one of the auxiliary unemployment numbers. The
BLS has six different regular jobless measurements - U-l, U-2, U-3 (the
one routinely cited), U-4, U-5, and U-6. In January 2008, the U-4 to U-6
series produced unemployment numbers ranging from 5.2 percent to 9.0
percent, all above the "official" number. The series nearest to
real-world conditions is, not surprisingly, the highest: U-6, which
includes part-timers looking for full-time employment as well as other
members of the "marginally attached", a new catchall meaning those not
looking for a job but who say they want one. Yet this does not even
include the Americans who (as Austan Goolsbee puts it) have been "bought
off the unemployment rolls" by government programs such as Social
Security disability, whose recipients are classified as outside the
labor force.

Second is the Gross Domestic Product, which in itself represents
something of a fudge: federal economists used the Gross National Product
until 1991, when rising US international debt costs made the narrower
GDP assessment more palatable. The GDP has been subject to many further
fiddles, the most manipulatable of which are the adjustments made for
the presumed starting up and ending of businesses (the "birth/death of
businesses" equation) and the amounts that the Bureau of Economic
Analysis "imputes" to nationwide personal income data (known as phantom
income boosters, or imputations; for example, the imputed income from
living in one's own home, or the benefit one receives from a free
checking account, or the value of employer-paid health- and life-
insurance premiums). During 2007, believe it or not, imputed income
accounted for some fifteen percent of GDP. John Williams, the economic
statistician, is briskly contemptuous of GDP numbers over the past
quarter century. "Upward growth biases built into GDP modeling since the
early 1980s have rendered this important series nearly worthless", he
wrote in 2004. "[T]he recessions of 1990/1991 and 2001 were much longer
and deeper than currently reported [and] lesser downturns in 1986 and
1995 were missed completely".


Nothing, however, can match the tortured evolution of the third key
number, the somewhat misnamed Consumer Price Index. Government
economists themselves admit that the revisions during the Clinton years
worked to reduce the current inflation figures by more than a percentage
point, but the overall distortion has been considerably more severe.
Just the 1983 manipulation, which substituted "owner equivalent rent"
for home-ownership costs, served to understate or reduce inflation
during the recent housing boom by three to four percentage points.
Moreover, since the 1990s, the CPI has been subjected to three other
adjustments, all downward and all dubious: product substitution (if
flank steak gets too expensive, people are assumed to shift to
hamburger, but nobody is assumed to move up to filet mignon) , geometric
weighting (goods and services in which costs are rising most rapidly get
a lower weighting for a presumed reduction in consumption), and, most
bizarrely, hedonic adjustment, an unusual computation by which
additional quality is attributed to a product or service.

The hedonic adjustment, in particular, is as hard to estimate as it is
to take seriously. (That it was launched during the tenure of the Oval
Office's preeminent hedonist, William Jefferson Clinton, only adds to
the absurdity.) No small part of the condemnation must lie in the
timing. If quality improvements are to be counted, that count should
have begun in the 1950s and 1960s, when such products and services as
air-conditioning, air travel, and automatic transmissions - and these
are just the A's! - improved consumer satisfaction to a comparable or
greater degree than have more recent innovations. That the change was
made only in the late Nineties shrieks of politics and opportunism, not
integrity of measurement. Most of the time, hedonic adjustment is used
to reduce the effective cost of goods, which in turn reduces the stated
rate of inflation. Reversing the theory, however, the declining quality
of goods or services should adjust effective prices and thereby add to
inflation, but that side of the equation generally goes missing. "All in
all", Williams points out, "if you were to peel back changes that were
made in the CPI going back to the Carter years, you'd see that the CPI
would now be 3.5 percent to 4 percent higher" - meaning that, because of
lost CPI increases, Social Security checks would be seventy percent
greater than they currently are.

Furthermore, when discussing price pressure, government officials
invariably bring up "core" inflation, which excludes precisely the two
categories - food and energy - now verging on another 1970s-style price
surge. This year we have already seen major US food and grocery
companies, among them Kellogg and Kraft, report sharp declines in
earnings caused by rising grain and dairy prices. Central banks from
Europe to Japan worry that the biggest inflation jumps in ten to fifteen
years could get in the way of reducing interest rates to cope with
weakening economies. Even the US Labor Department acknowledged that in
January, the price of imported goods had increased 13.7 percent compared
with a year earlier, the biggest surge since record-keeping began in
1982. From Maine to Australia, from Alaska to the Middle East, a
hydra-headed inflation is on the loose, unleashed by the many years of
rapid growth in the supply of money from the world's central banks (not
least the US Federal Reserve), as well as by massive public and private
debt creation.


The US Economy Ex-Distortion

The real numbers, to most economically minded Americans, would be a face
full of cold water. Based on the criteria in place a quarter century
ago, today's US unemployment rate is somewhere between nine percent and
twelve percent; the inflation rate is as high as seven or even ten
percent; economic growth since the recession of 2001 has been mediocre,
despite a huge surge in the wealth and incomes of the superrich, and we
are falling back into recession. If what we have been sold in recent
years has been delusional "Pollyanna Creep", what we really need today
is a picture of our economy ex-distortion. For what it would reveal is a
nation in deep difficulty not just domestically but globally.

Undermeasurement of inflation, in particular, hangs over our heads like
a guillotine. To acknowledge it would send interest rates climbing, and
thereby would endanger the viability of the massive buildup of public
and private debt (from less than $11 trillion in 1987 to $49 trillion
last year) that props up the American economy. Moreover, the rising cost
of pensions, benefits, borrowing, and interest payments - all indexed or
related to inflation - could join with the cost of financial bailouts to
overwhelm the federal budget. As inflation and interest rates have been
kept artificially suppressed, the United States has been indentured to
its volatile financial sector, with its predilection for leverage and
risky buccaneering.

Arguably, the unraveling has already begun. As Robert Hardaway, a
professor at the University of Denver, pointed out last September, the
subprime lending crisis "can be directly traced back to the [1983] BLS
decision to exclude the price of housing from the CPI ... With the
illusion of low inflation inducing lenders to offer six percent loans,
not only has speculation run rampant on the expectations of ever-rising
home prices, but home buyers by the millions have been tricked into
buying homes even though they only qualified for the teaser rates". Were
mainstream interest rates to jump into the seven to nine percent range -
which could happen if inflation were to spur new concern - both
Washington and Wall Street would be walking in quicksand. The
make-believe economy of the past two decades, with its asset bubbles,
massive borrowing, and rampant data distortion, would be in serious
jeopardy. The US dollar, off more than forty percent against the euro
since 2002, could slip down an even rockier slope.

The credit markets are fearful, and the financial markets are nervous.
If gloom continues, our humbugged nation may truly regret losing sight
of history, risk, and common sense.
_____

Kevin Phillips's new book, Bad Money: Reckless Finance, Failed Politics,
and the Global Crisis of American Capitalism, was published last month
by Viking.


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