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Markets: The Problem with Government Accounting
New York: January 24, 2005
By John R. Stephenson

Have you ever wondered why your own assessment of a situation doesn't seem to fit the "official" government view? Say, for instance, you go away for a few months and come back only to discover that the price of heating oil, a movie or food in a restaurant is up. Yet, much to your surprise, the government figures report (in the form of a Consumer Price Index or CPI) that prices haven't budged. But why is this so?

Why is it that the official government view of things seems so different from our own? Many people we know are unemployed or actively looking for work and yet the government tells us that the unemployment rate is at multi-year lows? Things cost more, we have less in savings and yet the official numbers come out and they show prices have hardly budged. The reason for this discrepetancy? The official numbers out of Washington are heavily massaged.

The major reason for the divergence between common sense and the way the government calculates its figures is the use of "hedonic adjustments." Say, for example, the cost in absolute dollar terms of a Cadillac goes up, but according to the way that the Bureau of Labor and Statistics (the arm of government charged with collecting and recording such statistics) calculates, it can still be recorded at the old price level because the new Cadillac is "more comfortable" than the old Cadillac. If the price of gasoline on the open market rises by 20 percent, the Bureau of Labor and Statistics may only record this as 12 percent, if, according to their hedonic adjustments, the gasoline is "better" than the previous gasoline on the market. In November of 2002, the Bureau of Labor and Statistics reported that the price of heating oil was down by 11.1 percent. A check of the Wall Street Journal and the Financial Markets showed the opposite - that prices for heating oil were up 20 percent.

A study came out a few years ago that determined that roughly 56 percent of the figures that make up the consumer price index (CPI - the widely watched barometer that tracks inflation) are now hedonically adjusted. Proponents of the methodology of hedonically modified figures argue that, before these adjustments, the CPI used to overstate inflation nation-wide by as much as 0.2%. Not only is the CPI number being adjusted hedonically, but all government figures whether they are productivity, economic growth or the gross national product are subject to various forms of hocus pocus. Routinely, the government "smooths out" any large increases to widely followed statistics. Governments around the world announce figures that to participants in the bond and equity markets strain credibility. The purpose is the same all over the world - to make their own dismal performance as stewards of the economy look better.

But what is really going on is something far more insidious. The "official" figures are being massaged hedonically because by lowering the CPI number, the government can make the claim (by pointing at their own statistic) that inflation is low and hence they avoid having to raise the Social Security payments and the cost-of-living raises remain low. As I write, the government is currently examining other "adjustments" to the CPI number. By allowing these distortions to occur in the official numbers we can avoid dolling out medicine for the cure today. The only problem is when the chickens eventually come home to roost the problem will always be far bigger than it would have been otherwise. Of course, that problem will likely occur on someone else's watch.

The mainstream media has lapped up the "official" numbers barely questioning the logic behind these ridiculous pronouncements. In the meantime, in an effort to save Wall Street and the stock market, the Federal Reserve has created a liquidity explosion by lowering interest rates to a ridiculous level. With all this easy money slopping around, the price of all asset classes, whether they are housing or stocks and bonds, has been driven up artificially. Although the costs of goods and services are clearly up, these higher priced goods continue to work their way into the economy unchallenged because of the shoddy way in which the government accounts for inflation (hedonic adjustments etc.).

Governments around the world have a terrible track record of reporting "official" figures about the state of their economies and the U.S. government is no different. Whatever you do, learn the lesson and do not take your investment advice from the U.S. government or any government for that matter. As it always happens, the forces of the market or reality eventually come to bear on a situation and the more we wallpaper over the problem, publish phony statistics and encourage people to overpay for stocks, bonds and houses, the bigger the eventual problem will be. The economy is a mess, prices are rising and there is too much easy money driving the prices of all asset classes up. This is unsustainable. The smart thing for investors is to lock in to these low rates now. Get a thirty year mortgage or join that country club that you've been eying before it is too late. When the change comes, and it will, it will be far more painful than it would have been if we had dealt with these problems when they first occurred.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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