May 2005 Volume 2 Issue 4

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning -Henry Ford

When we are young, we are taught that 2 + 2 = 4. And we saw the world in those terms: clear-cut, black and white, no ambiguity.

Then, as we encounter quantum mechanics and real life, we realise that there are shades of grey and moral dilemmas; that things are not always as they may seem.

Later we run across books like “Damned lies and statistics” and concepts such as “voodoo economics” and slowly we realise that, for some people, 2+2 = whatever the agenda happens to require.

Or, as Yogi Berra might put it: Half the lies they tell me aren't true.

Which leads me to this question: do all the professionals and investors who pay attention to economic statistics and invest based on them fully understand what they are getting? In this issue, I will introduce two people who question the economic statistics that we routinely monitor and take at face value.


One person who questions the statistics produced by various US government agencies is Dr. Kurt Richebacher. A former Chief Economist at Dresdner bank (Germany’s third largest bank), he is regular contributor to The Wall Street Journal, Strategic Investment and other respected financial publications. Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebacher wrong.

He challenges the basic premise of the US recovery, stating that the US’s “stellar aggregate growth rates, particularly since 2000, have masked a dramatic deterioration in the four key fundamental determinants of long-term economic growth: national and personal savings, productive capital investment, profits and the current account of the balance of payments. All four are in shambles.” (Richebacher Letter, May 2005).

His latest critique of the economic statistics produced by the US is reproduced here (“When Statistics Lie”).

His basic issue is that the world has come to believe that the US economy is vastly superior to all other industrialised economies and that its massive productivity gains and innovation over the last decade have made it resilient and flexible, which helped it to quickly emerge from its mild recession in 2001.

The US reported Real GDP growth of 10.4% between 2000-2004. But Dr. Richebacher believes that this is not substantiated by other economic indicators, such as employment and real income gains.

He believes that America’s real GDP numbers are grossly overstated, due to understated inflation rates (Real GDP=Nominal GDP divided by GDP deflator {essentially inflation}).

He finds strong support from Bill Gross, Managing Director of the largest bond fund management company in the US, who bluntly accuses the US government of a ‘con job’ on inflation and GDP calculations.

Is there an incentive for the US to do this? Remember, with its huge budget and trade deficits, the US consumes over 80% of global savings. It would not be able to attract enormous levels of foreign capital at these historically low interest rates unless it was seen as a strong economy and a safe haven for investment. During the Internet mania, CFOs resorted to creative accounting because they knew that missing investor expectations would crush their share price. Perceived weakness in the US economy would lead to foreign investors either refusing to buy US debt or demanding much higher interest rates, which would slow down the economy due to the record levels of debt within the US.

Or as Mr. Gross puts it: Alan Greenspan has a dual prerogative at the Federal Reserve. He is charged with keeping inflation low and economic output high. The magic of hedonic/substitution adjustments keeps both of these birds flyin' at the same time, one under the magical 2% radar, which marks the dividing line between benign and worrisome inflation , and the other (real GDP), over the hurdle of 3% which suggest the continuation of high productivity. "….. "My sense is that the CPI is really 1% higher than the official numbers and that GDP is 1% less. You're witnessing a 'haute con job'.


Here are Dr. Richebacher’s main issues with the way the statistics are calculated:

  • Productivity Growth: From 1995-2000, productivity growth (output divided by employment) averaged 2.5%, but increased to 4.3% since then. Yet consumption has drastically expanded at the expense of productive investment and foreign trade, which lowers productivity growth. The huge trade deficits indicate the failure of gains in competitiveness, which should accompany productivity growth. He cites reports by Goldman Sachs (March 2004), Deutsche Bank (Nov 2004) and McKinsey (2005) that challenge the productivity hype.

