Sunday, December 30, 2012

Inflation Now a Concern for Latin America

The comparison between economic performance in Latin America, Europe and North America could not be further apart. While Latin America continues to power ahead, with average growth of around 4% in the last four years, the situation in Europe and North America is going backwards. European and North American governments are struggling to maintain budget spending, economies are struggling to pull away from the recent downturn and indeed a number of fiscal stimulus packages are having limited impact to say the least.

The situation in Latin America is very different and indeed experts predict strong economic growth for the future. However, only this week we saw the Brazilian central bank airing the subject of inflation and a potential increase in base rates in the short term.

The Dangers of Inflation

Uncontrolled inflation can do untold damage to an economy as we saw back in the 1990s when Brazil nearly collapsed. It makes no difference how strong the underlying economies are because high inflation, i.e. double digit inflation as seen in the 1990s in Latin America, can obliterate economies and ruin the future outlook. Therefore, while on one hand it is good to see the Brazilian central bank broaching the subject of inflation before it actually becomes a problem, will it actually become a problem?

When you compare the current Brazilian base rate of 7.25% against near zero base rates in the UK, US and other areas of Europe, it is difficult to justify how the Brazilian central bank can even contemplate increasing the rate in the short term. However, that is before looking at the rate of inflation which is currently 6.31% against expected economic growth this year of 3.1% and 3.65% in 2014.

The Latin American Economy

Average growth rates across Latin America have been around 4%, with the exception of a small dip in 2012, for the last few years. The rate of economic growth may be slightly under the 4% mark in 2013 and 2014, if estimates for Brazil are anything to go by, but they are still very positive figures especially when compared to Europe and North America.

One thing which many people seem to forget is the fact that while Latin America is now more prominent on the international trading stage, there are still many efficiency savings to be made. Governments across Latin America have been looking at reducing red tape, opening markets to outside investors and indeed massive investment in infrastructure projects is required sooner rather than later. So, even if the Brazilian central bank, for one example, was tempted to increase base rates in the short term the potential fund tightening aim and impact upon the economy would be partly offset by infrastructure spending, employment opportunities and efficiencies going forward.

Sunday, December 23, 2012

Rural Economy

Travelling by road is one of the best ways through which an individual can see a number of brand new worlds; aspects of life that an individual has never even thought about exploring. It helps an individual think out of the box and new ideas come flooding to the individual's mind. Traveling by road exposes an individual to different cultures, traditions and lifestyles and an individual starts appreciating things that he normally doesn't notice. One such exposure includes one being introduced to rural life at its purest form. Once an individual travels through rural areas, one realizes the immense importance that the rural economy holds in every person's life.

If you ever get the chance to travel on a highway at sunrise, you will understand how beautiful certain things in life are. The sun takes its time to actually become visible, yet it starts spreading its light way before it appears in front of living creatures. Such is the light that the rural economy radiates. It is like the sun; it starts giving life even when it is not visible to the naked eye. Pardon me if you are a little confused by this example, it will be very well explained in no time.

The day in a rural area starts way before it does in a city. While the dwellers of cities remain in their beds, rural folk hit the fields; after all, they not only feed themselves, they feed the dwellers of cities as well. Nature too, thus favors dwellers of rural areas and this is evident by the fact that the sunrise is never so beautiful in the confines of a city as it is in the open fields of the village.

The rural economy is the backbone of each country. It is simply impossible to function without it. However, the unjust standards that human beings have created have reduced the image of rural life to a rather low point where no one would want to go. Why would someone want to live on a farm when the same individual can get a perfectly comfortable life in the city? Why live in the moonlit darkness when you can live among bright neon lights? Why go through the trouble of preparing your own meal when you can visit the nearest McDonalds? Yet we fail to understand that the comfort in the city comes from the hard work of rural folk. The bright neon lights would never have been made if there were no raw materials. McDonalds wouldn't be able to operate for a single day if the rural economy collapsed.

Most third world countries are agro based countries. Sad as it is, rural life is considered inferior at a global level. What the world fails to understand is that agro based economies fuel life all over the globe. It is seen that countries that manufacture electronics and are involved in the development of technology are given preference over those which produce crops. The value assigned to manufactured goods is extremely higher than the value assigned to raw materials. However, the world fails to realize that if every economy started producing end products, there would be no raw materials left. The world fails to realize that survival without all the fancy gadgets and technology is possible, however, survival without food is not possible.

