Chapter 5: Misleading indexes and the trouble they cause

Adam Smith in the Wealth of Nations; vol.1 chapter 5 wrote:

“Every man is rich or poor according to the necessaries, conveniences, and amusements of human life.  But after the division of labour has once thoroughly taken place, it is but a very small part of these with which a man’s own labour can supply him.  The far greater part of them he must derive from the labour of other people, and he must be rich or poor according to the quantity of that labour which he can command’ or which he can afford to purchase.  The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which it enables him to purchase or command.  Labour, therefore, is the real measure of the exchangeable value of all commodities.

The real price of everything, what everything really costs............ It was not by gold or by silver, but by labour, that all the wealth of the world was originally purchased; and it’s value , to those who possess it, and who want to exchange it for some new product, is precisely equal to the quantity of labour which it can enable them to purchase or command ............Labour alone, therefore, never varying in it’s own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared.  It is their real price; money is their nominal price only.”

Much has changed in the two and a quarter centuries since Adam Smith wrote these words.  The quantity of money in circulation no longer depends on the output of gold and silver, nor of printed banknotes, not even of entries in banker’s ledgers.  Money is now “virtual”, recorded and exchanged in binary code by increasingly sophisticated and rapid electrical or optical devices.  Governments no longer control the quantity of money; they control, or rather attempt to control only the demand for money by changing short term interest rates.  Long term interest rates remain in the province of market forces, heavily influenced by expected rates of inflation and by the supply and demand for long term government bonds.  That inflation is a monetary phenomenon is not in doubt, but crude monetarism (like all “isms” should be) is out of fashion, mainly because there is no satisfactory single definition of the money supply.  However it is not the causes of inflation that I wish to discuss now, but the meaning and definition of inflation itself.
Inflation is otherwise known as the rate of increase in the cost of living and is measured by statistics known as the Retail Price Index or RPI in so far as it affects individual members of society.  This never was a simple index and has become over the years an extremely complicated set of indexes, many of which are intended to give a more accurate picture of how different groups of people are affected by rising prices and have been introduced to give a clearer picture of what is happening.  It seemed informative to strip out the effect of taxes and the Tax and Price Index (TPI) was intended to show the change in gross taxable income needed for taxpayers to maintain their purchasing power.   The latest version in the UK is the Consumer Price Index or CPI, introduced in 2004 to bring us into line with the EU.  The CPI produces a lower figure for inflation than the RPI by excluding housing costs and using statistical tricks to reduce results.

In the United States the CPI (consumer price index) was changed so that in August 2000 it would have been very nearly 4% over the preceding 12 months under the old definition but was about 3.5% under the new definition.  There is also a “core”CPI which excludes food and energy and produced a figure of 2.5% over the same period.  Not content with these measures the USA also has a Personal Consumption Expenditure (PCE) which tries to measure how people move to cheaper alternatives as prices of their first choice items increase.  Giving the lowest figure of all was the core PCE deflator coming in at only1.8%.

America is also using “hedonic” pricing methods to strip out the effects of improvements in quality of computers, cars, clothes, televisions and so on.  Hedonic pricing breaks down a product into its key features - say the memory and speed of a computer - and then assigns prices to those features rather than to the product as a whole.  This allows price rises due only to higher quality to be removed from the index and would show a fall in the cost of a feature instead of an increase or constant price for the computer as a whole.  Hedonic pricing would show an amazing reduction in the price of one candle power of illumination over the last one hundred and fifty years, but whether this is a factor that  should be taken into account when setting short term interest rates, or is simply an interesting statistical and sociological fact, is certainly open to argument.

Great Britain imports a high proportion of its food and manufactured goods.  The price of these items is therefore set by the rate of exchange of the pound and the cost of production in other countries. A large part of the RPI or CPI therefore does not depend on what is happening in this country.  The CPI is often called the “Chinese Price Index” and with considerable justification.  The cost of goods we buy from China changes in line with Chinese inflation rates and the exchange rate of the pound against the Yuan.

