How do we make sure we don't replay the current financial crisis five years from now?
So far, all the plans, revised plans and re-revised plans that have come out of Washington have focused on saving the banks, Wall Street, the financial system, the U.S. economy and the global economy from a devastating meltdown. That's certainly important.
But unless we address the root causes of this crisis, we're going to find ourselves back in trouble way sooner than we'd like. It took us only five years to go from the bottom of the 2000-02 technology crash and bear market to the top of the real-estate and financial-leverage boom market in 2007. Without essential reforms, I'm afraid we'll be looking at a crisis much like the current one in another five years or so.
What reforms are essential? I'd start with fixing the way we measure inflation. The official inflation number is so misleading that it played a huge role in creating the tech stock bubble that broke in March 2000 and in the leverage bubble that broke in 2007.
(In two columns coming later this month, I'm going to outline two other important reforms needed to help avert a repeat of the current crisis. You can weigh in with your own reform suggestions on my Market Talk message board.)
3 major shifts in figuring inflationMost criticism of the official inflation number, the Consumer Price Index, or CPI, has focused on the statistical flimflam used by the Bureau of Labor Statistics to calculate how fast prices are going up.
Chief among these is a technique called hedonics. Starting in the 1990s, some economists and government statisticians began arguing that a $100 increase in the price of, say, a car wasn't really a $100 price increase if the power, safety features or general usefulness of the car improved substantially. If the subjective value of the car went up by $100, then, despite the increase in what you paid, according to the government, the price didn't go up at all.
The objection to this kind of adjustment is that it introduces a huge amount of subjectivity into the process of calculating inflation. Determining the increased usefulness of a product or service requires a subjective judgment about the value of this or that feature. What is the extra horsepower of a car worth to a user? How about extra safety features? And to which user? And if the cost of a car went up by $100 even if it came with more and better features, wasn't the price still in reality $100 higher?
Hedonic quality adjustments weren't the only statistical adjustments that the government made to the inflation numbers. Starting in 1983, the government also started to measure changes in the cost of housing by looking not at the cost of a house but at what an owner would get if he or she rented out that house. Since in a housing boom the price of houses rises about three times as fast as rents do, this change understated the rate of inflation.
In the 1990s, the government also started to include substitution pricing in its inflation measure. In this adjustment, government statisticians assumed that if the price of something went up, people would use less and would substitute a less costly product or service. So when steak went up in price, consumers might buy more pork or chicken. Figuring out what substitution a consumer would make again added to the subjectivity of the inflation numbers. Including substitution destroyed the whole point of the exercise because it turned the government's shopping basket from an inflation measure to a set of lifestyle choices.
How big an impact?It's hard to figure out exactly how much these three changes have subtracted from the rate of inflation. The St. Louis Federal Reserve Bank calculated that the use of rental equivalents to estimate housing cost increases might have subtracted somewhere around half a percentage point from the official CPI.
Bond guru Bill Gross figures the changes were worth a full percentage point off the official inflation number. Other estimates put the effect of the change at anywhere from 5 to 8 percentage points.
Adding even 1 percentage point to the official rate would have put the real rate well above the 2% to 3% target as early as October 2002, when the official rate was 2.03%. At that point, the Federal Reserve, relying on the official rate of inflation, still had seven more months of cutting interest rates ahead of it and then 12 months with Fed-controlled interest rates at just 1%.
The distortion in the inflation rate compounded a huge policy mistake. In retrospect, keeping interest rates at just 1% for so long allowed the mortgage bubble to develop. Seven months spent cutting interest rates when the unadjusted inflation number showed that the central bank should have been raising rates just made that mistake even worse by giving cheap money a longer chance to build up momentum in lifting housing prices.