The law of demand and supply will continue to govern our world. Raw materials are produced in a greater quantity than high quality, finished goods. There is a lot more wheat in the world than Smartphones. Our imperfect standards will continue governing our lives. However, it is important that we take a moment to think of all the people who make up the rural economy and fuel our everyday lives and what our lives would be if they quit their jobs.

Sunday, December 9, 2012

Representational Monetary Identity

According to the Federal Reserve Bank of Chicago,[1] this is how fractional-reserve banking originated:

    Then, bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money.

There was also the need, however -- as there always is -- of keeping, at any given time, enough money to provide for expected withdrawals: "Enough metallic money had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment."

Hence the name "fractional-reserve banking": commercial banks must hold a fraction of all deposit money as reserves -- which legally (since 1971) are no longer valuable as gold but only as a public debt -- to provide for expected withdrawals: "Under current regulations, the reserve requirement against most transaction accounts is 10 percent."

In the fractional-reserve banking system, on which most of today's international monetary system relies, commercial banks create money by loaning it, hence as a private debt.

    Transaction deposits are the modern counterpart of bank notes. It was a small step from printing notes to making book entries crediting deposits of borrowers, which the borrowers in turn could "spend" by writing checks, thereby "printing" their own money.

For example, if a commercial bank receives a new deposit of U$ 10,000.00, then 10% of this new deposit becomes the bank's reserves for loaning up to U$ 9,000.00 (the 90% in excess of reserves), with interest. Likewise, if a loan of that maximum fraction of U$ 9,000.00 does occur and the borrower also deposits it into a bank -- regardless of whether in the same bank or not -- then again 10% of it becomes the latter bank's reserves for loaning now up to U$ 8,100.00 (the 90% now in excess reserves), always with interest. This could proceed indefinitely, adding U$ 90,000.00 to the money supply, valuable only as their borrowers' resulting debt: after endless loans of recursively smaller 90% fractions from the original deposit of U$ 10,000.00, that same deposit would have eventually become the 10% reserves for itself as a total of U$ 100,000.00.[2]

    Thus through stage after stage of expansion, "money" can grow to a total of 10 times the new reserves supplied to the banking system, as the new deposits created by loans at each stage are added to those created at all earlier stages and those supplied by the initial reserve-creating action.

Now let us further examine what is happening here. First, we have a deposit. Then, we have a loan of up to a fraction (of 90%) of this deposit. Finally, the borrower can deposit the borrowed money into another bank account, in the same bank or not. Suddenly, the trillion dollar question emerges: is the borrowed money in these two bank accounts the same?

    On the one hand, the answer is yes: all borrowed money came from the original deposit -- so it is that same original money.
    On the other hand, the answer is no: all money deposited into the borrower's account possibly stays in the original depositor's account -- so it is not that same original money.

How can that be?

Let us consider gold instead of bank accounts. Gold at once is and represents money. It is money by being its own social equivalence to all commodities, and so the generic exchange value in their price. It represents money by being the object in which all commodities must be priced, whether valuable or worthless in itself (independently of being money). Whatever we choose for the representation of money -- whether valuable in itself or not -- it must be socially identical to all commodities in their exchange value, or in their equivalence to it and to each other in it. This general equivalence is monetary identity, which is purely abstract. Yet money must also be an object, like gold, possibly a commodity with its own exchange value, again like gold: the object in which to price all commodities. This object is a monetary representation, which is not only concrete (like gold), but also replaceable -- say, as gold by silver.

The Problem
So let us go back to fractional-reserve banking. Now, by conceptually distinguishing money from its representation, we can clearly see what is happening in that ambiguous loaning from bank deposits: commercial banks are mistaking bank accounts for the money they represent. This way, when they deposit a loan from any account into any other, they must mistake the same loan for both accounts, hence duplicating its money, rather than subtracting it from the source account. That confusion between monetary identity (deposit money) and its representation (bank accounts) is thus what alone replicates loaned money: two deposits in different accounts must always be different money, even if one is just a loan of money from the other.

The same confusion affects a variety of monetary representations, like paper notes and metal coins. Even when sheer gold represents money, there is no inherent distinction between monetary identity and its representation. Any such inherent indistinction (confusion) is precisely what I call representational monetary identity.

