Government lies and squishy ethics - By Rob Arnott

<blockquote>"In 2003, I wrote a column in the Financial Analysts Journal entitled Legal and Moral Ethics, in which I noted that the more people focus on what’s legal, and the less they focus on what’s right, the further we slide down the slippery slope of fast-eroding ethical standards.


Fixing the problem of business ethics is easy, because most unethical firms are eventually unprofitable. This means that we can do well for ourselves, and do good for society, by shunning securities of companies that have squishy ethics."</blockquote>


Government lies and squishy ethics

By Rob Arnott
September 7 2008
Source

“There are three kinds of lies: lies, damned lies, and statistics.” Benjamin Disraeli, later popularised by Mark Twain.

Let’s drill down to examine three sets of government-issued lies, or should I say statistics, that shape our perceptions of the economy, and hence our investment opportunity set: “off balance sheet” (OBS) spending, deceptions in the inflation statistics and the pretence that we’re perhaps avoiding a recession.

What’s the expected US fiscal deficit in the coming year? $500bn (£283bn, €350bn)? Guess again. With the accrual of future obligations for Social Security, Medicare and Medicaid, and with the cost of the war in Iraq and Afghanistan – all of which are off balance sheet – the true deficit is roughly $1,000bn.

Regardless of one’s political views on Iraq and Afghanistan, most of us would reject the notion these wars are cost-free. They are taken “off balance sheet” because they are “temporary” – five to seven years into these respective conflicts. Similarly, the US counts Social Security, Medicare and Medicaid only as the money is spent.

If a corporate management team chose to count pension and post-retirement medical spending in their P&L – while ignoring the accrual of new obligations – that management team would quickly be spirited off. But the administration and legislature are complicit in this self-same deception.

What about the current rate of inflation? Through June the one-year GDP deflator (a measure of the difference between real gross domestic product and nominal GDP) is an absurdly low 2.0 per cent, and through July core one-year inflation is 2.5 per cent, if we ignore the inconvenient run-up in food and energy costs. Top-line inflation as measured by the consumer price index (CPI) is far higher at 5.7 per cent. But if our methodology had not been changed radically in 1992 (see shadowstats.com), CPI would now be approaching 9 per cent. Applying the European Union formulation for recalculating US CPI would deliver a similar figure.

What makes that vast difference between 2.5 per cent and 8.9 per cent? Half comes from the fiction that allows the DOC to ignore food and energy costs. The other half comes from the triple fictions of geometric averaging, “hedonic adjustments” and rental-equivalent home pricing. Suppose our consumption basket consists of two goods, widgets and gadgets, in equal measure. If widgets go up 10 per cent in price while gadgets go down 10 per cent, inflation is zero, right? No. Geometric averaging is based on 1.1 (up 10 per cent) times 0.9 (down 10 per cent), which equals 0.99. Our cost of living just dropped by 1 per cent.

As for hedonic adjustments, if your $2,000 computer of three years ago is replaced with a $2,500 computer that is 10 times as fast, your computer just dropped sharply in price. If your home is worth twice its value a decade ago, but it would command only 40 per cent more in rent, then housing is deemed to be up only 40 per cent.

None of these fictions was part of the inflation calculus a quarter century ago. They were invented to tamp down the reported rates of inflation. And they’ve succeeded admirably in doing so.

This also means that real GDP growth is based on a fictitious inflation index. While much excitement has surrounded the 0.8 per cent jump in real GDP in the second quarter (usually reported as 3.3 per cent annualised), it is up a scant 2.2 per cent in real terms over the past year. But recall that the GDP deflator is up just 2 per cent over that same span. If inflation in the past year was more than 4.2 per cent, and it was, then the true real GDP growth is negative. Additionally, wherever did we get the notion that a recession is defined by a drop in this fictitious real GDP?

If GDP is flat and the population is up 1 per cent, then the per capita GDP is falling. Isn’t that a recession for the average citizen?

In 2003, I wrote a column in the Financial Analysts Journal entitled Legal and Moral Ethics, in which I noted that the more people focus on what’s legal, and the less they focus on what’s right, the further we slide down the slippery slope of fast-eroding ethical standards.

Fixing the problem of business ethics is easy, because most unethical firms are eventually unprofitable. This means that we can do well for ourselves, and do good for society, by shunning securities of companies that have squishy ethics.

Fixing the problem of ethics in government is far more difficult, especially when we consistently elect those who lie most persuasively, but we can at least be aware of its implications for our investment portfolios.

Rob Arnott is chairman of Research Affiliates

Copyright The Financial Times Limited 2008