Price Indices – And Other Lies

December 9, 1996 – We have a problem. It is not an easy problem to solve, but it is an easy problem to understand. It has to do with money, and specifically, the US Dollar.

The problem is that the Dollar is constantly changing. The name remains unchanged, but not so a Dollar’s purchasing power. It is never the same.

Consequently, we know that a 1996 Dollar (i.e., the purchasing power of one of these so-called Dollars in 1996) is different from that of a 1990 Dollar. And if you’re old enough to have lived back then and remember some prices, you also know that a 1996 Dollar is different from a 1960 Dollar or a 1940 Dollar, and so forth. The point is that a Dollar in 1996 purchases less than a Dollar in any previous year, and the further you go back, the bigger the difference – the bigger the decline in the purchasing power of the Dollar.

Now, this ongoing decline in the Dollar’s purchasing power is also a problem, but it’s not the problem that I want to address at the moment. The problem at hand is one of measurement. If the Dollar is always changing, how can any measurements of price and value transcend time?

Economists try to adjust for this change in purchasing power. They use the Consumer Price Index, the Producer Price Index or some other statistical basket, and then these economists purport to measure the change in these indices to determine how much purchasing power the Dollar has lost. They then restate the Dollar to the chosen base year, and make their comparison of price over time in this adjusted Dollar. Economists then call this artificial creation a ‘real Dollar’, a name derived from the so-called real rate of inflation. How many times have you heard that term?

It has been expressively argued that economists use numbers much like a drunk uses a lamppost – more for support than illumination. Proof of this observation is the fiddling of price statistics and the hack methodology used to supposedly calculate the rate of inflation. Adjustments purporting to reflect the diminution in the purchasing power of the Dollar are seriously flawed.

For example, if an index of consumer goods is chosen to make the price adjustment, what do you put in the index? What consumer goods reflect consumer life style today compared to other moments in time? While it may have been meaningful to put straw hats in the index to reflect consumer purchases in the 1920’s, that item has no relevance today. If items in the basket change, is the basket meaningfully comparing changes in the cost of living?

There are other complications in the make-up of an index. Should computer chips be put in the index? They are clearly important to the way we live today, but doesn’t their rapid decline in price due to technological advances distort the true measure of the cost of living? If computer chips were included in the Producer Price Index in 1970, the dramatic increase in this index over these years (it has more than trebled) would have been substantially reduced. There are other problems as well.

The basic building block of all economic theory – the interaction of supply and demand – is blissfully overlooked in comparisons of Dollar purchasing power to any commodity. The supply and demand of commodities change over time. One year a drought or some other natural disaster may adversely affect supply. The next year changes in consumer preferences may affect demand. Therefore, the use of any commodity in an attempt to try measuring and comparing the purchasing power of the Dollar in one year with a different year is no more fruitful nor accurate than using an index. So what is the answer to this problem?

Basically, money must be compared to money. The Dollar must be compared to Gold, and then these moneys can be used to make the comparison of prices over time. But while this problem of measuring the purchasing power of money is easy to understand, it is not so easy to do. At least it wasn’t for me, until I eventually put together some common sense notions about money. Specifically, I began over time to understand some of the essential characteristics of Gold.

Gold has unique attributes. Some of these are obvious – its malleability, inability to be destroyed, heavy weight and other physical characteristics. But some of Gold’s characteristics are very subtle, and not so easily perceived. Among these are those factors that affect its supply and demand.

The aboveground stock of Gold grows by a fairly consistent rate, about 1.75% per annum. This annual increase is similar to the rate of world population growth. It is also similar to the rate of new wealth being created each year (i.e., the small balance left over each year from the production of new goods and services not consumed that year).

These similar growth rates mean the supply and demand for Gold is fairly consistent, particularly over long periods of time. Not so with the Dollar. Its supply can be manipulated – and regularly is manipulated – by governments and their handmaidens, the central banks. They can also manipulate the supply of Gold in the short-term by dishoarding their stocks of the metal.

Additionally, the demand for any national currency changes. For example, the Dollar is demanded less as an international medium of exchange today than it was in the 1950’s (the use of other currencies is supplanting the Dollar’s post-World War II role in this regard).

The upshot of all this is that the characteristics of supply and demand for Gold and the Dollar are the opposite of one another. In the short-term, the supply and demand of the Dollar is steady, but potentially volatile for Gold. Over the long-run, the supply and demand for Gold is steady, but not so the supply and demand of Dollars, which is changing. And it is these changes that create the problem of trying to use the Dollar to measure prices over time. So how do we solve this problem? We use the Fear Index, which provides a basic comparison of the worth of Dollars and Gold in exchange for one another. An illustration (I’ll use my Ford Mustang example) makes clear these price changes.

The Fear Index at the end of November was 2.01%, which is calculated as follows:

We can use the Fear Index to calculate the real meaning in price changes over time. For example, the Ford Mustang cost $2,500 when first launched in 1964, and it costs $27,000 today (a 7.7% per annum rate of growth). When calculating its price in terms of Gold, the Ford Mustang cost 71.4 ounces in 1964 ($35 per ounce of Gold) and 73.0 ounces today. However, because the Fear Index was 3.80% in 1964 and is today 2.01%, the 1996 Dollar price needs to be changed to reflect this difference, in order to turn 1996 Dollars into 1964 Dollars. In terms of 1964 purchasing power, a Ford Mustang today would actually cost $51,045 (3.80/2.01 times $27,000), which is a 9.9% rate of growth.

Meanwhile, the CPI contends that the Dollar was debased by only a 5.2% per annum. Here is how the government plays its tricks. Because Ford can produce its cars more efficiently today, this savings in cost is used by the government to lower the CPI.

There is one other trick the government uses. A 1996 car is far superior to the 1964 version, better built with more accessories, amenities, safety features and so forth. However, these “quality” factors that result from technological advances are factored into the government’s price adjustment calculations in an outlandish way.

Because you are buying “more car” today, the government adjusts the Dollar for these advances and concludes that the Dollar has not been debased as much. Therefore, it uses these technological achievements in a feeble attempt to help mask the true debasement of the Dollar.

Therefore, a true measurement of the loss of Dollar purchasing power over this time period would be a 9.9% per annum decline, a rate well above the actual 7.7% rise in the Dollar price of the car. But the government is not just satisfied with this distortion. It further reduces the actual debasement of the Dollar by using so-called quality factors to speciously distort the true picture, further reducing the reported loss of annual purchasing power in the Dollar to only 5.2% per annum.

Have you ever wondered why you may be working so much harder than you were in the 1960’s or 1970’s but have little, if any, more to show for it? The answer lies in the Dollar, and specifically, our reliance on it for performing our needed and ongoing economic calculations, i.e., for measuring the prices of goods and services.

The average standard of living in the country is declining, and while many people can sense this deterioration is taking place, few can calculate it. The reason is that they rely on government price indices, rather than Gold, to make their price measurements.