By John Mauldin
By John Mauldin
We begin this week with a simple pop quiz. Is inflation good or bad? Answer quickly. I’m sorry – your answer is wrong. Or rather, we can’t know if your answer is right or wrong because we are not sure what is meant by the question. We may think we know – and we may be right – but we can’t be sure, because the word inflation has different meanings for different people in different places and different times. In fact, even the same people in the same place and time can’t agree on a precise definition.
This is in part because most of us still think of economics as a science akin to physics or mathematics. Inflation is one way economists attempt to measure things. But unlike the distances between stars or atoms, or the certainty implicit in even very abstract mathematical models, our measurement of inflation is limited by and entirely dependent upon the tools we choose. In fact, the methodology we use has as much ability to determine the outcome as the actual data does. This week we begin a series on economic data with a look at inflation, but we’ll preface the series with a discussion of how economics may be more akin to philosophy or theology than the hard sciences. If you are an academic economist, you may want to move on to the next letter, unless you are capable of not taking yourself too seriously.
The Theology of Inflation
Long-time readers may know that for sins committed in my past lives I matriculated to Southwestern Baptist Theological Seminary in Fort Worth after graduating from Rice in 1972 (just as slide rules were starting to slip from the pantheon of must-wear gear for the respectable nerd). I decided not to pursue the religious endeavor beyond that point, which was a positive choice both for me and for the poor unsuspecting church that would have employed me. But little did I know that my theological studies were actually preparing me for a career in finance and investments, at least as well as my study of economics at Rice had done.
Fast-forward to a few years ago. I was sitting in a pub somewhere in London (I can get very lost in that town), meeting with the new chairman of Anglo-Irish Bank (who was a bank turn-around specialist with very interesting stories), and we were joined by Anatole Kaletsky. Anatole and I had been developing a long-distance relationship of mutual curiosity about all things economic, and he graciously took the time to meet with me late that night. (He needs no introduction to European readers as he is a fixture on the Continent with his economics writing and analysis; but for US readers, he has written since 1976 for The Economist and The Financial Times and was editor-at-large of The Times of London before recently joining Reuters and The International Herald Tribune. He has been named Newspaper Commentator of the Year by the BBC and has twice received the British Press Award for Specialist Writer of the Year. His Rolodex is ridiculous. And he is a founding partner in GaveKal, one of my favorite research firms.)
The point is that Anatole is an influence center, and that night in London I wanted to discuss the role of economic writers and analysts in society with someone who had established himself at a level that few attain. While I take the writing of this letter and the importance of economic forecasting seriously, I don’t take myself all that seriously. And so that night, encouraged by the better part of a bottle of a good chardonnay, I tossed out what I thought might be a provocative thought:
I think economists might be the functional equivalent of modern-day tribal shamans. Instead of peering at the intestines of sheep to forecast the future, we look at data through the lens of models we create, built with all our inherent biases, and then confidently predict the future or try to guide government policy in one direction or another, generally along paths that fit the predisposition of our immediate tribe. The most brazen of us move in and out of favor depending on whether we are telling our fellow tribe members and leaders and potential leaders what they want to hear.
Warming to my topic, I threw in this climactic line: “I think economics is more like religion and less like science than most of us want to admit.”
I clearly struck a chord in Anatole, and he readily admitted to having voiced the same thought at times. We talked late into the night on the topic. I was reminded of that conversation this week as I read a recent editorial by him on the role of economists….
The Lowdown on High Inflation
Building on what Anatole states [in his editorial], when it comes to inflation, we need more than just flexible tolerances. What we really need is a healthy dose of recognition that our measurements of inflation may not be able to even get us close to precise targets.
A couple weeks ago I published in Outside the Box a piece by my friend Gary Halbert in which he discussed the slippery slope of government efforts to measure inflation. He talked about the difficulty of measuring inflation and about the manipulation (his term) of inflation statistics over the last 30 years. John Williams of Shadowstats is the most-noted proponent of the position that inflation is running well above the current government number of 2% (for the 12 months ending February 2013).
Employing the methodology that was used in 1980 under the Carter administration, inflation is currently about 9.6% (see chart below). Using the government methodology from 1990, inflation today is a little under 6%.
(The following will be regarded as a contentious statement by the gold bugs and hyper-inflationists out there. For some of you, to accept it would be like admitting your religious beliefs are wrong.)
I am often asked what I think about those alternate inflation numbers. The answer is that I think it is clear that the methodologies used in 1980 and 1990 are visibly, patently, demonstrably wrong. If inflation were now at 9.6%, then interest rates should be closer to 12% and not the 1.75% we see on the ten-year treasury today (more on that topic in a minute). Over time, markets respond to actual inflation and not government statistics. Argentina’s government can state that inflation is “only” 10%, but the market thinks it is 30% and rising.
The government calculation of inflation in 1980 or 1990 was the best they could do at the time. Gentle reader, it was a government calculation. There is nothing ex cathedra about either methodology. In religious terms, neither rises to the stature of the original Greek documents or the Latin Vulgate Bible. Changing the words (the equations) in economics should not be seen as somehow equivalent to the changing of the fundamental documents of a religion. There is nothing sacred about 1980 CPI methodology, and in fact we can look at it empirically and understand that it was pretty flawed.
You might have some personal investment bias (read quasi-theological reason) to want inflation to be high. But that is a belief system. It is one form of faith-based economics (and I maintain that most economic schools require of their adherents a measure of faith and belief). Expectations of high inflation are for some people a basic tenet of their belief system. Saying there is only a little inflation must therefore be a government manipulation.
Let me really get some of you upset, which is one of my roles as an analyst. I think we must constantly be comparing our assumptions against what we observe in the real world, and then see where our models, with their built-in assumptions, bias our conclusions about what the data says.
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