Meditations on Hedonics
by Thomas, Realty Reality - Global Real Estate Markets Forum. October 7, 2004
The author swears he is not joining the ranks of the web author. A recent article by John Berry proved too agitating to resist.
See: Bill Gross's "Con Job" Was Inaccurate and Flawed - John M. Berry, Bloomberg.com
Mr. John Berry of Bloomberg news challenged Bill Gross' analysis of hedonic adjustments and how they are applied by the Greenspan Fed. Mr. B took issue with Bill's claim that the numbers coming out of government statisticians were a "con job" that was "foisted on the public." Mr. B is not alone; I've read several of these hatchet jobs over the last few days. I am writing to suggest that I am also critical of Gross but for different reasons. As head of Pimco, Bill is not just a bond vigilante, he is head of the whole posse. In this role, he has done an excellent job of educating the public about some of the realities of modern economics. With respect to criticizing hedonic adjustments, however, Gross is behind the curve. Within the so-called bear-market community this has been a topic of discussion for years. (Even some of the most clueless bulls like Larry Kudlow probably have some awareness of the issues, but it doesn't suit their needs to peer into the dark side.) Government statistics have been discredited for as long as I have been reading the financial literature. It is said that LBJ used to send the numbers back for "improvement" and he never took any guff.
I don't have time (nor am I paid) to crank out a scholarly document on hedonic price adjustments and cooked numbers. A quick visit to Google armed with a few keywords and you'll find the Boskin Commission's analysis of hedonics and extensive discussions about the profound flaws with their reasoning. (Start with an excellent series by Walter J. "John" Williams.) I will take a slightly different tact and simply apply a little reasoning, common sense, personal experience, and some smell tests.
Hedonic adjustments are used for a reason.
Early in the article Mr. B noted that "the impact of hedonics on the change in the CPI is grossly exaggerated. Its use has essentially no impact on the overall index because some hedonic adjustments tend to raise the inflation rate, offsetting others that tend to lower it." That's just stupid. Why they bother to do it? = I'll tell you why: The adjustments have a huge effect on the measured inflation. That's Gross' point, for heaven's sake! In my world -- the world of physical science -- first you show the raw data and then you try to tease out additional insights with mathematical tricks. Apparently government statisticians like to cook the numbers first and then serve them up. Don't believe everything "the government" tells you, Mr. B. But now let's pass some of the details by our nostrils.
Products that I buy are of poor quality.
Mr. B mentioned improvements in automobiles, using airbags emblematically to illustrate that a number of features have been added over the decades. To argue that cars are better, however, tells me that Mr. B never owned a car made by General Motors, Ford, or Chrysler. = In short, modern cars are a piece of junk, programmed to repeatedly fail. The parts are made of plastic or low grade metals. (Don't blame the Chinese; we can't afford a trade war now!) A 2 mph collision in a parking lot will cost $900 because your plastic bumper "cracked." I don't recall bumpers "cracking" when I was a kid. Remember when brake pads lasted for years, and, if the pads replaced, the rotors were reused? Seems so long ago. Power windows are great added value (added in the 1960s), but now they break because a 50 cent piece of plastic from Malaysia snaps, resulting in a $450 repair (two in four years on my 2000 Grand Am, to be exact.) Why such an expensive repair for such a cheap part? That's easy. We no longer replace failed parts; we replace "units." Not just any old units, expensive units. My chincy fuel pump unit, for example, gave out twice -- twice -- last year: 2 x $700. Cha-Ching! And, buy the way, ask any farmer or handyman who can no longer fix his own car whether owning a car has gotten to be an expensive undertaking. I recently traded my Grand Am in for a Toyota: The 2000 list price was $18K whereas the trade-in value was $3K. Ouch.