With no representational identity of money, not a single fraction of bank-account balances could belong to both its depositors and their borrowers. As account money, deposits from loans are new money. However, as deposit money, they are just fractions of other account balances. Hence banks lacking up to 90% of all money their clients can withdrawal: bank loans are just bank-account money that vanishes once repaid.

Additionally, because all money created by commercial banks is just a sum of balance fractions borrowed from client accounts, that money must be worth only as credit, or as the corresponding debt principal. This way, except for money not yet in loans nor else reserved -- whether in bank accounts (excess reserves) or not -- but not from loans, bank loans are the whole money supply left for paying their own interest. Consequently, such an interest-paying, self-indebted money supply must grow at least at its own interest rate less any other money off the banks' reserves.

Then, who should create the additional money? Supposedly, governments would do it. Yet historically, central banks have been issuing most of this money in exchange for promises from their governments of paying it back with interest, just like commercial banks replicate it in exchange for promises from their clients of paying it back with interest. So paying the additional interest (that on public money-as-debt) requires even more money: central banks must create -- and are creating -- ever new public money-as-debt for paying interest on both private and old public money-as-debt, thus recursively amplifying the problem.

The Solution
In both this exposition and the world, we can already see the disastrous consequences of such a monetary system, with its limitless, exponential growth of the money supply as a debt -- first private, then public. We have a problem: debt becoming money. What is the solution? The answer comes from understanding the problem: since to create irrational, self-multiplying money we must confuse monetary identity with its representation, the solution is to disentangle them.

By which not even gold money, for having as much a representational identity as that of bank accounts, is immune to its own self-indebtedness. Indeed, it was by creating proxy representations of monetary gold that fractional-reserve banking originally flourished. The reason is that -- as we will see -- with any monetary proxies of gold, its representational monetary identity must become a debt.

Hence the advent of central banking: because monetary gold proxies are already a debt, all additional such money, even if public, must be borrowed. So any public-debt-free, government-issued monetary proxies of gold, for not solving the money-as-private-debt problem, could only postpone the money-as-public-debt one.

Still, if the only solution to the whole (both public and private) money-as-debt problem is an inherently distinct monetary identity, then how to implement it?

Fortunately, an already existing monetary system inherently distinguishes monetary identity from its representation: the Bitcoin monetary system.[3] It uses public-key cryptography (the same technology of private Internet connections) to implement monetary identity as a private key and its representation as the corresponding public key, so this representation becomes inherently distinct from its represented money. The whole Bitcoin system relies on that distinction: as an essentially decentralized monetary system, it controls the money supply by self-certifying a public chain of monetary transactions, which contains money representations (public keys) alone, and never the money (private keys) they represent. This way, monetary identity remains nonrepresentational, private, possibly anonymous (pseudonymous), and impossible to replicate.

Yet in case Bitcoin eventually fails, any other solutions, not only to the money-as-public-debt problem, but also to the underlying money-as-private-debt one, must also consist in distinguishing monetary identity from its representation.

    See Modern Money Mechanics.

Sunday, December 2, 2012

Consumer Price Index (CPI): Does It Measure Inflation?

What is Inflation?

Before we discuss the CPI and government economic data, we much first fully understand the concept of inflation. Inflation, in the most general terms, is a RISE in price levels of goods and services measured over a period of time. When price levels rise, each unit of currency buys fewer goods and services. Inflation also measures the erosion in purchasing power of money, the loss of REAL value in the medium of exchange. Inflation impacts everyone in society, rich or poor, young or old, working or unemployed. Anyone that has to buy food, goods, and services, pay bills, or transact in the economy is directly affected by inflation.

The CPI - official measure of inflation.

The government's key measurement for inflation is known as the CPI (Consumer Price Index). It has been around since 1913 and traditionally measured a basket of goods, which consumers would purchase. Then the price the basket of goods was compared on a year-over-year basis.

For instance you price a steak, a loaf of bread, a gallon of milk, etc. The following year you price the same products, look at the price change, and you are able to determine the rate of inflation. How much have items increased in price. That is (was) the purpose of the CPI, the rate of change on a fixed basket of goods (with a modicum of replacements when a product is no longer serving its core use, such a computer for a typewriter).

The CPI is very important data point for a couple of key reasons:

    Used to adjust Social Security benefits.
    The Federal Reserve uses it as their key measure of inflation to adjust monetary policy.

Obviously a lower CPI would be beneficial for both those key reasons.

The Cost of Living?

