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Wednesday, May 11, 2005 11:27 PM

Grossly Distorted Procedures

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Sometimes I wonder if GDP stands for Gross Domestic Product or Grossly Distorted Procedures. Then again, it sure seems that all government reporting is highly suspect, not just the GDP. Mish readers just tuning in may wish to refer to previously discussed gross distortions such as job growth via the birth/death model in Making Sense of April Payroll Numbers as well as gross distortion of the unemployment rate in Searching For Jobs and Where the hell are the jobs?

Tonight we will focus on Hedonics and Imputations.

Hedonics is a way of accounting for the changing quality of products when calculating price movements. For example, today's computers are 2 to 3 times faster and have more memory than models produced just a few years ago. If someone can buy a better computer today than last year for the same price, have not prices really fallen? Here is another example. Is it realistic to compare the price of a 1955 Chevy with the price of a 2005 Toyota with air conditioning, DVD player, anti-lock breaks, seat belts, air bags, side air bags, power steering, power brakes, etc etc etc?

To say that cars have gone from 1955 prices to 2005 prices and calling the ENTIRE rise "inflation" is obviously wrong although many "inflation alarmists" do just that. Sorry folks, but that is not a straight up valid comparison. Would you be willing to drive to work a Model T ford today? If not, then comparisons of car prices today vs. 1920 or 1950 or whenever are pretty absurd.

Here is an article that explains hedonics and how they are used in calculating the CPI. I highly recommend following that link when you have time to see how hedonics are measured by our government in actual practice.

My take is there are reasonable uses for hedonics and absurd uses for hedonics. Accidentally overstating or understating the affect of hedonics (or purposely if you believe in conspiracies) is one problem with hedonic adjustments that are by their very nature SUBJECTIVE. Why would the Government purposely want to overstate quality improvements and understate poor quality replacements? That is an easy question to answer: To lower the CPI, thereby making inflation look lower than it is and minimizing Social Security increases and Ibond payouts. It is obvious (to me anyway) that we are quick to count improvements but loathe to count poor workmanship or substitution of inferior materials.

My biggest gripe with hedonics however, is not with CPI calculations but as applied to the GDP. That computer that sold for $1000 two years ago might sell for $800 today and have more memory and a faster CPU as well. Yes that is price DEFALTION for sure and perhaps needs to be adjusted in the CPI but is that any reason to adjust the GDP and say we sold more computers in 2005 although price wise sales were REALLY down? The logical answer is no, although that is not what we do.

I contacted the BEA today asking for the latest hedonic and imputation measurements. They pointed me to some online articles and tables and emailed me an Excel spreadsheet. Unfortunately the figures are severely behind and the latest numbers for imputations was from 2003. The most current figure I have for hedonic adjustment to the GDP is 2.257 TRILLION dollars which is roughly 22% of the GDP.

To the best of my knowledge the US is the only major country that hedonically adjusts its GDP. I believe Japan was recently considering using hedonic GDP estimates but I am not sure of the final outcome. To me, price is price and sales are sales as far as GDP is concerned. To say that we sold 50% more "whatever" in 2005 than 2004 although actual PRICE sales of "whatever" have dropped seems absurd.

Not only is the US GDP distorted by hedonics but we "lord it over" the EU as well. If we did not hedonically adjust our GDP for subjective quality improvements our "growth" would not be anywhere near as strong as it looks.

While we are on the subject of distortions, how long will it be before we hedonically adjust wage growth? Real wages in the US are falling at their fastest rate in 14 years, according to data by the Financial Times.

Inflation rose 3.1 per cent in the year to March but salaries climbed just 2.4 per cent, according to the Employment Cost Index. In the final three months of 2004, real wages fell by 0.9 per cent.

The last time salaries fell this steeply was at the start of 1991, when real wages declined by 1.1 per cent.

