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Games Washington Plays. Trick #1: Hedonic Pricing
Monday, July 27, 2009, by Stathis

For all of you out there who listen to economists and think they know what’s going on, hopefully you will begin to realize that the official data you see is nothing but an illusion after you read this multi-part series of articles.

And for all of you skeptics and “loyal” republicans, who care only about supporting the current administration, take note - this economic deception is not party-specific - it’s Washington-specific.

When you see headlines like Stocks Advance Following Better-Than-Expected Inflation Read,” what do you think will happen once people realize they’re being fooled? The fact is that inflation is well above government numbers. Most likely, it’s hovering around 10% today, and I expect it to go much higher under Bernanke’s weak dollar policy.
If short-term rates are not raised to combat soaring inflation, the situation will get much worse. And this must happen very soon – not by 200 basis points, but much higher. Will such a move slow consumer spending? Sure it will. But that’s much better than massive inflation and the continued destruction of the dollar.
The problem with deciphering the nation’s economic data is that it’s so voluminous. As well, appropriate frames of reference are rarely provided. And many assumptions are not disclosed when the data is reported to the public, making interpretation problematic. This leads to reporting by the media that mirrors what the “experts” state about the economy.
But this deception has a purpose. For Wall Street and off-beat financial institutions, it provides more confidence to investors who shuttle more money into the stock market, leading to increased business. For corporate America, it provides higher profits as consumers spend more credit thinking their future is promising.  
For several years now, this financial deceit has kept the economy running. Perhaps if consumers are kept in the dark long enough the economy will rebound; or so Washington figures. But where will future spending come from now that home equity loans and credit cards have been maxed out, there’s no net job or wage growth while outsourcing strengthens each day?
How will Washington convince foreign banks to continue financing its record debt against the weak dollar, while American diplomacy continues to create global discontent?   
How is it possible that inflation has remained low over the past decade while housing, healthcare, energy and higher education costs have skyrocketed? Does that seem reasonable to you?
How has the government been able to conclude that inflation doesn’t present a problem for the economy? Furthermore, how can the government report inflation without measuring food and energy costs? Does that seem reasonable? 
Washington and its partnering economic organizations take a very rigid approach to economic analysis that often leads to myopic conclusions. Instead of forecasting based on trend analysis and global macroeconomics, most economists focus on daily and monthly data as reported.
As we’ve seen, this data is not only inaccurate, but it doesn’t reflect other issues of larger magnitude, scope and duration. Washington feels that the best indicator of economic health is the quarterly GDP, which is extrapolated over the next three quarters and subject to revision for up to five years.
But the government uses an additional method to distort data. Similar to many economic numbers reported by the U.S. government, the GDP is also subject to what is known as hedonic price indexing, which can at times create investments when there were none or much less than reported. In short, hedonic pricing can lead to an understatement of inflation and improved living standards. 
The primary use of the hedonic pricing method is to identify price factors based on the premise that price is determined both by internal and external characteristics of goods and services. This may sound confusing but you’re probably more familiar with hedonic pricing than you realize.
The most basic application of hedonic pricing can be seen when used in the housing market. Using this method, the price of a property is determined by the characteristics of the house (size, appearance, features, condition) as well as those of the surrounding neighborhood (accessibility to schools and shopping, crime rate, level of water and air pollution, value of other homes, noise, traffic, etc.).  
Regardless where it’s used, the hedonic pricing provides an estimate of the extent to which each factor affects the price. In other words, price is rated high or low relative to the direct and indirect features of the product (or house, from above). When comparisons of price change are measured over time, a determination is made whether these changes represent low or high prices relative to the previous reporting period.  