When the CPI came about it was used to strictly measure INFLATION, as described above. It did so for 70 years without any major changes. More recently in the last few decades, the model used for calculating the CPI has changed drastically. In fact, it no longer measures inflation, but rather the "cost of living".

The Cost of Living measures the CHOICES a consumer has made based on price changes. In fact INFLATION directly impacts those choices. Many of the changes that have been made to the CPI over recent years have been argued based on the Cost of Living and the freedom of choice. It would seem a sound argument if we forget the purpose of the CPI to measure inflation.

The "Cost of Living" is not synonymous with inflation, yet politicians and the media frequently use the words "inflation" and "cost of living" interchangeably.

The philosophy behind the changes.

The first big change was made in the mid 1980s, it removed housing from the CPI and replaced it with a "rental equivalent". It was argued that not everyone buys a house and some that do buy also rent homes, thus we should measure the inflation of rent rather than the inflation of home prices. This made a significant and measurable change to the CPI and lowered the results.

However, it was the "Cost of Living" argument in the 1990s that brought forth the largest changes. A powerful argument based on measuring the "Cost of Living" and freedom of choice. The belief was the CPI was not reflective of consumer choices, that consumers would make changes in their purchasing to meet a Standard of Living. In order to measure this Cost of Living, we must make significant changes to the method and make some "adjustments".

These major changes fell into three distinct areas:

    Geometric Weighting.

These three changes to the CPI model radically changed the results. For the first time in almost 80 years we were no longer measuring inflation, but instead measuring the "Cost of Living".

Substitution Method.

The first big change made to the CPI model was the Substitution Method.

In the 90's it was argued by Boskin (brief bio: Dr. Michael Boskin, chairman of the Council of Economic Advisors 89-93, was the chairman of the Commission on the Consumer Price Index, whose report transformed the way the government measured inflation, GDP and productivity. ) that CPI was over stating inflation and a method he had been working on would give a more accurate measure of inflation. His argument was, "We should allow for substitution here because people can buy hamburger instead of steak, when steak the price of steak goes up." While it correctly points out people's freedom of choice, it clearly does not measure inflation. The consumer purchasing hamburger doesn't change the fact that steak has increased in price. Clearly the substitution method hides or masks the actual impact of inflation.

The term "Cost of Living" was best defined, perhaps by accident, by Boskin, who was trying to phrase the substitution changes, but realized that it impacted the Standard of Living. The model he used had been known as the Utility of Living (or Utility Efficiency), this is defined as the cost of meeting the essentials REGARDLESS of the standards. By the definition, the Utility of Living is met by purchasing hamburger instead of steak, since they both offer protein. However, it is clear that the Standard of Living has declined significantly, even though the Utility of Living has met its burden.

The "Cost of Living" soon became the standard term used with the CPI, however I think most people missed the real definition and mistakenly assumed it meant the same thing as "inflation".

For those not familiar with the substitution methodology, I have included some text from the Bureau of Labor and Statistic (BLS) website used as an example of this methodology. It clearly sheds light on the fact that while a certain level of Utility of Living is met, the Standards of Living could be significantly lowered. Yet, most importantly, the substitutions mask the REAL impact of inflation.

The CPI is constructed as an aggregation of basic indexes computed for approximately 200 item categories, such as "ice cream and related products, in each of 38 geographic areas. Within each of these index components, or strata, prices for specific items in a sample of outlets (stores) are combined to produce a basic index. Consequently, the use of the formula will address only the issue of consumer substitution within strata.

Substitution can take several forms corresponding to the types of item- and outlet-specific prices used to construct the basic indexes:

    Substitution among brands of products, for example, between brands of ice cream;
    Substitution among product sizes, for example, between pint and quart packages of ice cream;
    Substitution among outlets, for example, between a brand of ice cream sold at two different stores;
    Substitution across time, for example, between purchasing ice cream during the first or second week of the month;
    · Substitution among types of items within the category, for example, between ice cream and frozen yogurt;
    Substitution among specific items in different index categories, for example, between ice cream and cupcakes.


The CPI additionally receives an adjustment to the cost of a product based on the product's "Ease of Use" or "Lifestyle Benefit". The idea is that technology has benefited our lives, so the cost that the consumer pays for the product would be artificially reduce by its "ease of use" when calculating the CPI. This is known as Hedonics and reduces the cost of the goods in substituted basket.

Example: My new smart phone cost is artificially lowered in the basket of goods because it allows me to access my email, thus saving me time and a lifestyle benefit.