If the BoE raises short term interest rates it may reduce price inflation directly by raising the value of the pound in foreign exchange markets and hence reduce the price of imported goods.  Unfortunately this raises domestic unemployment by making home produced goods and services less competitive and damages the balance of payments which in the long run will damage the exchange rate of the pound.  In general a price inflation index, particularly if massaged for political reasons, is not a good first order target for domestic monetary policy.

There were long periods in the 1980’s and more recently in the 1990’s  and early 2000’s when price inflation was behaving very well while wage and asset inflation was rising at too high a rate.  Wage inflation at a rate higher than our foreign competitors has been the main reason for the rapid decay of our manufacturing industries and the resulting loss of jobs and deteriorating balance of payments.  Over much of the last forty years our relatively high rate of wage inflation has been largely compensated by a relatively high rate of depreciation in the exchange rate of the pound.

Wage inflation is not the only factor in our loss of competitiveness.  The virtual total eclipse of our domestic motor manufacture by Germany during a period in which the pound steadily weakened against the deutsche mark had as much to do with technical incompetence and government monetary policies of “stop go” as it had with the trade union’s ability to extract wage increases completely unrelated to productivity.

Wage inflation is the primary indicator of monetary laxity and must lead inevitably to higher price inflation although this can be kept in check for quite a long time by a higher exchange rate which, in turn, may be the result of external factors such as the Euro weakening against the dollar, capital flows into the country, or the overwhelming influence of currency speculation unrelated to any reality in trade or capital flows.  Wage inflation inevitably leads to loss of competitiveness, as Britain has not shown itself to have the technical skills to increase productivity in a significant way.  In manufacturing, agriculture, and to a smaller degree in retailing and administration increased productivity can reduce the loss of competitiveness caused by wage inflation.  In most of the service industries, particularly in health and education the scope for increased productivity is very limited.  On top of this people want to work shorter hours, the population is ageing and government adds more and more regulations increasing labour costs.

Although people are very aware of price inflation they are also aware that they are becoming poorer if their income does not keep pace with wage inflation.  Those who are retired on fixed incomes or, if they are lucky, on incomes linked to the RPI are particularly aware of their relative loss of purchasing power.  They are more dependent on the services of others than the general population.  The older people become the less able they are to DIY and eventually become dependent on nursing care which increases in cost with the wages index not the price index.

Inflation became a serious problem for the UK and to a smaller extent in the USA during the 70’s.  As physical controls on commercial banks powers to increase the money supply were replaced by changing short term interest rates, a succession of measurements of money supply were used as a target.  Goodhart’s Law states: “that any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes”.  The behaviour of M3 in this context was particularly disheartening and was, during the 80’s replaced by Mo (cash) for a short time, even though, in the era of exploding use of credit cards cash itself was obviously not a suitable indicator.

At one point in the late 80’s Nigel Lawson, then Chancellor, tried shadowing the Deutsche Mark, using interest rates as the controlling factor.  The theory seemed reasonable: if the value of the Deutsche Mark remained stable and the pound remained linked to it in value then the pound must be equally stable.  The RPI increased by only 27% between 1985 and 1990 which seemed to validate the theory.  Wages however were increasing at twice the speed of prices and property prices were heading for outer space.  Once again we were looking at the wrong target, and a sideways glance at the, by then, neglected M4 broad money supply should have added to the disquiet.

During the 90’s many of the advanced countries turned to targeting inflation directly.  In the UK, once the disaster caused by the very high interest rates of the ERM membership period had subsided, we started to do the same thing with progressively greater success as the decade progressed.  It was however politically disastrous that the very high increase in personal debt accumulated during the property and stock market boom of the late 80’s was not eroded by inflation, as had happened during the 70’s.  High unemployment kept wages down in the early 90’s so that the very high levels of personal debt were not rapidly reduced by wage inflation as had happened during the 70’s and 80’s.

“The lost decades” of Japan were due to the vice like grip of debt exacerbated by falling wages.  We crawled back to the surface after the collapse of the housing bubble in 1990 with the aid of wages rising at about 4% and lulled into euphoric bliss by raging house inflation and an interlude of dot com mania.  2007 brought financial ruin from money forgery gone completely mad.   