This problem is not localized to the car industry, however. I broke a 40-year old blender. That blender was a faithful servant. I'll never do that again. How do I know? Simple again. Modern blenders don't last more than five years. We have a 60-year old refrigerator in a cabin, yet somehow we've managed to go through three refrigerators (and four dryers!) since moving into our house 20 years ago. In short, we are in a disposable society. So here's the question: If we can buy inexpensive stuff that breaks that breaks relentlessly, is inflation tame? Are blenders "less expensive" (on an adjusted basis) because they have more buttons or "more expensive" because they have the life expectancy of a tadpole? Hmm....
Computers and software are disposable, too!
Computers and software are big portion of the CPI. Why? Because they are the products that have gotten cheaper the fastest. What government statistician worth his weight in paper would not put a huge statistical weighting on them. Computers can buff up the CPI like there's no tomorrow. This is especially true because you get to cut the imputed price in half (on paper, of course) every time their speed doubles. Here's another good question: When the Feds put in this speed correction, do they also account for the fact that this added speed is required to run new Microsoft programs that are twice as bloated? (Don't blame the Indian code writers; we still don't need a trade war.) While we're on that topic, I'm sure the Feds correct for improving software. I just can't get enough fonts! Do you think that they adjust for the incessant upgrades resulting from Microsoft's unwillingness to even pretend to maintain backward compatibility? (BTW-The Intel, Dell, and Microsoft upgrade cycle constitutes an excellent three-body analogue of the "chicken and the egg.")
Food and energy are important.
Let's dig a little deeper into the removal of the energy component. They don't just yank out the cost of natural gas, heating oil, and gasoline. This would be way too easy. Hell. I could do it. They earn their paychecks by surgically excising the effects of energy on the products we buy: This is not a trivial calculation. You can rest assured that the government statisticians, answering to bosses who are political appointees, would never cook these numbers, especially in an election year. If you dig back to March and April of 2002, you will find government statistics showing that energy prices dropped month-over-month. Ire from energy analysts was summed up by one analyst who said, "there was not one day in May in which the energy was cheaper than any day in April." Of course, we can simply dismiss those energy analysts as nimrods...just like Gross. And, by the way, why are they removing energy again? Oh. That's right. Mr. B noted that energy prices "are highly volatile with large increases often partly or wholly reversed." Am I to presume that oil will drop back to $10 per barrel early 2005 or will it be delayed?
Substitution adjustments are based on a fundamentally flawed premise.
When I substitute chicken for beef because the price of beef has gone up, I am accepting an inferior product. (Of course, if Mr. B disagrees, I'll gladly make a deal with him: We pool our resources to buy meat. I'll eat the steak and he can eat the chicken.) So you see, a substitution also constitutes a reduction in quality, which, in turn, should cancel out the substitution. Do the Feds account for this? Probably not. There's even more layers of this (overpriced) onion, however. Let's say beef and chicken are both up 50% (which they are). When I switch to chicken, one could view it is a wash because the chicken has also inflated. Alternatively, one could argue that my dinners have gotten cheaper. Hmmm...I wonder which way the government statisticians "lean" on this one. On the off-chance Mr. B has a penchant for eating chicken and cannot digest this example, let's take it to the limit. Let's say beef and chicken soar and I resort to eating squirrels and grubs. Is inflation really tame now? Maybe this would create a deflation scare. Hey. Wait a minute. Maybe the Argentineans, by substituting garbage for food and panhandling for jobs, suffered from crushing hyperdeflation! Wow! In short, hedonic substitution and hedonic quality decreases should, at best, cancel. Government bean counters should stick with cooking beef and chicken, not the beans.
Imputed rents are baloney.
We are in what many believe to be a housing bubble. (Somebody send an email to Greenspan.) Houses are very expensive. Accompanying taxes based on their assessments are extraordinary. As a consequence of this bubble, some rents are depressed. To use imputed rents as a substitute for buying a house is, at best, silly. So Mr. B might cunningly fire back, "Low interest rates make houses more affordable." To wit, I pithily respond, "Baloney" (which is an excellent, low cost beef substitute.) Although the monthly payments may be lower, the houses still cost a small fortune. Would you pay $2,000 for a refrigerator, if you could pay for it with a 4% ten year loan? How about a $4,000 refrigerator on a 20 year, 0% interest loan? Come on. Your payments would be miniscule! I didn't think so. In fact, what this example really illustrates is that the money has gotten cheap. Odd. That always seems to happen when you print the stuff Bernanke-style. I fear than money will get very cheap before Greenspan retires. By the way, if you try to argue a house is an appreciating asset, you're wrong--stupidly wrong. Houses require, crudely speaking, 4% of their value in annual maintenance. They rot, peal, and generally suck the life out of the owner. The reason they go up in price is because the homeowner is constantly pumping money into them, which is rendered possible by the FOMC constantly pumping money into the homeowners.
