Inflation Is Worse Than We Think

Inflation Is Worse Than We Think
John Tamny 07.16.08, 11:45 AM ET Forbes

When inflation is presently considered, those who possess a more sanguine outlook about pricing pressures have pointed to the Consumer Price Index to bolster their view that inflation is not a problem. While the dollar has fallen to record lows versus gold and other foreign currencies in the past year, the CPI measure of inflation has remained comparatively quiescent.

To be sure, the CPI announcement Wednesday morning that prices are up 5% since last year–1.1% in June alone–isn’t good news by any stretch of the imagination. But in defining actual inflation, it can’t be said enough that it is always a monetary phenomenon resulting from the currency in question losing value. The problem with the CPI, however, is that consumer prices themselves transmit all sorts of information unrelated to currency strength or debasement. So while rising prices can be a symptom of inflation, they can also result from all manner of things that have nothing to do with the value of the currency.

Indeed, increased sales taxes have nothing to do with changes in the value of the dollar, but when it comes to the CPI, they are booked as inflation. If hotel rooms in New York City become very expensive relative to the past, some would consider this an inflationary event despite simple logic showing otherwise. Put simply, if New York hotel rooms suddenly cost $200 a night more than they once did, the broad impact on the price level would, by definition, be zero due to the fact that consumers would have $200 less to spend on goods that were formerly attainable.

Conversely, if, due to productivity enhancements, a laptop computer today costs $1,000 when it previously would have set a consumer back $2,500, there would be no deflationary event to speak of there either. Falling consumer prices–whether they’re the result of productivity innovations or cheap imports from overseas–can in no way change the real price level. That is because cheap goods merely expand the range of products we can buy. If a consumer has $1,500 extra after the computer purchase, that money is used to demand other goods that were at one time out of reach, either through savings or immediate consumption.

As economist Nathan Lewis wrote in his essential book, Gold: The Once and Future Money “Prices are supposed to change,” and the “information transmitted in changing prices organizes the market economy.” In other words, it is through freely set market prices that the consumer communicates to the producer what, and what not, to bring to market. When monetary authorities target consumer prices, they inhibit this important method of communication and, as a result, the economy suffers.

To the extent that there is a monetary devaluation, it shouldn’t be assumed that a weaker unit of account will immediately be reflected in all consumer prices. This is because prices are very sticky. Because of consumers’ preference for routine, producers are often reluctant to break those habits with price changes.

More important, there’s a way to increase the cost of a good without increasing the nominal price of that same good. Indeed, as a recent USA Today story showed, ice cream makers suffering from rising dairy costs have, in many cases, reduced the size of standard ice cream containers to 1.5 quarts from 1.75 quarts. Frito Lay and Dial have done the same with bags of potato chips and bars of soap.

Forbes Chairman and Editor-in-Chief Steve Forbes has pointed out that while the pastries he buys each morning at Starbucks cost the same amount, they’ve shrunk in size. Containers of Shedd’s Spread Country Crock used to contain 48 ounces of margarine, but buyers now pay the same price for 45 ounces. Frequent RealClearMarkets contributor Doug Johnson notes that the cost of a package of diapers for his children hasn’t gone up, but now there are four less diapers in each package.

So not only are consumer prices a bad measure of inflation given the numerous inputs that lead to one price, but those prices frequently hide real increases that government measures of inflation can’t register. Ultimately, it has to be recognized that the only true measure of inflation does not involve prices but rather involves the value of the dollar itself.

And when we consider the dollar, the most reliable benchmark is not the greenback’s value versus the euro, yen or pound, but the dollar’s value in terms of gold. Gold did not serve as a measure of money for thousands of years because it was unstable, but it has been used as “money” given its historical constancy in terms of price. Thanks to a massive stock of gold around the world relative to small new annual discoveries, gold is the single best measure of money we have. When the price of gold moves, this is not a signal that gold’s price has changed. Instead, it tells us that the dollar’s value is rising or falling.

Notably, gold has risen 283% against the dollar since June of 2001. While a dollar used to buy 1/253rd of an ounce of gold, as of this writing, it buys 1/970th of an ounce. For those wondering why all manner of commodities–from gasoline to corn to meat–have become so expensive over the last few years, look no further than the dollar’s debasement. Just as gold’s rise was a major inflationary event in the 1970s, so it is today. CPI and other government measures of inflation that show that light pricing pressures are charitably wrong.

And to the extent that some have great faith in CPI-like measures, they need only look at countries outside the United States to see that our version of CPI is greatly understating true inflation. Sure enough, if it’s agreed that inflation is purely a monetary concept, we then need only look to other countries whose currencies have greatly outperformed the dollar in this decade.

Despite the fact that the euro and pound have crushed the dollar in recent years, government inflation statistics in both show it at 16- and 18-year highs, respectively. The Aussie dollar is near parity with the greenback (from the $0.50 range back in 2001), but inflation there is also at a 16-year high. Qatar and Vietnam have had direct-dollar links for quite some time–meaning that our monetary policy is theirs–but CPI measures in both countries show it registering 15% and 25%, respectively. And while China has allowed the yuan to rise 18% against the dollar since July of 2005, inflation there is at an 11-year high.

About the worldwide inflation story, the lesson is not that non-dollar currencies are strong. Quite the opposite. In reality, non-dollar currencies are very weak; one need only measure them in gold this decade to see that. Their weakness is masked by the dollar’s much greater enervation since 2001. While the dollar is still the world’s reserve currency, downward movements in its value almost always lead to broad currency debasement just as periods of dollar strength cause world currencies to strengthen.

So while inflation problems around the world confirm that our government measures of inflation are faulty, the bigger story is what a rising dollar price of gold means for the average American. In short, when gold rises, paychecks are emasculated, investment in innovative, job-creating enterprises subsides and money flows to the relative safety of the “real.”

Rather than clinging to the CPI as false evidence of light inflation, and worse, targeting consumer prices, monetary authorities should instead target a stable gold price with an eye on bringing it down substantially. If history is any kind of indicator, an upward correction of the dollar would quickly cheer an electorate that presently has much to complain about.

John Tamny is the editor of RealClearMarkets , a senior economist with H.C. Wainwright Economics and a senior economic advisor to Toreador Research and Trading. He can be reached at jtamny@realclearmarkets.com.