Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (23 page)

—Wilhelm Röpke,
Crises and Cycles,
1936

The stock market became a national obsession in the late 1990s. Brokerage firms were more than happy to cheer prices higher, but they needed an explanation:
why
was the stock market doubling, tripling, or, in the case of the Nasdaq Index, up thirteen-fold from early 1991? The formulation needed to be simple, and it was—it was captured in one word: productivity.
²

Alan Greenspan was the leading productivity mythologian, whipping up enthusiasm in practically every speech. His repetitious cheerleading

¹
Wilhelm Röpke,
Crises and Cycles
(London: William Hodge & Co., 1936), p. 149.
²
William A. Fleckenstein and Frederick Sheehan,
Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve
(New York: McGraw-Hill, 2008), p. 36

145

for the “more rapid-pace of IT innovations,” which eliminated the “doubling up on materials and people” that had caused “inevitable misjudgments. … Decisions were made from information that was hours, days, or even weeks old” was grounded in the productivity improvements that never existed.
³
In 2001 and 2002, when the superstars of the miracle wrote off $100 billion or $200 billion of nonexistent value, it was obvious that the emperor wore no clothes.

The steps by which the productivity calculation entered the fat farm and exited a superstar model will be described by component. The government inflation calculation plays a large role, since productivity is a measure of “real” improvement. To calculate real improvement, the inflation rate is subtracted from the increase in production. If the government understates the inflation rate (the government’s CPI is 1 percent, when it really was 4 percent), it is overstating productivity.

The Boskin Commission

Alan Greenspan’s 1983 Social Security Commission did not solve the problem of funding benefits. (See Chapter 6.) The insiders knew this at the time. The chairman of the commission had wrapped its conclusions in vagaries that politicians then draped in platitudes. A decade later, the funding problem was too big to ignore. The Federal Reserve chairman offered a solution. Testifying before the Senate and House Budget Committee on January 10, 1995, he told the committee that the inflation rate was overestimated.
⁴
He suggested that the anomaly be investigated.

If Greenspan was correct (or if his assumption could at least be rationalized), this would be a godsend. Benefits could be cut, and congressional constituencies would never know it. After Greenspan passed the baton to the politicians, Congress passed it to Michael Boskin. The Boskin Commission (officially, the Advisory Commission to Study the Consumer Price Index) was duly formed.

³
Greenspan gave this speech many times. These specific quotes are from “Technology and the Economy,” at the Economic Club of New York, New York, January 13, 2000.
⁴
Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before a Joint Hearing of the Senate and House Committees on the Budget, January 10, 1995: “The present budget scoring process is already partly dynamic but tends to underweight the impact of supply-side changes and relies on a consumer price index that may overstate inflation by 0.5% to 1.5%. The likely benefits of reduced spending and tax cuts are difficult to calculate, but should nonetheless at least be estimated and considered as Congress debates its courses of action. Overoptimism is dangerous in budgeting, but so is willful ignorance of a program’s positive fiscal effects.”

Boskin was the right man for the job. He had served as chairman of President Bush’s Council of Economic Advisers from 1989 to 1993. He proved a worthy successor to CEA functionaries Arthur Burns and Alan Greenspan. The Boskin Commission found that inflation was overstated by 1.1 percent. Several recommendations were made by the commission to the Budget Committee. These were instituted by the Bureau of Labor Statistics (BLS) with great efficiency—with too much efficiency.

There was no pretense on the Boskin Commission’s part that its mandate was other than to reduce the
measurement
of the annual Consumer Price Index (CPI).
⁵
The Bureau of Labor Statistics’ CPI is applied to social security benefits each year. It is used to compensate recipients for the increasing cost of living: if the CPI rises 3 percent, the next year’s benefit checks rise by 3 percent. Also, inflation-indexed U.S. Treasury bonds are indexed to the annual rise in the CPI. The lower the CPI, the less the government has to pay holders of these bonds. A synopsis of the commission’s mandate precedes the report: “The Advisory Commission to Study the Consumer Price Index (a.k.a. The Boskin Commission) was appointed by the Senate Finance Committee to study the role of the CPI in government benefit programs and to make recommendations for any needed changes in the CPI.”
⁶
The purpose was
not
to improve the government’s measurement of changes in consumer costs. The purpose was to measure the influence of the CPI on the cost of government programs. The Boskin Commission was to “make recommendations for any needed changes in the CPI.”

