WHY DOES INFLATION TROUBLE 
ELECTED OFFICIALS?
by Monty Guild
Guild Investment Management, Inc.
February 26, 2008

Winter has been a busy travel season for us at Guild Investment Management. We are frequently traveling to noteworthy markets around the world to meet with economists, business leaders, political leaders, officers of companies in which we invest and local, country, or industry-specific analysts. In the last few months four of us, including myself, have traveled throughout North America, Taiwan, Hong Kong, China, Singapore, Britain, East Africa, and India.

In our travels one very significant trend emerged as a constant in each and every country we visited: inflation. Inflation is on the rise, not just in one or two regions but all around the world. And this spells trouble for the elected officials in many countries.

WHY DOES INFLATION TROUBLE ELECTED OFFICIALS?

It is an undeniable fact that elected officials like to give voters and special interest groups gifts in order to curry favors and to create votes and political donations for themselves and their political party. One side effect is that revenues must be raised to pay for these gifts and pork-barrel projects. If revenues are not raised sufficiently as a result of economic growth, then tax rates must be raised which is an unpopular alternative for most politicians.

The alternative for a country or government is to run budget deficits. This requires selling bonds to others to finance the national spending in excess of national income. If you float bonds, you must pay interest on them and the rate of interest charged will depend on; a) the perceived credit worthiness of your country, and b) the perceived rate of inflation. 

WHY COUNTRIES MANIPULATE ECONOMIC STATISTICS

The imperative to produce favorable economic figures (strong growth with low inflation) gives politicians a huge incentive to misrepresent, spin, fudge, readjust and manipulate the inflation rate as well as many other economic statistics produced by the government's economics bureaus.

Incentive #1-If your economic statistics are good, you pay lower interest rates on your borrowing. 
Incentive #2- If your inflation rate is low, you pay less on government retirement programs, other debt or on contracts which are tied to inflation adjusted payments. 
Incentive #3- If your economic growth rate is good and your inflation rate is low, you avoid the psychological damage caused by a rapidly rising cost of living to your electorate. For example, once an inflationary psychology is developed consumers and businesses hoard inventory goods and services. 
Incentive #4- Good economic statistics help create an interest among foreigners to invest in your economy and create jobs and wealth for your people. Foreign investment also creates many other ancillary benefits. 

THE UNITED STATES ANNOUNCED A 2.1% INFLATION RATE.
IN REALITY IT WAS MUCH HIGHER. 

As measured by the Consumer Price Index or CPI, the Bureau of Labor Statistics places the rate of inflation at 4.3% and the core CPI at 2.1%. This is simply inaccurate. The fact that this figure is so out of touch with the reality on the ground begs several questions. 

First, why do government statisticians and economists still refer the core CPI? Effectively stripping out the food and energy components? Core CPI, no longer reverts back to the basic CPI range as it once did. This is due to the fact that rises in food and energy prices are no longer the one-time cyclical events that they may have been decades ago. Today, they are long-term secular events and even the Federal Reserve officials have pointed this out. This alone makes the use of the core CPI outmoded and possibly devious.

Further, anyone familiar with the statistics behind CPI construction knows that since the 1980's statistical techniques have been used to understate the CPI and other government inflation statistics.

The manipulation of the basket of goods within the CPI over the past two decades has generally had the effect of reducing inflation. For example, a number of years ago the cost of a home was removed from the basket and rents were substituted. The effect of this was to grossly understate the CPI for the last several years as housing prices have been booming. Further, even with the current decline in housing prices, rents remain much cheaper than house payments.

Another technique to mask inflationary pressures was the discontinuation of the publication of the M3 measure of the money supply in March 2006. It was discontinued after many economists began to believe that it gave a clearer insight into the rate of growth of money in circulation. This was important because many economists believe that the rate of growth of the money supply influences the inflation rate. 

THE SEARCH FOR ACCURATE CPI DATA 

Fortunately, some economists make a living by monitoring the discontinued statistics and making them available to others for a fee.

One such organization is shadowstats.com. The proprietor John Williams and his team monitor much of the important data that is "adjusted" or discontinued. According to them, CPI growth for the last 12 months would have been 7.6%, if the gimmicks introduced since 1990 were removed from the calculations. And according to Williams, if the gimmicks introduced since 1980 were removed, the CPI number would have been 11.8% for the last 12 months. This is versus the published 4.3% CPI. 

"...YOU CAN'T FOOL ALL THE PEOPLE ALL OF THE TIME"

The old adage that, "You can fool all of the people some of the time, and some of the people all of the time, but you can't fool all of the people all of the time", has once again been proven to be true. Many investors and business owners have become aware that inflation is strongly reasserting itself and they are voting with their capital...the vote is decisively for higher inflation worldwide.

It is therefore no surprise that we are seeing rapid rises in certain commodities such as gold, platinum, iron ore, steel, oil, food and many other global commodities. 

WEALTH MOVING FROM DEFICIT COUNTRIES TO SURPLUS COUNTRIES

The big rise in commodities has sped up the long-term transfer of wealth from the profligate trade deficit countries like the U.S. and much of Europe, to the commodity-rich, exporting and trade surplus countries of the Middle East and Asia. The process was well underway previously, but the big rise in commodity prices is only speeding up the process. 

AFTER THE WEALTH IS PARTIALLY TRANSFERRED, THE POLITICAL POWER WILL BE TRANSFERRED ALSO

We expect China, India, and Russia to be much more powerful politically in a couple of decades, and the U.S., Europe, and Japan will have less power in setting the global agenda. 

SUMMARY OF OUR INVESTMENT POSITIONS

We believe we have positioned our portfolios well so that they will continue to benefit from the rising prices of gold, platinum, iron ore, steel, other metals, energy, and agriculture products. We also own investments that will benefit from the rapid economic growth in India, China, and other developing economies, and from the growing use of alternative energy throughout much of the developing world. 

© 2008 Monty Guild
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