CPI Manipulation Has Exacerbated the Income Gap

NEW YORK ( TheStreet) -- Although inflation as measured by the official consumer price index appears low today, the CPI is based on flawed methodology that over time has caused it to be close to meaningless as a measure of the cost of maintaining a standard of living.

In 1983 and again in 1995/96, the calculation of the CPI was modified by the then sitting governments to reflect a much lower inflation rate. The object was to save the government a huge sum in entitlement costs over the ensuing years, and, indeed, it has accomplished that goal.

An inflation rate even 2 percentage points higher over the 30-year period would mean that the cost of the ongoing entitlement programs would be about 80% higher.

Today, these are more than $2 trillion annually. So, the math implies that the cost, at an inflation rate of 2 percentage points higher, would be about $3.6 trillion, or $1.6 trillion more than today.

Both John Williams at Shadowstats.com and Ed Butowsky at Chapwood Investments have done work on the inflation bias, and both conclude that inflation reality is much higher than that reported by the official CPI.

One of the biggest issues in the political world is the growing gap between the incomes of the wealthy and the middle class. The data presented in what follows build a very strong case that an unintended consequence of the policy of reporting a downwardly biased CPI has a lot to do with this growing gap.

Think of the scenario where employees at major corporations are given "cost of living" increases each year equal to the "official" CPI. If the CPI underreports inflation, the employees actually lose purchasing power. At the same time, if the corporations raise their prices equal to the real rate of inflation, the corporations actually increase their margins and profits.

One way to look at this is to look at the share of national income from wage earners and from corporate profits. The first graph shows a definite uptrend in corporate profits' share of Gross Domestic Income (GDI -- the income counterpart of Gross Domestic Product), especially since the mid-1990s, and the downtrend in wage earnings as a percent of GDI, which appears to be long-term in nature. The relationship between wage earnings and corporate profits, while a lot more volatile, shows a definite long-term downtrend.

Courtesy of ShadowStats

The second graph shows the growth in the official CPI, Average Hourly Earnings, Corporate Profits, and the ShadowStats (John Williams) computation of inflation.

As you can see from the graph, wages have only kept pace with "official" CPI, but corporate profits have grown more in line with the ShadowStats inflation rate (ShadowStats Alternative CPI, 1980-based), interrupted only by an occasional recession. It is also clear from the graph that the real divergence between the series began in the mid-1990s, about the time the government began to seriously manipulate the computation of inflation.

Courtesy of ShadowStats

The growing gap between the wealthy, as represented by corporate profits, and the middle class, as represented by wage earnings, has been, in no small part, caused by the understated rate of inflation.

The political class, of course, rails against this growing gap. Nevertheless, it appears to be an unintended consequence of the policy of that political class, which understates inflation so as to slow the increasing cost of entitlements.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Robert Barone is a partner, economist and portfolio manager at Universal Value Advisors, an investment advisory firm in Reno, NV.

He previously held positions as an economist for Cleveland Trust Company and as professor of finance at the University of Nevada. During his tenure at Comstock Bancorp in 1996 he became a Director of the Federal Home Loan Bank of San Francisco, serving as its Chair in 2004.

Barone also served as Director of AAA of Northern California, Nevada and Utah and a Director of its associated insurance company. He currently serves on AAA's Finance and Investment Committee. Along with his son Joshua, he founded Adagio Trust Company in 2000. Barone received a Ph.D. in Economics from Georgetown University.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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