A Tender Subject

According to the Coinage Act of 1965, "United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues." In other words, you can tender somebody a $20 bill, and it's legal to do so, but that's as far as it goes. The person you tender the bill to isn't required by law to accept it, and you can't take it to the Federal Reserve Bank and ask for $20 worth of something else in exchange. I suppose it would be legal to tender the $20 to Ben Bernanke and ask him to mow your lawn in return, but that gets into the problem of how many lawns could the chaiman possibly mow? There are a whole lot of $20 bills in circulation.

I need to read a good history book about money. I understand, I think, that money is merely a substitute for barter, but I'm not comfortable with the way money can take on a life of it's own, conjuring itself up out of thin air. If the derivatives market for stocks and bonds is worth four times as much as the combined market cap of those stocks and bonds, you have to wonder if our financial system is moving to quadruple entry bookkeeping. Either that or four sets of books:-)

CPI Calculation Hides Inflation

I've been meaning to figure out how the CPI (Consumer Price Index) hides inflation for years now, and finally got around to looking at the components. It's not a secret or a government conspiracy, it comes down to a question of what the CPI is built to measure. The answer appears to be that the CPI was built to measure how the average American consumes, and the year-over-year increase in those consumption costs. I have full faith in the BLS (Bureau of Labor Statistics) that they are doing a good job measuring this increase. The problem is, it has very little to do with inflation.

By measuring out-of-pocket expense, the CPI ignores the role of financing and debt in the American economy. The CPI is telling us that housing costs (the rent equivalence figure for people who own homes) rise not at the same rate of housing prices, but at the same rate as mortgage payments. In a narrow technical sense, this is correct. The cost of housing to the average American in any given year is the cost of financing and maintaining the home. But since when is inflation supposed to represent the financed cost of goods?

I like referring to the BLS inflation calculator which can report that a 1994 dollar buys $1.36 in 2006. Too bad that housing costs 100% more today than it did 12 years ago, but thanks to relatively low interest rates and creative mortgage financing, the CPI doesn't see it.

It makes me feel a little dumb to think how I've been sure for a decade that inflation was being hidden by cheap imports, the deflationary hypothesis of the global market, but it turns out inflation is underestimated through measuring the average American's out-of-pocket cost for goods and services, rather than their actual cost. So the CPI gives the medical component a weight of less than 6% in the average American's budget when it was already at 16% of the GDP in 2004! But Americans who actually purchased their own health care paid an average cost of $11,500 in 2006, when the median family income was $43,200. So health care costs for a family are running at 25% of the median family income, and have risen over 60% in the last five years, but the CPI reports medical care at less than 6% of the average American's expenses? They aren't measuring inflation at all, they're measuring household budgets.

Mortgage Interest Deductions

As I've been house shopping in recent months I've spent a lot of time trying to calculate mortgage payments in my head. I can't. The reason is that the exponentials in the formula are too tough to approximate unless you're a savant. So I wrote up a page about how compound interest is calculated on mortgages, and seeing the interest piling up got me thinking about the vaunted tax deduction for mortgage interest.

You can deduct the interest you pay the mortgage lender in any given year from your Federal income taxes if you itemize, filing Schedule A. You can also deduct your local real estate tax. By filing Schedule A, you lose the standard deduction, which is currently $5,150 for an individual or $7,550 for a head of household.

But it's not such a simple calculation for most people. If we ignore the standard deduction by assuming, say, you would have gotten there with charity, state taxes or health expenses in any case, we can just look at the tax brackets. If you're wealthy and paying in the highest income bracket of 35%, then as long as you don't run afoul of the AMT (Alternative Minimum Tax), you're getting a 35% discount on your mortgage payments through the reduction in your income taxes. However, if you're in the 15% tax bracket and you really need the money, you're getting a 15% discount on your mortgage. Put simply, the mortgage deduction favors the wealthiest taxpayers.