How you actually measure Hedonics and determine the reduction in the calculation even leaves some economists scratching their heads. Not only is it subjective, the mathematical impact further reduces the CPI data.

I understand that our life styles through the increase of technology have benefited, but to tell people that we are going to artificially reduce the cost of the product when calculating CPI because she/he received a lifestyle benefit is silly. Why, because the consumer did not receive a discount when they bought it.

Geometric Weighting

Geometric weighting works hand-n-hand with the substitution method and determines the weighting of an item in the basket of goods based on price changes.

If the price of an item that is measured increases, they LOWER the weight of that item to reduce the impact of the price increase.

The argument is that if the price goes up you will buy less of it and theoretically that makes sense. However, you still need eat, pay for gas, pay your bills, etc.

If the price impact is TOO much then they substitute the product out for something else, again making the assumption that the consumer will buy something different because the item cost too much.

There is nothing wrong with this approach IF and only IF you want to measure the Cost of Living based on a certain income and how inflation impacts people's purchasing decision.

However, and this is VERY IMPORTANT, this approach is NOT measuring inflation but rather how REAL inflation is impacting consumer spending habits.

Simple Example:

Let's say that Milk makes up 10% of the food basket of items in the CPI.

Milk prices rise 20% this month.

You would assume that because the price goes up by 20% the weighting of Milk should also increase, if we are to assume that you purchase the SAME amount of milk.

However, the Geometric Weighting system LOWERS the amount of MILK weighting in the basket because it is making the assumption you are buying less of it because it is more expensive. Theoretically this is true to a certain extent. However, we still need to eat, buy gas, etc.

The fact is the price of Milk increased by 20%, regardless of the consumers decision to purchase it or something else, or less of it.


While all these changes directly impacts the CPI, the broader problem is that the Federal Government and Federal Reserve report this as the "official" measure of INFLATION and use the words "cost of living" and "inflation" synonymously. The problem is clearly one of semantics. We are told the government is measuring inflation, when clearly they are measuring something different.

It's a semantics problem that the International Labor Organization (ILO) has clearly addressed when this question was posed to them about measuring inflation:

Which of the two types of index (i.e. a fixed basket index CPI and Cost of Living index COLI) is preferable as a means of measuring inflation?

    There are two diametrically opposed views. One view is that a clear distinction needs to be made between a fixed basket index and a COLI and that a fixed basket is preferred as a means for measuring inflation. A second view is that a COLI does provide precisely that information which is required of an inflation measure. The arguments for the first view are as follows: The fixed basket approach adheres to the principle of a straightforward comparison of prices, therefore only indicating a change in prices, whereas a cost-of-living index provides information about how, given price changes and the substitution processes, expenditure would have to change to maintain the original Standard of Living or level of utility. A fixed basket is therefore a pure price index, while a cost-of-living index is an index which may show change even when all prices stay at the same level. As such, the latter cannot be considered as an appropriate measure of inflation. The argument for the second view is as follows: the COLI is a price index whose weights change to reflect changes in consumer preferences. It is intended to measure the change in the cost of maintaining a given Standard of Living and takes into account substitutions in response to changes in relative prices. However, it can "also be interpreted as measuring the change in the value of a fixed basket of goods and services where the fixed basket is a particular blend of the baskets in the two periods compared" (Hill, 1997). A COLI is preferred because in practice fixed basket indices may be biased estimates of inflation (especially in the indices with weights that are updated infrequently) and therefore are measuring changes in the value of a basket of goods and services that is no longer representative.

It is interesting that the ILO simply relates the different opposing views and does not say that one is correct or the other is wrong, just different. Furthermore it is clear that you can't replace one with the other, as you are measuring two different things, Price Changes vs. effect of those prices changes to the Cost of Living.

I spoke with the ILO about the CPI vs. COLI subject. They stated you can NOT replace one with the other, they measure two different things. One measures inflation based on price changes, the other measures the Cost of Living based on "utility efficiency". When asked about the U.S. CPI method, the ILO stated it is a Consumer Cost of Living that is now being used as the current method of measuring inflation, not the traditional fixed basket of goods. I asked which is better; they said depends on what you want to measure. However, you cannot say one is the other, because they are not.

It's interesting to note that measuring the Consumer Cost of Living (COLI method) is impacted by inflation affects from the fixed basket of goods, as consumer substitutions must change to avoid price increases, the definition of substitution.