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Having been prompted to contribute rather than just tear apart others contributions, I needed to wait until I had something seminal to say. But statistics and particularly US Government Statistics have been a bug bear of mine for sometime. And the worst of all those is the way Inflation is defined, measured and used.

The final trigger was this article in the Financial Times.

Actually, it is, for the most part, uncannily accurate for the guy that was effectively asleep at the wheel as the problem arose. It would, however, have been more truthful if there had been greater use of the first tense singular, but I digress.

The issue, as I see it, is that this financial crisis came upon us by stealth. Almost nobody saw it coming. This is in part because those in power were too busy running around telling lies to each other and everyone else. But perhaps more importantly, it arose because we are measured the wrong things in the wrong way and put them to the wrong use, and nowhere is this more true than with inflation.

In my view, the system requires a complete overhaul. We need to stick with the basic premise of monetarism, that a growth requires stable inflationary conditions, and that this can be achieved by controlling the money supply. But in order to do this, we need to define more accurately what we mean by inflation, how we measure it and how we use that information, particularly to keep inflation within an acceptable range.

Basically, a nation becomes wealthier on a per capita basis through improvements in the wealth generation process. As we perceive ourselves to be contributing more, then we need to be able to pay ourselves more, so that we can benefit from the fruits of labour and entrepreneurialism. In other words, we pay ourselves a fair proportion of what we have earned. However, the value of money changes and we must make an adjustment to make fair year to year comparisons. If the cost of everything is rising then the wage packet needs to adjust to reflect this before we consider whether we as individuals or as a nation have been contributing more or less. That is where Inflation comes in. But it is not as simple as it might appear.

First of all we cannot simply compensate ourselves at the rate of inflation if that rate is beyond the range required for a sustainable economy. If that occurs it is necessary to under-compensate ourselves in order to bring things back within in the target range, which is generally acknowledge should be of the order of 2 -3% per annum. As it seems reasonable to try to get Inflation back within range over a period two years then it seems that we should only 50% compensated for any increase above that level. Imagine that inflation is determined at 7% per annum then we should only have wage inflation of 5%. We need to take the hit for previous past excess that cause inflation to overshoot. On the inverse it could be argued that we need to over compensate when inflation goes to the underside. This is likely to happen anyway, but in the normal scheme of things, we would not get a wage reduction unless our employer has a severe liquidity problem. It might, however, be considered useful to protect workers remuneration by regulation when such reductions are being made purely for cost advantage, and to bolster the bottom line. However, there is a limit to the degree to which government can sanction companies going out of business.

Inflation is also used to determine things like GDP growth and real investment returns. It is therefore of paramount importance that we can measure it accurately and effectively. So we come on to the subject of what you measure and how you measure it. Well lets start with the things that don’t work, analyse why they don’t work to see where we went wrong and then to determine how the system can be fixed. As I see, it there are three key areas where the existing system has failed.

  1. Asset Prices including Housing
  2. Commodities
  3. Imports

Let’s start with the good news which is Oil. In the past, huge increases in the cost of oil and other commodities have pushed inflation up, and this has resulted in higher interest rates. This situation is absurd. The Central Banks kick the economy when it is down because they fear inflation. But the bottom line is the increase in energy cost whilst driving up prices is probably not inflationary in the sense that I understand it. As I understand it, “Cost Inflation” as opposed to “Price Inflation” is about us charging more for what we do. If we have to pay more for oil imports, this does not mean that because the price of gasoline and everything else that has crude oil as a primary input goes up that we should be penalised twice by the imposition of higher interest rates by the central bank. We as individuals and businesses already have to face up to more difficult external market conditions which if anything are going to drive the economy towards recession rather than away from it. Imposing a double whammy of higher interest rates would be wholly counter productive.

On the other side of the coin and this is where Alan Greenspan completely blew it, imported cheaper manufactured goods or a stronger currency are not something that workers in our own country can take credit for, and should not therefore be rewarded with lower interest rates. OK, if say 50% of production is domestic, and our domestic industry is being put under pressure by cheaper imports, then it is fair to reflect the price pressures on our own producers, but we cannot be rewarded for productivity improvement or cost reductions in other economies.

Asset price inflation is a difficult area and the cost of housing and stock markets have not previously been included in the most commonly used inflation indices, but the money supply must reflect asset values. These asset prices have a huge impact on the money supply and do not generally reflect increases in productivity. Often they are simply unearned bonanza derived from excess money supply. This excess contribution to the money supply must be removed. However, it should not necessary to include these in the Inflation Index, as the growth in these assets is directly related to amount of money available to individuals. This comes as mixture of earnings and available credit. The first I propose to deal with earning growth implicitly within a new inflation measure and therefore need not be counted again. The second is down to the lending policies of the banks and the regulation of the Central Bank itself, and again it is not appropriate to include this in the lending policies.

What I am proposing is that we start over with a new inflation index which I will dub Producer Cost Inflation (PCI). The purpose of this measure is to reflect the increased cost of everything we do, but nothing we do not do. In order to measure this, we need to break the economy down into segments, analyse the increasing cost in each segment and then weight each segment according to the importance of its role in the economy. This is going to take us a long way from the shopping basket approach, as each item in that basket will comprise elements of each of our segments of the economy.

The first segment we shall consider is imports and exports. These will be isolated and ignored, because we are interested in controlling costs within our own economy rather than what is going on elsewhere in the World.

Secondly, we look at domestically produced commodities. We ignore the sale price, because that simply reflects prices on World markets. We look simply at the cost of production. This may be a bit more complicated, but if you look at the quarterly production of say a coal mine, establish its total revenue, deduct its before tax profit adding back any government subsidies, and then divide by it output it is not too hard to come up with a production cost. A similar approach can be taken with all commodities including Agricultural to establish a Value Added Unit Cost.

We then look at Manufacturing Costs. Again take the revenue income, and in this case deduct feedstock costs and profit, again adding back any subsidies to establish unit costs for each class of goods and divide by the production volume to establish a Value Added Unit Costs in each case.

A similar approach can be taken with Distribution and Retail, establishing Value Added Unit Costs in each case.

To arrive at the CPI all it is necessary to do then is to determine the weighting of each segment of the economy, work out their year on year Value Added Unit Costs increases as a percentage and then weight them into the new PCI Index. This index would then be used to determine the central bank lending rate.

However, we have yet to show how the growth of assets prices can be controlled in the money supply and why we have left them out the inflation measure altogether. To understand more, we need to look at economy that has taken growth to extremes, whilst dealing with high inflation and huge monetary growth. What they do in China is deceptively simple. They control the bank lending by having variable reserve ratios that are determined periodically by the Central Bank. It is has been shown that is possible to separate out the control of asset price inflation and consumer inflation by dealing with them by separate mechanisms. The contribution to inflation of goods and services can be dealt with by adjusting interest rates, whilst contribution of asset prices to inflation can be controlled by varying the reserve ratios of the lending institutions.

Source: Statistics: Where It All Went Wrong