The mortgage deduction also works against home buyers who are starting out in life. The interest you pay on your mortgage drops as the years pass, and in the final years, you probably won't even bother filing Schedule A unless you have the state and local taxes to make it worthwhile. At the same time, your income is likely to rise over the years, and as you work your way up into a higher tax bracket, your mortgage deduction is becoming less and less. This may inspire some people to buy new homes and take out larger mortgages, but the only way this can be justified as an investment is if housing prices continue to rise.

I get a big kick out of the Housing Cost Calculator sponsored by the Center for Economic and Policy Research because it's predicated on the notion that housing is way overvalued in pretty much all markets and will eventually return to trend. The only possible tax benefit of losing a ton of money by owning real estate is if you own it for your business and are depreciating it all along. If you sell it for less than you paid for it, at least there will be less capital gains tax recaptured.

Where Is The Money Coming From?

In 1950, the Public Affairs Institute published a book by Morris S. Rosenthal titled "Where is the money coming from?" The copy at my local college library was stolen or lost, so until I can find one to read, I'll just go with the theory that great names think alike, and speculate that he was interested in the same fundamental economics question that I am.

The money we pass from hand to hand is nothing more than a promise, a promise backed by the Federal Reserve bank that the note is legal tender for all debts, etc. We use paper money backed by a promise because the alternative is barter, which is poorly suited to the modern welfare state. It's kind of funny that the general perception of Socialists is that they are against money, when nothing could be farther from the truth. Without money, without the trade in promises from central banks, socialism couldn't exist as we know it today in Europe and the U.S.. Just imagine if in the place of monthly checks, the government sent entitlement recipients boxes of paperwork they could trade each other.

But it's hard to understand how a country that's piling up debt can print more money to pay its bills without causing catastrophic monetary inflation. Economists and other optimists will point to the low unemployment rate as a proof that all is well in dollar land, but I could employ everybody who wanted a job by myself, if they were willing to accept my promise that the pieces of paper I gave them were worth something. The service economy appears to be with us to stay, but it's difficult to understand how the services people render each other can be capitalized into cash, if nothing of resale value is created. A shrink can charge a hundred dollars an hour (on the government's tab) for keeping a patient entertained and it all gets included in the GDP, but how has that added to the national wealth?

It's enough to make me wonder if I should have subscribed to The Daily Reckoning instead of the Wall Street Journal.

The New Economy Inflation

Every blog needs a first post to work out the template wrinkles, and the new economy seems like a fair target for a new blog. The WSJ carried an Op Ed this morning by Richard W. Fisher and W. Michael Cox, the president and vice president of the Dallas Fed, respectively. That piece was titled "The New Inflation Equation" and it made the point that "central bankers can no longer afford to contemplate inflation without regard to worldwide output." Not being an economist myself, I didn't realize central bankers were in the habit of ignoring worldwide output, but I'll defer to the experts on this point.

I believe the article was really written for other economists and academics, pointing out that a widely used technical approach to calculating inflation was in need of updating. However, it seems to me that economists should be looking closer to home for flaws in inflation calculations. If housing costs in the US collapse in the near future, then perhaps the current inflation index isn't as far off as it feels, but if housing holds up and the dollar loses value, it would be an indication that the inflation rate has been reported at an artificially low level for years.

Taking world productivity into account would seem to make a lot of sense in a global economy, but I don't see somebody living in Bejing or New Delhi paying $250,000 for a single family home in middle America, or $750,000 on the right or left coasts. Imported deflation has been used for years to offset our home grown inflation, and it seems to me we need a new inflation equation that accounts for and eliminates the effect of those imports on our inflation rate. We aren't paying the bill for that imported inflation, we're just running it up on credit. It reminds one of the New Economy, where manufacturing doesn't count for anything. The new economy and the new inflation are all about doctors and hospitals selling expensive services to unproductive people in the last months of their lives, and the government footing nearly half the bill out of general funds (the other half from payroll taxes). If we could apply a payroll tax those workers in China and India, maybe then it would make sense to include their productivity in our inflation index:-)

Inflation and how the CPI is constructed are two of the issues I hope to demystify for myself and readers in the coming months. My guiding principle for economics will be, if I can't understand the explanation myself, than neither can anybody else, including the author.