advertisement
Lessons from the bubbles
But even reversing the adjustments that have distorted the official inflation figures won't fix the basic problem with the way we calculate inflation. Think of this: If the price of a can of soup goes up 10 cents, that's inflation, but if the price of a stock soars by 100%, that doesn't count as inflation at all.That might have made sense once upon a time, when increases in the money supply in one country didn't have a chance to move around the world to create global asset booms or when traders in New York couldn't borrow yen in Tokyo to bid up the prices of stocks in New York and London. But it sure doesn't make any sense in the current global economy, when floods of cash can move directly into asset markets, leaving the prices of goods in the real economy relatively unaffected.
Look at what happened in 1999 and 2007 as bubbles in the asset markets expanded toward bursting. In August 1999, the Federal Reserve did indeed increase interest rates to 5.25% from 5%, but that was only a return to the 5.25% rates of September 1998. Interest rates had been higher in March 1997, but then the Fed spent the next year and a half lowering rates until they hit 4.75% in November 1998. There wasn't any reason to raise rates in 1998 because inflation was a very modest 1.6% -- officially -- that November.
Of course, stock prices were showing a rather amazing rate of inflation of their own. The Nasdaq Composite Index ($COMPX) climbed 39% in 1998 and 86% in 1999. Alan Greenspan's Federal Reserve kept its hands in its pockets as asset values soared, however. The Greenspan Fed's policy was to let asset bubbles follow their own course rather than intervene.
The central bank could have raised interest rates to slow the economy as a whole -- and the stock market along with it -- or it could have used its power to set margin requirements to reduce traders' ability to borrow money to buy shares without affecting the economy as a whole. But instead, the Federal Reserve chose to do nothing. Half of the Fed's mandate is to control inflation, but since the bank doesn't include asset prices in its view of inflation, it could reasonably decide to do nothing.
More from MSN Money
Same problem, same lack of solution in the run-up to the mortgage bubble that broke in 2007. The Federal Reserve knew housing prices were rising in a speculative fever -- Greenspan famously dismissed the bubble as "froth" -- but with official inflation so low, the Fed didn't need to move aggressively to reduce the rate of inflation in asset prices. Again, the Fed could have raised interest rates to slow the general economy or used specific powers -- in this case its power over bank reserve requirements and lending standards -- to reduce the amount of mortgage money available to homebuyers without slowing the economy as a whole.
Another look at the numbers
A few economists have begun to develop systems that would include asset prices in a measure of inflation. The job is hard, but from the papers I've read, not impossible.The miscalculating of inflation contributed to our current financial and economic mess in another way as well. When we talk about the growth rate in the economy, we talk about the real rate of growth -- i.e., the rate of growth after subtracting inflation. If the real rate of inflation is higher than the official rate of inflation, that means the actual rate of growth in the economy is lower than the official rate of growth.
So when the economy grew at 1.2% in the fourth quarter of 2005, 1.1% in the third quarter of 2006 or 0.6% in the first quarter of 2007, the actual growth rate for the economy was close to or below zero. If we weren't in a recession in those quarters, we were near one.
And what did the Federal Reserve, which has managing the economy as the other half of its job, do about these signs of dangerous weakness? Nothing, of course, because by the official growth numbers, as affected by the official inflation numbers, there wasn't any problem.
Video on MSN Money
Big Oil's bet on pricesRumors are swirling that oil company Total is about to buy Nexen. What's interesting about it is the rumored price -- $36 a share -- because that price would make sense only if oil is headed back to $70 to $80 a barrel, Jim Jubak says.
The very weak actual numbers of economic growth might have provoked earlier measures to stimulate the economy. At the least, they would have raised a red flag on the health of the housing market: How could home sales be booming and prices soaring even as the real economy delivered something near zero growth? Someone at the Fed or in the U.S. government might have asked that.
But they didn't.
Because reality, as measured by the official numbers, distorted the truth of the real economy and the real asset markets. There's no guarantee that fallible human beings presented with accurate data won't make mistakes. Even huge mistakes. But with distorted data, we don't have a chance of getting it right.
Continued: Developments on a past column
< previous | 1 | 2 | 3 | next >
Rate this Article
High