All smell tests fail.
Let's just check a couple:
(1) Money supply (M3) is up something like 8% a year throughout this millennium (chuckle). I don't have the numbers in front of me, but they're large. Is inflation tame?
(2) My big costs in life are: (1) healthcare, (2) tuition, (3) housing (including municipal taxes, which are up 71% in three years), (4) food, and (5) energy. Is inflation tame? (As an aside, my favorite inflation indicator is college tuition.)
(3) Oil is up from $10 a barrel in the late 1990s to $50 dollars a barrel. Is Mr. B really going to claim that inflation is tame? (Of course, he could call that "volatility.")
(4) There is a boom in commodity prices attributed to China by most (and to Greenspan's witless monetary policy by others.) Prices from soybeans to copper are all up stunningly. Is inflation tame?
Mr. B's conclusion was a zinger.
"The real surprise about Gross's column -- something that might have added credibility to the notion of Greenspan and a conspiracy to have a low inflation rate -- is that he fails to mention the Fed chairman's frequent assertion that the CPI overstates -- yes, overstates -- inflation by perhaps as much as a percentage point a year."
I concede. Mr. B is absolutely right. Representatives of the federal government (and affiliated central banks) don't lie; never have, never will -- especially before Bush's re-election when telling the truth is of paramount importance. Give me a break, Mr. B! This is a load of malarkey (which is an excellent baloney substitute.) Greenspan is the guy who said you can't see a bubble until it's over. (Do we look that stupid?) He says there is no housing bubble. (Does John Templeton look that stupid? BTW-I thought you couldn't detect bubbles, Al?) He endorsed dot-coms at their peak. (Now who looks clueless?) Greenspan even thinks derivatives are good. (Time to have a little chat with Warren Buffett, eh?) Greenspan told consumers to get adjustable rate mortgages as interest rates were hitting 45 year lows. (He just jumped into the "criminal and menace to society" division and made a strong case for euthanasia.) To assert that something is true, because Greenspan says so, is utter nonsense.
Stephen Roach called Greenspan's monetary policy "a joke." Jimmy Rogers called him a "Boob." Bill Fleckenstein calls him a "menace." The Mogambo Guru likes the term "liar." As an academic, I have always been partial to "all of the above."
In a nutshell...
Mr. B just claimed that the biggest bond trader on the planet was clueless and the most clueless central banker on the planet was not. He might want to rethink this stance. It is also advisable to dig a little deeper into stories before typing. If Mr. B had interviewed Fleckenstein, Tice, Grant, Gross (what a concept), Roach, Rogers, Auerback, or any number of astute market analysts, I am confident that they would have endorsed Gross' contention. Ex-Fed governor Pete Petersen could cause sleepless nights. Heck. Give me a six-pack and an introduction and I could get Volcker to join in. Gross versus Greenspan? No contest.
On closing, my suspicious side suggests that Mr. B is serving as a mouthpiece for the Feds. Maybe this is inadvertent. Maybe I'm a whack job. It would be a shame if it was true, however, given Bloomberg's illustrious reputation.
"You can't print, borrow, or spend your way to prosperity."
Thomas: c. 2002
Please pass this on to any Wall Street bankers, central bankers, economists, or journalists you might know. They seem to have forgotten.
© 2004 Thomas
About the Author
Thomas is the nom de plume, who also posts essay work on the financial markets at Prudent Bear. We are glad to offer his commentary on behalf of Realty Reality.