  • Housing: This is another item that helps in suppressing inflation rates. In 1983, at a time of sharply rising housing prices, the Bureau of Labor Statistics, or BLS abandoned the ‘asset price method’ which measured price changes in owner-occupied housing, replacing it with “owners’ equivalent rent of primary residence”. This is an arbitrary assessment of the rent an owner would pay for occupying his own home, rather than the increase in the value of the home itself! 28.4% of the CPI comes from the actual rent that tenants pay and from ‘assessed’ owner’s rent (owner occupied houses account for 82% of all properties). As national rental vacancy rates have climbed from 7.8% in 2000 to 10.2% in 2004, rental rates are low. Thus, the entire housing sector accounted for only a 2.2% contribution to CPI (even while prices for homes rose at an average of 11% in 2004).

  • Hedonic Pricing: According to Dr. Richebacher, this is the main culprit in helping suppressing inflation rates, thereby boosting GDP and productivity growth rates. It essentially converts quality improvements into price reductions.

    • Used in the 1980s for computers, when massive gains in computing power were the norm, hedonic adjustments to business spending on computers (less than 1% of nominal GDP then) translated, at times, into accounting for up to 40% of real GDP growth! Since 2000, business investment in computers has risen by 9.3%, but with hedonic adjustments, its contribution to GDP growth has been an increase of 113.4%.

    • The Consumer Price Index (CPI) calculates the cost of a basket of goods and services and reports inflation based on the rise in the costs of buying the same items in the future. In the 1990s, the Boskin Commission recommended hedonic adjustments for a wide variety of products, now accounting for 46%
      of CPI components, according to Bill Gross. Thus, price reductions for ‘quality’ improvements (an arbitrary assessment by government statisticians in the Bureau of Labor Statistics, or BLS, which monitors the CPI) apply to almost half of all CPI items.

    • Another adjustment is the ‘substitution effect’: statisticians assume that if steak gets too expensive, then the rational consumer substitutes chicken for steak in the CPI basket. Naturally, this assumption reduces the inflation rate (but is that really how consumers behave?)

    • Fixed arithmetical weighting for CPI items was changed to flexible geometrical weighting, which automatically assigns lower weighting to items with rising prices.

    • A number of government outlays for social services are linked to the inflation rate. A lower inflation rate reduces government expenditure and the budget deficit, creating the potential for bias in reporting CPI numbers.

  • Employment: In 2004, nominal growth rates for hourly earnings grew by 2.6%, the lowest in the history of this data series and the first inflation adjusted decline since 1993. In April 2005, wages grew at the slowest rate in 14 years.

    (Regardless of this, consumer spending remained robust throughout the period, though savings rates declined to record lows and household debt grew to record levels. The sharp boom in housing prices and the lowest interest rates in 45 years allowed consumers to refinance their mortgages, releasing vast sums of increased home equity that the consumer spent. As interest rates rise, this source of easy money will dry up [but the debts will have to be repaid!]).

    • Statistically, the BLS uses the concept of the “discouraged” worker. Unemployment surveys ask people whether they are unemployed. If so, they are then asked if they are actively seeking employment. If the person says no, they are not counted as unemployed. As there are several million of these “discouraged workers”, taking them into account would increase the unemployment rate from 5.2% to over 7%.

    • In March 2001, total private sector employment was 111.5 million and in April 2005, it was estimated at 111.5 million. But it could have been worse. The BLS changed its methodology in 2004, ‘creating’ 1.1 million new jobs between April 2004 - April 2005. BLS surveys 160,000 businesses to determine hiring trends, and used to add 35,000 new jobs monthly as a plug factor for hiring by new businesses it estimates are formed monthly that are not yet reporting. In April 2004 it changed its Current Employment Net Birth/Death model, to ‘create’ 630,000 new jobs in the following quarter. And in 2005, this model has ‘created’ 256,000 new jobs.

