Economic reports depend on definitions

By DAVID MOON, Moon Capital Management, LLC
August 25, 2013

Recent data from the Bureau of Economic Analysis (BEA) indicates that US economic growth over the past three years was actually 13 percent per year greater than first reported.

Did the BEA discover some previously hidden pocket of economic growth or a prior math error?

No. It simply changed the definition of Gross Domestic Product (GDP.)

One of the changes is that the BEA now includes increases in unfunded pension liabilities in the calculation of “economic output.” For an index calculation that is largely done on a cash basis, that change makes no sense.

The other, larger definitional GDP change relates to spending on research and development of both technological and intellectual assets.

As skilled negotiators know, defining the terms of a transaction is often more important than the stated price of an item.

Measuring economic activity is no different.

We all know that the Consumer Price Index (CPI) is some type of measure of an increase in prices. Anyone with a checkbook or debit card, however, also knows that it bears little correlation with life.

How is this? Because of the way we define the terms.

For example, federal income taxes are excluded from the calculation of the CPI. An item on which some consumers spend as much as 20 or 25 percent of their income is excluded from the calculation of the supposed changes in their cost of living.

Even though 65 percent of the households in the US own their own home, the cost of housing is not based on the market value or replacement costs of houses. It’s calculated by asking homeowners what rent they would charge if they hypothetically rented their home to someone else.

The cost of shelter comprises a third of the CPI calculation.

In July, the core rate of the CPI increased 1.7 percent compared to a year earlier.

Did your household expenses increase more or less than 1.7 percent last year?

The Bureau of Labor Statistics (BLS) actually publishes thousands of different consumer price indexes. The most commonly referenced is the CPI-U for All Items Less Food and Energy index. The rationale is that, since the prices of food and energy are so volatile, it is more logical to exclude them from month-to-month or year-to-year analysis.

Why is this important? The CPI is used as the adjustment basis for Social Security payments and millions of private pensions. Many insurance benefits are also affected by the CPI.

Annual tax bracket adjustments are based on the CPI. By understating the real increase in prices (and overstating the purchasing power of a dollar) the BLS causes taxpayers to creep into higher brackets without any corresponding increase in their real incomes.

Because of its assumptions about consumer use of supplementary products (such as tea and coffee) the Congressional Budget Office claims that the CPI actually overstates real changes in consumer prices.

Again, it’s all about how you define the terms.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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