The government wanted to reduce the cost of social security. Therefore, the recommended changes reduced the consumer price index, as reported by the civil servants to the people they serve. Greg Mankiw, chairman of President Bush’s Council of Economic Advisers from 2003 to 2005, said at the time, “[T]he debate about the CPI was really a political debate about how, and by how much, to cut real entitlements.”
⁷
Barry Bosworth of the Brookings Institution called the revised CPI an “ ‘immaculate conception’ version of deficit reduction, in which spending is cut without Congress taking the blame.”
⁸
Jack Triplett of the Brookings Institution extended the argument: “What I liked least about the Commission Report was exactly what made it so influential—its guesstimate of 1.1 percentage points of bias. … The Commission (and others that have followed) used ad hoc reasoning to come up with a number. … [T]his seemingly so precise 1.1% number caught the eyes … of the press and the politicians, and also of economists.”
⁹
Triplett went on to chide the report for succumbing “to the lure of political statements in its choice of language to describe the effect of CPI measurement errors on Social Security expenditures.”

⁵
Fleckenstein and Sheehan,
Greenspan’s Bubbles
, p. 39.
⁶
http://www.ssa.gov/history/reports/boskinrpt.html#exec.

Despite such criticisms, there was little public discussion of the Boskin Commission or its influence. One reason is the complexity of the parts. It is difficult to launch a coherent critique if the method by which the government has underestimated inflation (or underestimated the unemployment rate, or overstated productivity) is not understood. What follows is not a blow-by-blow analysis of methodologies. Rather, it is an explanation of some (but by no means all) of the larger distortions that, in themselves, show how government calculations are divorced from the reality of how we live and pay our bills.

Before the Boskin Commission, period-to-period CPI changes were calculated arithmetically. The Boskin Commission recommended that they be calculated geometrically. The change was made to account for “substitution effects.” For example, if the price of beef rises relative to the price of chicken, consumers will substitute chicken for the beef they previously ate. Since the price of chicken rose less than the price of beef, the CPI will be relatively lower. That the consumer might want to eat beef rather than chicken is not a consideration.

⁷
Jack E.Triplett, “The Boskin Commission Report After a Decade,”
International Productivity Monitor
, no. 12, spring 2006, p. 56.
⁸
Barry P. Bosworth, “The Politics of Immaculate Conception: Congress Should Set the Budget, Not the CPI,”
Brookings Review
, spring 1997, pp. 43–44.
⁹
Triplett, “The Boskin Commission Report,” p. 46.

Jack Triplett wrote: “It is merely a mechanical fact that an unweighted arithmetic mean of positive quantities will be greater than an unweighted geometric mean. The difference between the two is not evidence of substitution bias. [Meaning: That consumers actually bought chicken instead of beef—author’s note] No inference … can be drawn from the fact that the geometric mean basic component gives a lower estimate of price change than the arithmetic mean, since this will always be the case.”
¹⁰
In other words, the mathematics of using the geometric calculation will always be lower, but the statisticians had no knowledge of whether consumers substituted chicken for beef.

Here is an example of how these calculations differ. The price of a hog rises from $100 to $161 over five years. The “annualized” rise—this is the geometric calculation—is 10 percent a year. The change each year—the arithmetic calculation—is a little over 12 percent: 61 divided by 5. Using the new math, 2 percent is lopped off the consumer price index.
¹¹

And what has been the result? John Williams, author of
Shadow Government Statistics
, who has reconstructed and made the comparison, calculates that the geometric figure reduces the CPI by about 2.7 percent annually. The effect of compounding at a lower-than-accurate rate, year after year, has had a devastating effect on social security payments.
¹²
Williams calculates payments today would be double the current checks if the government had not changed methodologies.
¹³

Geometric averaging is the most straightforward of the changes suggested by the Boskin Report. Without a key to the magicians’ locker at the BLS, quantification of other distortions is difficult. They are more a matter of intuition. For instance, the BLS reduces the price we pay for products by quality or a “hedonic” adjustment.
¹⁴
(This is the same concept as that used in the “real” cost of computers, which distorts productivity and GDP measurements. This will be discussed later in the chapter; see “Productivity.”)

