Archive for March, 2014

Be Cautious Using Price Indices

March 24, 2014

I’d just like to say that I’ve thought about something I probably should have dealt with in my previous post.

Namely, the fact that the “real” value of expenditures during the years of World War II is complete bullshit. Why? Because the deflator is totally wrong in those years.

Understand: like any index used to measure inflation, the GDP deflator is essentially a measure of prices. And like all measures of prices, it can only really be said to reflect the real purchasing power of money if prices actually reflect the effects of supply and demand-that is, the market is allowed to find the price which will clear it. However, during World War II, prices were heavily regulated and controlled. As such, while there is an underlying inflation going on in the prices that would clear the markets for various goods, the actual prices are not allowed to go any higher, and inflation manifests as chronic shortages and rationing, rather than higher prices. As soon as the price controls are lifted, there will appear to be a sudden burst of inflation-appear-but in reality this is merely the inflation that had already occurred, finally materializing.

Incidentally, Milton Friedman has compared the policy of fighting inflation by controlling prices to fighting a fever by breaking the thermometer. I thinking this doesn’t quite go far enough. It’s akin to fighting a fever by breaking the thermometer and ingesting the contents.

At any rate, I’m making some effort to correct for this, by trying to create a “price control corrected” index. You can clearly see what I’m talking about in the Consumer Price Index published by the Bureau of Labor Statistics. In late April of 1942, the General Maximum Price Regulation restricted most prices from rising above their highest levels in March of that year. Prices continued to be controlled throughout the War, and for a bit afterwards Truman and the Republicans fought over whether or not to end them, with the Republicans eventually prevailing, thanks in no small part to the courageous and heroic efforts of Senator Robert Taft of Ohio. In October of 1946 Truman was forced to do away with meat price controls to end a shortage, because by September polls indicated the public had turned against the controls, and not long after the Democrats suffered a massive electoral defeat in the mid term elections-by which I mean four days-in November, Truman abolished all price controls except on rental housing, sugar, and rice-but even before that, the conflict over the issue resulted in a brief lifting of controls in June of 1946, as a result of Truman vetoing a bill which would have continued the controls for only 9 more months-the re-imposition of controls in July was much less extensive than it had been during the War. not surprisingly, this shows up in the Consumer Price Index.

pricecontrolledcpi

The period in red is from April of 1942 to June of 1946. You can see that as soon as price controls ended, the price index shot up. But there was no sudden burst of new money, no sudden shift in the supply or demand for money. Prices rose to clear markets that had previously be restricted from doing so by Government fiat. So correcting for the actual gradual, rather than sudden decrease in the purchasing power of consumer dollars, one needs to “back date” the inflation into the period of price controls. My first attempt at doing so looks like this:

correctedcpi

The “corrected” CPI has been adjusted to increase gradually over the period April 1942 to October 1946-which allows for an adjustment period for the prices and also for the gradual, or punctuated nature of the end of controls. I can then use this corrected price index to “correct” other indices, like the GDP deflator, by assuming the same ratio between a corrected index and the corrected CPI as the uncorrected index and uncorrected CPI. An important point here is that a sudden apparent increase in prices can cause estimated “real” income to fall, or rise less than it really did-conversely, an apparent stagnation of prices can cause estimate “real” income to rise, even if it is actually flat.

The effects can be significant. For example, between 1942 and 1945, I would have previously estimated that the “real value” of total private expenditures fell about 17%-back dating the inflation hidden by price controls, the actual drop is more like 24%. Additionally, the boom in the private economy after the war is more dramatic as well, which is a given since it recovered from deeper depths during the war than I thought-A rise of 66% from 1945 to 1948 as opposed to 51%.

Anyway, food for thought.

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Climate Cycle, Meet Business Cycle-Preliminaries

March 3, 2014

I’ve been wanting to write something up for a while about my thoughts on the idea of “cyclical” climate variations, and in particular to express extreme skepticism about them, but one element in particular. Many, with some degree of enthusiasm, have noted that there is a claimed “cycle” in economic activity with (very roughly) the same periodicity claimed to exist in climate: The Kondratiev Wave.

I’ll be perfectly frank. I don’t think the Kondratiev Wave exists. I don’t think it is an actual, real thing. I think it is complete and total bull crap.

But before I can write up a long ass post explaining why it is complete and total bull crap, I want to just post up some fun things.