Altering Inflation Data
Washington’s use of hedonic pricing explains why both core (includes healthcare but not food and energy) and non-core CPI (includes food and energy) numbers haven’t been high considering the fact that healthcare and energy costs have skyrocketed. Hence, Washington has used hedonic pricing to hide the effects of inflation not because they’re evil, but as a way to boost consumer confidence.
They’re able to carry out this charade with little scrutiny from critics because the hedonic pricing methods used by Washington’s puppet economists are very difficult to calculate, especially since the methodologies used have very little transparency. Americans are being conned by their officials they elected.
Unfortunately, you’re not to going to hear much about these inaccurate reporting methods because the U.S. media lacks the intelligence to question anything besides the lifestyles of Hollywood celebrities. As well, there’s no financial incentive for large financial firms to blast the improper reporting of economic numbers since the majority of financial products rely on a bullish economy.
Advocates of hedonic pricing argue that it provides a way for the government to account for improvement in the quality of goods and services by adjusting the price or relative amount of inflation that has occurred. You can decide for yourself if their approach seems reasonable.
Let’s look at a real example of hedonic pricing. The Bureau of Labor Statistics conducted a price analysis of television sets for the purpose of calculating the CPI in 2005, noting the price remained at $329.99 over several months. However, significant improvements were made such as a better screen.
Using hedonic pricing, the BLS concluded these improvements resulted in an increase in valuation of the television sets by more than $135. Thus, when determining inflation data for this product, the BLS reduced the price value of these television sets by 29 percent (a deflationary effect) due to improvements, although the sales price remained at $329.99. That sounds like “Enron accounting” to me.
The same methodology is used by the government for many other goods and services from computers to autos. Despite any enhancements in quality or added features, the problem is that consumers are still subject to the same price as far as their wallet is concerned.
Thus, it’s inaccurate to assume that product improvements will enhance the consumer appeal of goods in the same manner as a price cut, unless we assume that capital is not the limiting factor. While such an assumption might be moderately reasonable by an optimist during a strong economic expansion, (when money is plentiful) it is severely flawed during weak economic conditions. 
In conclusion, hedonic pricing can effectively result in decreased inflation (or is deflationary) if the cost is the same, or a smaller amount of inflation if the cost is higher—as long as the goods and services have been improved or additional features have been added relative to the previous economic reporting period.  
While the hedonic pricing method has some merit for commodities, I hope you can appreciate the disconnect in equating a real price decline with enhancement of services or features which, according to hedonic pricing, has the effect of lowering the sales price of the item due to perceived enhanced consumer value.
This is simply not true. In order to have any validity, one must factor in the relative demand or need for these items. If this is not done, hedonic pricing could add a deflationary component to the economic data resulting from improvements to say, 10 billion television sets; an amount that obviously will not be purchased anytime soon at any price, hedonic or real.
In short, hedonic pricing allows Washington to offset higher prices for gasoline, food and healthcare with the deflationary effect (due to hedonics) for consumer electronics. Maybe you can begin to understand now why the inflation data over the past few years has been low, while energy, healthcare, higher education, and many other costs have soared. 

Altering GDP
Prior to 2005, the government used hedonic pricing to calculate the change in productivity resulting from computer purchases by businesses. For instance, if a company bought a computer for $2000 and replaced it two years later at a cost of $1000 for one with twice the processing speed, this was considered to represent a four-fold increase in computing productivity.
These changes were expressed as a four-fold increase in economic productivity for that component of the GDP. The rational was that the company replaced the computer for half the cost and with double the processing speed. Therefore, its productivity increased by four-fold per dollar spent, which added $4000 to the GDP, when in fact only $1000 should have been added.
Washington has since abandoned this exercise for the treatment of “computer productivity,” after significant protest from outside critics. But it still uses hedonic pricing for GDP calculations of many other goods and services.  

Converting Inflation into Debt
When you consider the U.S. trade deficit with China, it becomes easy to appreciate the broad effects of hedonic pricing. While Chinese imports have been inexpensive, (due to unfair trade practices and currency manipulation) the U.S. government subsidized these costs by incurring a record trade deficit, which was financed largely through the purchase of U.S. Treasury bonds by China.
And Washington has been able to keep consumer spending high during stagnant economic conditions by passing out credit and transferring part of the costs of Chinese imports (using hedonic pricing) into the national debt. Fortunately for Washington, China has been willing to allow such a transfer through its large purchase of U.S. Treasury securities. Perhaps this is the “new economy” the government and Wall Street were referring to.

Why Distort Inflation?
I’ve detailed how GDP data is inaccurate. I’ve also discussed how hedonic pricing can lead to higher GDP and lower inflation data. It should be obvious why Washington would want to inflate GDP data. But why would it care to suppress inflation data?
When you have an economy as vulnerable to a disaster as in America, the most dangerous scenario would be a loss in consumer confidence. But there’s also a direct financial incentive to understate inflation. Consider the fact that annual Social Security (via CPI-W) and Medicare benefit increases are earmarked to the CPI.
With these programs already in trouble, Washington is doing all it can to minimize cost of living adjustments. The CPI is also used to adjust for annual changes in lease payments, wages in union contracts, food-stamp benefits, alimony, and to determine tax brackets. Thus, miscalculation of this one number can have broad-reaching effects on the benefits and wages of millions. Finally, suppression of inflation data would also decrease the future liabilities of government programs.  
In conclusion, the next time you see some economist claim there is no recession in place or that inflation is as Washington reports, you will know you are dealing with a mental midget. The sad reality is that most economists have no mind of their own to question the shenanigans by Washington; the few that do often lack the backbone to publicly question the data.
Other than supporting Washington propaganda, we should wonder what purpose economists in America serve. Other than some independent minds at the Economic Policy Institute and a few others here and there, I can’t seem to find any value from economists. They really need to take a cold hard look at reality and acknowledge the humiliation they have created for themselves and their profession.

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