Existing methods for controlling the supply of new money.

Every basic textbook on economics describes the way banks developed from goldsmiths who found they could issue more credit notes for gold than the amount of gold they actually held in their vaults.  Gold was the original “base money”, which placed a physical limit to monetary expansion by banks over several centuries.  The last vestige of gold as base money finally ceased in 1971 when the USA stopped backing international payments with gold as they had done since the Bretton Woods agreement in 1946.  The Bretton Woods agreement succeeded in holding the rate of inflation and international exchange rates reasonably steady until 1967.  Incidentally it was General de Gaulle’s refusal to accept USA Bank Money and insisting on gold in exchange for French assets that led to President Nixon leaving the gold standard.  

After 1971 the UK tried several methods for controlling money creation by the banking system. Eventually all controls except that over short term interest rates and all targets except inflation, as measured by the Retail Price Index (RPI) and its successor the Consumer Price Index (CPI), were abandoned. 

For a full account of the history of control methods tried during the 1970’s and early 80’s see: “A history of Money from Ancient Times to the Present Day” by Professor Glyn Davies.  The last edition was published in 2003 by the University of Wales Press.  This is a very readable and scholarly account of the forces acting on the money supply over several centuries in Britain, the USA and Japan, by an academic with considerable practical experience who acted as adviser to the Julian Hodge Bank.  Also “Controlling the Money Supply” by David Gowland 2nd edition 1984 published by Croom Helm.   “The World’s Money” by Michael Moffitt 1984 published by Michael Joseph Ltd is also a very readable account of the battle to control money supply as the Euro dollar became a dominant force. Michael Moffitt was an investment adviser at Shearson/American Express in New York.

When we abandoned all controls over the clearing banks apart from setting short term interest rates we could no longer use interest rates to control, or to be more accurate try to influence, the exchange rate. Obviously you cannot control two different things independently with only one control lever.  This was dramatically illustrated when we failed to remain in the European Exchange Rate Mechanism (ERM) in September 1992 in spite of raising interest rates, very briefly, to 17.5%.  Speculators in the international money markets called our bluff, using the virtually unlimited supplies of bank credit available for sterling to place what was obviously a one way bet.  

The major problem arising from the use of interest rates to control inflation is the resulting loss of control over exchange rates.  If we raise interest rates to reduce inflation the pound immediately rises in value even if we do not wish what is left of our manufacturing industries to suffer the resulting losses.

The European Central Bank (ECB) faces an even worse problem as they try to control the money supply in thirteen countries all with differing economic circumstances and without any central political control over individual members’ budgetary policies.  The President of France, M. Sarkozy has clearly shown that he intends to prevent French industries from being damaged by a strong Euro even if this means putting pressure on the independence of the European Central Bank.  This could lead to the destruction of the Euro as a single currency for Europe.

The methods used by the Bank of England to control inflation by means of changing short term interest rates are set out in a paper prepared by the BoE for the Monetary Policy Committee (MPC) in 1999 entitled: “The transmission mechanism of monetary policy”.  The paper describes the mechanism of control over short term interest rates which forces the clearing banks to set their short term interest rates in line with the rate set by the BoE.  The paper also discusses the ways in which changes in short term interest rates change expectations of inflation and the time delays between making changes and the resulting changes in inflation.

Shortcomings of the Consumer Price Index as a target for inflation.

Chart No. 5, above, shows the CPI, which is currently used as our inflation target split between the inflation rates for goods and services.  The CPI was introduced into the UK in 1996 and took over from the RPI as our target for inflation in December 2003.  For this reason the RPI has been used for earlier series as the CPI was not available.   

The Consumer Price Index can be divided into two parts: Goods and Services.  The Goods part has been very subdued for a long time while the Services part has been running at about twice the figure published for the whole index, as illustrated in the chart.  