How is the stock market supposed to rally with headlines like that? Clearly there is a problem with measurement. I suggest the government hedonically adjust jobs to show that people are making more money than ever. Here is how we do it: Between 1990 and now, jobs are obviously more satisfying. The average person accepts less pay now because they really enjoy the work so much more. I believe that job satisfaction has risen 1% a year and needs to be properly accounted for. All one has to do is look around to see that jobs at Walmart and McDonalds are highly in demand and computer programmer jobs much less so. The worst job is that of the CEO whose job desirability has steadily worsened to the point that millions of dollars in additional pay barely compensate for the wretched drudgery of it all. The logical conclusion is we need to hedonically adjust wages. With correctly applied hedonic adjustments we will be able to show that the Walmart employees are overpaid and CEOs underpaid. I am sure with proper measurements, the headlines will accurately report that CEO pay is down and wages at Walmart have skyrocketed. Clearly the government has more work to do in this area. I am willing to offer my services for the right price. BTW I sure hope everyone detected this entire paragraph to be sarcasm.

OK, now that we have tackled hedonics let's turn our focus to imputations.

According to the BEA imputations are made to place a market value on certain transactions that do not occur or are not observable in the market economy. Specifically, six imputations are included in the estimates of personal income: Imputed pay–in–kind, employer–paid health and life insurance premiums, the net rental value of owner–occupied farms and the value of food and fuel produced and consumed on farms, the net rental value of owner–occupied non-farm housing, the net margins on owner–built housing, and the imputed interest paid by financial intermediaries except life insurance carriers.

That is a mouthful so let's state it in clear English: Imputations are a part of GDP that the government decides to estimate value, where no cash actually changed hands. In other words, if I scratch your back and you scratch mine but no one gets paid, then back scratching is undercounted in the GDP. Clearly it would be a travesty of justice if economic activity like that was under reported in the GDP. It goes far beyond that however, into complete fairy tale absurdities. For example: If you own your own house, the government recalculates your income as if you were really renting from yourself and paying yourself rent! In light of some earlier sarcasm you might think I am making this up but rest assured I am not.

Imputed rent just happens to be one of the most frequently asked questions of the BEA. Here is their response: The BEA treats homeowners as businesses, which pay rent to themselves. Therefore, homeowners contribute to the real estate industry's GSP even if not employed by the industry. In addition, like businesses, homeowners' property taxes paid to state and local governments are included as part of real estate TOPI.

Here is the most current imputations table. If you scroll down to line 67, under the innocuous title of "Rental income of persons with capital consumption adjustment" you will see that the government assumes that homeowners are paying themselves $153.8 billion in rent!

On line 145 under the innocuous title of "Services furnished without payment by financial intermediaries except life insurance carriers" you will see an imputed figure of $335.2 billion. Enquiring Mish readers just might be wondering "What the H is that?" so here goes: The Government imputes the total value of "free checking accounts" to be worth a mere $335.2 billion. Personal income was thus boosted by this amount because the government thinks banks don't charge you enough for the privilege of living off your float!

OK Mish what is the Total Gross Imputed Distortion (TGID) of all this nonsense? Look on line two and you will see that it is a mere $1635 billion dollars. If we add in the Total Gross Hedonic Distortion (TGHD) of $2257 billion dollars you come to the conclusion that the Total Of All Distortions (TOAD) is a mere $3892 billion out of a total 2003 GDP of $11004 billion. Gee, it seems we are a mere 35% distorted. Bear in mind that is what the government readily admits to. My guess is that the real TOAD is far uglier.

What is it we do not know and where does the nonsense stop? As long as we are counting services rendered but not paid, why aren't we adding in the value of sexual relations? Consider for example teenage sex. How much is that worth to the average teenage guy? With just a little more creative thought processes and by merely carrying current procedures to their logical conclusions we can really get our GDP revved up. Isn't that what we are implicitly doing anyway?

PS I am quite interested in finding out how different the US is from other countries. If some readers from Japan, Europe, Canada, or Australia know if your governments are or are not this grossly distorted, and/or if you really think these are not Grossly Distorted Procedures then please drop me a line. Thanks.

Mike Shedlock / Mish

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