¹⁰
Triplett, “Boskin Commission Report,” p. 53.
¹¹
Fleckenstein and Sheehan;
Greenspan’s Bubbles
, p. 39.
¹²
Williams is author of the electronic newsletter
Shadow Government Statistics
, “Analysis
Behind and Beyond Government Economic Reporting.” www.shadowstats.com
¹³
Williams, “The Consumer Price Index,”
Shadow Government Statistics
, October 1, 2006
¹⁴
Quality
is used here for what readers may know as “hedonic” adjustments. The two are not synonymous, but they are close enough for this discussion.

According to Steve Leuthold, founder and chief investment officer of the Leuthold Group, a research firm in Minneapolis, the average price paid for a new car in the United States has risen from $6,847 in 1979 to $27,940 in 2004, a 308 percent increase. Over those years, the Consumer Price Index assumed that car prices rose 71 percent, to $11,708. Thus, the government-calculated CPI eliminated 82 percent of the price increase.
¹⁵
The Consumer Price Index does not measure the cost of goods in dollars, yet, a consumer must pay $27,940 for a new car.

Such quality adjustments are used to reduce prices in the areas of apparel, air fares, gasoline, hospital services, television sets, microwave ovens, television sets, washing machines, clothes dryers, and textbooks. Discount air fares do save money, but no adjustment is made for cramped and dirty seats and endless delays: What is the cost of lousy service in a service economy?
¹⁶

Another fanciful figure is house-price appreciation. House prices are about one-fifth to one-quarter of the CPI. The Bureau of Labor Statistics does not include house price sales in the CPI. Instead, it calculates the “owners’ equivalent rent.”
¹⁷
(The data are gathered by survey—basically, by asking homeowners how much they would pay to rent their own house.) In 2005, the change in the cost of purchasing a house rose 3.1 percent, according to the BLS and calculated in the CPI. According to OFHEO (Office of Federal Housing Enterprise Oversight), another government agency, house prices rose by 13.3 percent in 2005. The cumulative effect over the decade from 1995 to 2005 can be viewed in Table 12-1.
¹⁸

¹⁵
Fleckenstein and Sheehan,
Greenspan’s Bubbles
, p. 40.
¹⁶
Ibid., p. 41.
¹⁷
Boskin Commission Report discusses the history of owners’ equivalent rent on pages
8 and 41; http://www.ssa.gov/history/reports/boskinrpt.html-ref.
¹⁸
These data were gathered from www.OFHEO.gov. OFHEO (the agency) was replaced
by the Federal Housing Finance Agency in 2008. The historical OFHEO house price indexes do not seem to be on the FHFA site.

Table 12-1

OFHEO “Real” House
Price Change BLS “Rent Equivalent” Housing as a % of CPI

Index
2005 13.33% 3.1% 23.4%
2004 11.99% 2.9% 23.2%
2003 7.85% 2.2% 23.4%
2002 7.43% 3.1% 22.2%
2001 7.53% 4.7% 22.1%
2000 7.55% 3.4% 20.5%
1999 5.13% 2.4% 20.5%
1998 4.98% 3.1% 20.5%
1997 4.59% 3.8% 20.2%
1996 2.58% 3.1% 19.6%

Note: Over this period the rent equivalent was first called the “owners’ equivalent rent,” then the “owners equivalent rent of primary residence,” and now, “rent of primary residence.” It is a subset of “shelter,” which runs about 10% higher (in total proportion of the CPI) than rent equivalent/ house price appreciation.

There are two periods within this decade to isolate. The first period is 1998 to 2001, the years when Greenspan touted productivity. The second period is 2002 to 2004, when Ben Bernanke led the Federal Reserve’s deflation campaign, which will be discussed in Chapter 23. Low inflation was the Federal Reserve’s rationale for cutting interest rates to 1 percent. According to a recent study, owners’ equivalent rent reduced the reported CPI by 2.9 percent in 2004.
¹⁹
On April 23, 2004, Federal Reserve Governor Ben S. Bernanke stated: “[M]y own best guess is that core inflation has stopped falling and appears to be stabilizing in the vicinity of 1-½ percent, comfortably within my own preferred range of 1 to 2 percent.”
²⁰