The main reason for the virtually zero rate of inflation for Goods is that a very high proportion of our goods are imported from China and the price of these goods has been kept down both by much lower production costs in China and by an increasingly favourable rate of exchange against the Chinese Yuan.
In addition to having a profound effect on our CPI index by actually reducing the cost of imported goods over recent years, the rise of the Pound in relation to the Dollar has saved us from the worst effects of increases in oil and raw materials because they are priced in Dollars.  This effect has recently gone into reverse.

Changes in the world price of commodities such as oil or metals is bound to have a direct effect on any price index which does not deliberately exclude them but changes in these prices cannot be controlled by changing our interest rates.  They could be controlled by changing world interest rates but that is not within our power. 
Chart No. 6

The chart above shows the three exchange rates that have been critical for the published indices of inflation in the UK over the last sixteen years.  The blue columns show the number of Yuan to the pound rising from just under 8 to the pound in 1990 to nearly 16 in 2007.

The Chinese have controlled their currency in relation to the US dollar and the white columns show the number of Yuan to the dollar rising sharply in 1995 to just over 8 to the dollar.  Since 1995 they have held the rate steady until, under much pressure from the USA they have allowed it to rise slightly, (a rise in the value of the Yuan shows as a fall in the number of Yuan to the dollar).
The Pound has not been controlled against either the Dollar or the Yuan and the rate of the pound to the Yuan has been affected by the large fluctuations of the pound against the Dollar.  Unfortunately the scale of the chart does not clearly show the extent of the changes of the pound against the dollar as a percentage, but the number of dollars to the pound (red Columns) was down to about 1.44 in 2001 and is about 2.06 now (24-7-07) or a rise of about 43% in the dollar value of the pound.  As the Yuan was being kept in line with the dollar the pound also rose by about 40% in relation to the Yuan.

These figures demonstrate that the CPI depends to a large extent on factors completely outside our control.  Exchange rates are not the only variable in our costs of imported goods; the rate of internal inflation in China also has a direct effect on the price of their goods landed here and this is completely out of our control and is not affected in any way by changes in our interest rates.

Only the Services part of the CPI is under our control to the extent that interest rates can be used to reduce internal demand and can act as a restraint on wages if reduced demand reduces competition for labour.

The old Retail Price Index (RPI) is itself an arbitrary measure of inflation which excludes some important living costs, not least the cost of houses, and its replacement – the CPI – standing for Consumer Price Index or known more cynically as the Chinese Price Index is even more arbitrary and produces a consistently lower figure for inflation than the RPI.  

It is therefore futile to target the CPI as a measure of inflation because it is neither a measure of our rate of inflation nor is it much affected by our only control lever, namely interest rates. 

There are very strong incentives for governments to use a price index which produces the lowest acceptable figure.  The CPI uses mathematical methods for averaging prices which produce a lower figure than the RPI from the same data and it does not include housing costs or local taxes.  But even more important is the fact that imported goods account for about half of the index and the cost of these has not moved for several years.  

A better target for inflation would be earnings inflation.  It is a true measure of reduced competitiveness and an index of earnings is far more difficult to distort than an arbitrary index of prices. It is difficult to fudge by the many devices currently in use to lower the RPI and CPI, and above all it is the measure most closely linked to what people perceive as inflation. Wage inflation is a true indicator of our international competitiveness, whether it is the price of our goods for export or the cost of services provided to tourists.  It is the only indicator that truly represents the deterioration in the value of money to the people.
Wage rates control the cost of all services, as is confirmed by the fact that the services component of the CPI closely follows wage rates.  Our international competitiveness depends primarily on wage stability and people’s perception of inflation is strongly affected by their financial position relative to their neighbours.  Of all the factors that affect our rate of price inflation wage rates are by far the most important of those factors over which we have control.

We could therefore simply keep interest rates at about 2.5% above the rate of wage inflation; a rate of interest less than the rate of wage inflation is effectively a negative rate for all people in employment and a steady loss for those on fixed incomes.  The effective rate of interest on this definition has been negative for very many years.  People have long realised this truth and borrowed up to the hilt to take advantage of it.