As before, I will use US GDP data, with the portion representing Government spending removed, to represent actual meaningful production. Except this time, I really want more data than just back to 1890, so I use simple method to estimate the state and local spending from the federal spending: from 1890-2013, there is a correlation between a change in federal spending as a fraction of GDP and a change in federal spending as a fraction of total spending-the correlation is better in later years, so one should be a little bit weary of extending it back in time. But let’s proceed with reckless abandon nonetheless. The main purpose is to properly restrict what are mostly war spikes to increases in federal spending. I can use this relationship to estimate how much of the total government spending before 1890 was made up of federal spending and how much state and local spending. One can then use the estimated fraction, federal/totgov, with the actual federal spending, to get an estimate of total government spending in years before 1890. Anyway, this is what that fraction looks like, with the estimated portion highlighted:

fedtototalpercent

Note that with this, I can extend the total government as a percent of GDP back to 1792. However, the GDP data go back to 1790. After converting from percent of GDP to billions of dollars-and deflating the series to constant 2013 dollars-I observe that the first couple of years saw a slight declining trend. I simply assume 1791 was about 2.2% higher than 1792, and the same for 1790 relative to 1791, to extend the data backwards. This is less than satisfactory, but I wanted to be able to have a reasonable estimate for every year. Anyway, I then subtract those values for total government spending from GDP. For those of you who haven’t taken an undergraduate macro course: well, first of all, don’t, if you are at almost any University in the US. Second, GDP is defined as the sum of all final expenditures by: Consumers (C) Government (G) Investors (I) and the difference between Exports and Imports (“Net Exports”) (NX). So we are basically talking about GDP – G, or C + I + Nx. As measures go, this has a few things to recommend it over GDP including G. But it depends what you are trying to “measure.” And it still suffers from a number of defects. Nevertheless, as a measure of economic growth and fluctuation, I find it nigh infinitely superior.

Anyway, frequently, economists refer to fluctuations in GDP as representing an “output gap”-this basically refers to the percent departure of the GDP from a long term trend curve. There are lots of ways to calculate a long term trend curve, and how you do so determines a great deal about what you will conclude about cyclical variations in output. It’s also questionable whether the entire thing is a very meaningful concept, or more specifically, what meaning to attach to the long term trend curve. My current think is somewhere between that it is meaningless data torture, and that it represents just a proxy for progress. Again, let’s proceed with reckless abandon regardless.

My method for removing the long term trend line has as a goal not removing anything that might conceivably represent a short term variation. So I want a highly aggressive filter. Oh say, I’ve got that. Specifically, I take the following steps: I take the growth rate year over year, for each year relative to the previous. I then lag that back one year. For all years but the first and last, I average those two series. For the first and last, I take the average of the next two, and previous two years, respectively. Then, I iteratively smooth it: I take three point centered averages, with the first and last points double weighted to extend the centered averages to the end of the series, 1110 times-that is 10*(years-2)/2 (since years happens to be 224, an even number). I then use this final smoothed series of “long term growth rates” to create a compound growth curve starting at 1 in 1789. I multiply this by a factor suggested by regression against GDP-G. I then take the ratio GDP-G/TREND1, This seemed to consistently under estimate values in the first half of the data. So I did the smoothing on that ratio 1110 times, and multiplied TREND1 by that factor, which was the new estimate of the long term trend. Then I take the ratio of the actual GDP-G to the trend curve, to estimate the “output gap”:

OutputGap

Some things stand out: One, we are currently about 9% under trend. That is pretty bad, although not exceptionally bad. Another thing that stands out is the Great Depression. Actually, it’s probably the first thing that jumps out at you. What you might not recognize, is what is going on in the 1940’s, when it spikes below trend again? That’s what I like to call the “War Depression.” War Depressions are actually common feature in much of the data-notably associated with the War of 1812, the Civil War, World War 1, and World War 2 (after that, wars no longer stand out as times of exceptional government displacement of economic activity, which becomes the peace time norm). In the case of the War Depression of the 1940’s, it’s a Depression you’ve never heard of. That’s because people didn’t lose their jobs. In fact, employment grew, because the Government drafted people into the military and made exceptions for war time production jobs, and so on. But private investment was way down-this wasn’t growth, this wasn’t a consumer economy, this was a Soviet style Command economy. Instead of people choosing between scarce means to their own ends, the Government choose between means to it’s ends. In that sense, and in the sense that people live an austere life under rationing and price controls, this was truly a depressed economy. You might call it the opposite of a jobless recovery. A jobful depression. As Hayek says in the Keynes v. Hayek rap, round two,  “Creating employment is a straightforward craft, when the nation’s at war, and there’s a draft. If every worker was staffed in the army and fleet, we’d have full employment-and nothing to eat.” And let’s be clear about that: the intervention of the Government caused those conditions. No ifs, ands, or buts. In 1942, GDP-G was at trend-or at least, only slightly below, to the point of statistical indistinguishability. And it took a considerable growth rate to get there, since this is coming out of the Depression. The ramp up in War spending-mostly after 1942-didn’t end a Depression that was already over. It created a new one that it hid in the standard statistics. But when the spending on the war ended, when the Government lifted a lot of war time price controls, rationing, and other things that-as I said before-made it a Soviet Style Command Economy-massive cuts in Government spending were associated with expansion of investment-and that’s an important point, this wasn’t “pent up consumer demand” that merely offset decreased Government spending-this was a booming recovery of investment, less than it was consumption. And why not? Frankly, the situation both during the Depression and the War was, from the perspective of the investor, terrifying as hell. This is documented fact. And when you combine the War Depression and the Great Depression together, they make the single longest slump of non Government output below trend in US history, at 18 years from 1930-1947. Contrast that with the over trend boom periods from 1879-1893 (15 years) and 1895-1913 (19 years). I note the latter two periods for a couple of reasons: first, conventional wisdom is that an over trend economy must reflect an “inflationary gap”-with demand generally outpacing supply driving up the price level. But during the first period, the deflator decreased almost 9%-the average inflation rate was about -0.6%. The second period, despite being well over trend for a long time, was just ~1.8%-from 1879 to 1913, the price level increased only about 23.5%. Compare to 1979-2013, which saw an increase of 261.3%. And that was emphatically not a period where every year but one was above trend! Second, that period, 1879-1913, popped out of the analysis. I did not go fishing for it. But it happens to correspond to the period associated with the classical gold standard. Like, pretty much exactly. So that seems to me a pretty strong indication that, at least back then, a gold standard worked quite well, in the sense that it allowed strong, persistent economic development, even above and beyond the long term growth rate, with long term stable prices. I think there are a lot of questions about how good it would be to reinstate it now-especially unilaterally. Notably, the performance under the Gold Exchange Standard was not very good at all, or Bretton Woods for that matter-however, a strong case can be made that the major shift in monetary policy in 1913-internationally, in the demise of the classical gold standard, and in the United States, the creation of the Federal Reserve system-was a shift to an inferior system, and certainly the alleged goals of the creation of the Fed were not actually achieved. Notably, the claim in Econlib’s Gold Standard article that the economy under the Fed, at least after WWII (the interwar years generally being handwaved as “practice” before Central Bankers allegedly became wise and enlightened) is dated. More up to date, mainstream analyses (not my analysis either, people like Christina Romer-not exactly a Right winger) the volatility of the pre-Fed era has generally been over estimated. The same is true for what it says of unemployment. Note that a much less powerful attenuation filter is used to assess volatility relative to trend than I do. Though I do find that the entire Fed period has a greater standard deviation of the “output gap” than the 100 prior years, it appears that the data I use and the method for removing the trend does show “improvement” in decreased volatility if you compare 1946-2013 with the 68 years before the Fed. On the other hand, the standard deviations for 1879-1913 and 1979-2013 are nearly identical-the latter period is only very slightly lower. Factoring in the possibility that my method is leaving in things that really shouldn’t count as “volatility,” the possibility that the Measuring Worth data suffers from defects that cause it to intrinsically over estimate past volatility (which may or may not be the case) because of their methodology, and the possibility that recent economy has been “luckier” in terms of avoiding supply shocks, and there really is not much evidence here that the Fed stabilized output relative to the Gold Standard-although it does appear to have depressed output relative to the Gold Standard. Well, to be fair, that could be because of the larger government, and not the monetary policy. Similarly, as that paper I linked points out, the larger Government “theoretically” should reduced volatility, as well as reducing growth-acting essentially as a poor man’s good monetary policy. I’m not sure I buy that, since there isn’t much reduced volatility to attribute in the first place.

Hm, I’m rambling quite a bit. Why was I writing this again? Oh, right, I just wanted to describe the data I’d be using for my post on the (non) existence of the Kondratiev Wave. Anyway, we’ll revisit that later. For now, there are several interesting things for readers to ponder.

Also this was a great opportunity for me to ramble on about economics on what is ostensibly a science blog. 😉