      The ability to create new jobs through statistical interpretation rather than actual survey data (and which accounts for a large % of new jobs created) is troublesome. As Dr. Richebacher says “to assume that a collapse of job creation, as measured by the regular surveys, is accompanied by booming job creation through new business formation is an absurdity.” To see the impact of this adjustment, click here: http://www.bls.gov/web/cesbd.htm

  • Imputation: Table 7.12 of the Bureau of Economic Analysis (BEA) report Imputations in the National Accounts and Product Accounts tells us that $ 1.6 trillion of the total US GDP of $ 11 trillion (14.5%) is ‘imputed’. These are specific components of GDP that statisticians add by estimate because they see spending or benefits that involve no cash payment.

    • In 2003, total disposable income of private households amounted to $ 8.1 trillion, of which $873 billion (11%) was from imputations. Thus income, in terms of cash, was lower by this amount. On this basis, personal savings rate are actually negative.

  • Trade: US imports of advanced technology products are running at well over $ 200 billion a year, exceeding exports by $ 37 billion. But here is a key issue: Imports of these products enter the US GDP calculation at their actual, low prices. Domestic spending on these hi-tech goods, in contrast, enters the same calculation at the elevated level of hedonic pricing. Imports are subtracted from GDP, while domestic spending measured with hedonic pricing inflates GDP. The net effect is inflated US real GDP and productivity growth.

    In March 2004, Goldman Sachs published a report titled “Has outsourcing inflated the GDP numbers?” The author lists several reasons why US GDP growth appears significantly overstated and points to a probable heavy distortion through internal outsourcing of services by US multi-nationals. Questioning US statistics, he cites that the US recorded $ 661 million in professional service imports from India in 2002. However, the Indian industry estimates that India exported $ 6.6 billion in such services in the year.

    • In 2003, total disposable income of private households amounted to $ 8.1 trillion, of which $873 billion (11%) was from imputations. Thus income, in terms of cash, was lower by this amount. On this basis, the personal savings rate would actually be negative.

  • Corporate Profits: These jumped from $681.3 billion in Q4 2001 to $940.6 billion at an annual rate in Q2 2004. Dr. Richebacher attributes this extra-ordinary jump to two extra-ordinary items: higher prices on inventories and huge financial gains on the exploding carry trade. When he examines profits as a share of GDP in current dollars, the struggles of the non-financial sector are apparent. As a whole, the non-financial sector’s profits amounted to 6.1% of GDP in 1997 but only 3.9% in Q3 2004. For the manufacturing sector, this share slumped from 2.5% to 0.9%.

In summary, Dr. Richebacher believes that the domestic inflation rate is understated by at least 1.5% per annum. If his assessment is correct and were accounted for in the GDP deflator, it would materially reduce real US GDP and productivity growth. Investor perception of the attractiveness of investing in US equity and debt markets would change, possibly dramatically.


Among others, Dr. Richebacher gets support for his analysis from a key mainstream financial executive. Bill Gross is the Managing Director of PIMCO, the largest bond fund management company in the world. Others who have written on this issue are economists such as Peter Bernstein, Jim Grant, Stephen Roach, Marshall Auerback and Caroline Baum.

Mr. Gross is quoted as saying “"Talk about a con job! The government says that if the quality of a product got better over the last 12 month that it didn't really go up in price in fact it may have actually gone down! For instance, prices of desktop and notebook computers declined by 8% a year during past decade, the WSJ reports but because the machines computer power and memory have improved, their hedonically adjusted prices have dropped by 25% a year since 1997. No wonder the core is less than 2% with computers dropping that much every year."

"Actually, to make the case for a government con job, it's important to point out that the bulk of these hedonic adjustments have come only in the past few years, when it became necessary to buttress Greenspan's concept of our New Age Economy."

"Today no less than 46% of the weight of the US CPI comes from products subject to hedonic adjustments. PIMCO calculates that without them they would be between 0.5% and 1.1% higher each year since 1987." Mr. Gross’s article is reproduced here: Haute Con Job

Dealing with numbers is always tricky, and even more so when transparency is an issue and there is a potential bias due to the effect of the numbers reported. It was never easy for Yogi Berra either: I usually take a two hour nap from one to four. I wish all misstatements were so visible.



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