How I Achieved Maximum Success with 2


How I Achieved Maximum Success with 2Albert Einstein, a man who knew a thing or two about celestial mechanics, supposedly once called compound interest “the most powerful force in the universe.” While the remark was likely meant to be funny (astrophysicists can be hilarious), it sheds light on the often overlooked fact that small changes, over time, can yield enormous results. Over eons, small creeks can carve large canyons through solid rock. The same phenomenon may be at work in our economy. A minor, but persistent under bias in the inflation gauge used in the Gross Domestic Product (GDP) may have created a wildly distorted picture of our economic health. It would be impossible to measure the economy without “backing out,” inflation. That is why economists are very careful to separate GDP reports into two categories: “nominal” (which are not adjusted for inflation), and real (which are). Only the real reports matter. The big question then becomes, how do we measure inflation? Just as I reported last week with respect to the biases baked into the government’s GDP revisions, the devil is in the details. As it turns out there are a number of official inflation gauges that vie for supremacy. Most people tend to follow the Consumer Price Index (CPI) which is compiled by Bureau of Labor Statistics, a division of the Department of Labor. The CPI is regarded as the broadest measurement tool, but it has been changed many times over the years. Most famously, its formulas were loosened in the late 1990’s as a result of the “Boskin Commission” which said that the CPI overstated inflation by failing to account for changes in consumer behavior. I believe those changes seriously undermined the reliability of the index. But the CPI itself has to contend for relevance with its stripped down rival, the “Core CPI,” which factors out food and energy, which many believe are too volatile to be accurately counted. The core CPI is almost always lower than the “headline” number. Another set of inflation data, the “GDP Deflator” is compiled by the Bureau of Economic Analysis (part of the Commerce Department), and is used by them to calculate GDP. The deflator differs from the CPI in that it has much more flexibility in weighting and swapping out items that are in its sample basket of goods and services. While the CPI attracts the lion’s share of the media and political attention, it is the deflator that is relevant when looking at economic growth.
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On a quarterly basis the two numbers are usually close enough to escape scrutiny. (However, the most recent 2nd quarter GDP estimates relied on annualized inflation of a ridiculously low .7%!). But if you look at a broader time horizon a very clear pattern emerges that makes a great difference in how we perceive the economic landscape.
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Available data sets for both the CPI and the GDP deflator go back to 1947. That 66 year period falls neatly into two phases. From 1947 to 1977 both yardsticks moved together almost identically, both rising 173% over that time. But in the ensuing 36 years (until 2013), the CPI is up almost three fold (292%) while the deflator is only up about two fold (209%). The CPI rising 40% more than the GDP deflator is an extremely significant factor. How did that happen? As it turns out, quarterly inflation assumptions have been, on average, .17% lower for the deflator than for the CPI since 1977. That is a small number. But as with compound interest small numbers add up to big numbers over time. On August 11th, German media got hold of and published an internal Bundesbank report which maintained that Greece would likely need further relaxation of the terms of its rescue bailouts. The report contained revelations that could be deeply embarrassing to the government of Angela Merkel that has maintained forcefully that German taxpayers would face no further commitments. The revelations could potentially be a potent weapon for her political opposition in the upcoming election. More broadly, the revelations reveal a wide gap between economic reality and the sunny face of EU optimism. The Bundesbank is widely considered to be the epicenter of Germany’s notoriously conservative banking culture. Unlike central banks in other countries, such as the Federal Reserve and the Bank of England, the Bundesbank has been known to operate with actual political autonomy. The leaked report claims that the Greeks have been “barely satisfactory” in their compliance to prior commitments. In addition, the Bank harbored “substantial doubt” that Greece would be able to implement the required reforms and that Greek approval of the process resulted from “political necessity”. In late September Germans will go to the polls for a national election to determine the makeup of their national parliament, the Bundestag. Some believe that Chancellor Merkel’s ruling coalition may be vulnerable. There is a very strong, and growing, belief among rank and file Germans that the country should reject open ended financing of southern EU members who cannot put their fiscal houses in order as the Germans themselves have managed to do. This sentiment puts them at odds with the current ruling coalition in Berlin. The ‘dream’ of a European Union demands the eventual yielding of complete sovereignty to the EU by every member nation. But each nation faces a different cost/benefit. To the southern tier nations access to the sound euro currency, appeared as a huge opportunity. It most cases EU membership was well supported on the street. For the major core ‘contributing’ nations the rationale was not so simple. It varied not just between member nations but also between their leaders and people. The French leaders and even those of the ‘Buffer’ countries saw the EU as hobbling Germany and preventing intra-European war. German elites have long been the most extreme champions of EU integration, which would doubtless put the Germans in a position of extreme power across the entire Continent. However to such a political victory will require sacrifices that the German “volk” do not appear willing to make. Having failed three times to secure an empire by force of arms, German political leaders have seen the EU as the chance of achieving one through financial muscle. Apparently, they are prepared to pay vast sums of money to achieve this grand aim. This aim is no doubt supported by domestic industrialists who are keen to secure captive markets. Germany’s EU dilemma stems from the unwelcome fact that the chronic debt problem of the so-called ‘periphery’ nations, occurred before the EU has secured full sovereignty over its member states. Greece gained admittance to the EU and remarkably to the Eurozone by falsifying its financial statements. But, desperate to gain memberships and credibility, the Eurozone ignored the deception. Most members felt also that Germany and the ECB would cover any shortfalls. However, when the Greenspan asset boom collapsed with the U.S. and EU economies sinking into recession, periphery nations of the Eurozone were unable to resort to their habitual currency debasement. They financed their ballooning deficits with massive hard euro currency loans. As the recession deepened, Eurozone banks were ordered, and other EU banks ‘encouraged’ to invest in the euro denominated debt of periphery Eurozone member nations. As conditions worsened, bailouts were organized by the so-called Troika of the EU, ECB and IMF. There can be little doubt that these negotiations were controlled by the Germans, who ended up with the lion’s share of the liability, 122 billion euro to be exact. The Germans however demanded an Austrian School-influenced austerity solution to the profligacy of the periphery Eurozone members. As expected, this policy drove Europe into corrective recession, which appears to be having some success. In this light the Bundesbank revelations could not come at a worse time for Merkel. German citizens, encouraged by opposition politicians, are becoming increasingly angered by their political leaders apparent willingness to sacrifice their hard earned wealth to gain European dominion. In an attempt to calm the situation, Merkel said, “We don’t have to do everything in Brussels.” While many correctly recognize this shift as a desperate means to shore up electoral support, this dramatic apparent rebuff of the key EU dream of centralized power could temporarily weaken international support for the Eurozone. If the Chancellor retains power, look for such rhetoric to dissipate. However, a rebuff at the polls could severely reshuffle the current balance of power in the entire Eurozone, and begin a shift towards decentralization. A small nation, Greece continues to threaten the euro, the EU dream and with them the German drive for empire. This should remind us all how fragile the experiment remains.

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