From the June 2007 issue of Research Magazine • Subscribe!

June 1, 2007

Test Your CPI-Q

Not long ago, telling someone they looked like a million dollars was a compliment. Say it now and they might rush to schedule an emergency medical check-up.

A million dollars is not what it used to be. This is what a friend recently sold a two-bedroom apartment in Manhattan for, which he bought for under $270,000 in 1993. Even a billion dollars is not a big deal anymore. Corporate takeovers of this size, all cash, no longer make the headlines.

Definition of Inflation

One definition of inflation is the loss of the value of money. Surely, you need a lot more of it to be called a fortune. This year, for the first time ever, only individuals with a net worth of over $1 billion made the Forbes list of 400 richest Americans. In 1982, when it was first compiled, you could squeak in with a mere $200 million in today's dollars, while the list was headed by a guy with just $4 billion. Today's richest man, Bill Gates, is worth $56 billion, a 14-fold increase after inflation.

The accelerating loss of the value of money is best seen from the outside. Since 2000, the U.S. dollar has lost 7 percent on the real effective exchange rate. Over the same period, China's foreign currency reserves -- mostly dollars -- have grown from $150 billion to over $1 trillion.

Another definition of inflation is more money chasing a set quantity of goods and services. This is certainly true of goods and services consumed by the upper middle class. If you send your kids to prestigious schools, drive a luxury car, collect art, dress in expensive boutiques, take vacations abroad, eat out in quality restaurants or have wine with dinner, you have seen your bills rise at double-digit rates, not the benign 3 percent that the government has been reporting.

On the other hand, if you live in the world of Wal-Mart and sub-prime mortgages, you may have seen not just stable prices but outright price declines. Families from the lower-middle class down can now afford more goods and services, and a far greater variety, than only a decade ago. Their buck now goes a lot farther as almost all generic goods have become cheaper.

Consumers in this category still face inflation -- for example, gasoline prices more than doubled since 2000, while rents have also increased -- but their inflation has certainly remained moderate, matching or even trailing the official CPI.

Class-Based Inflation

Plenty of studies and data sets show that the rich are getting richer and far more numerous than ever, while the poor are running hard to stay in place, with the attendant thinning out of the middle-income brackets. The divergent trend in inflation for different social classes is perhaps the most dramatic sign of this process in socio-economic terms.

That a class-based rate of inflation can be discussed at all is significant. In the earlier postwar decades, a very broad income spectrum of Americans shopped at Sears and Montgomery Ward -- even though they tended to buy different things. Today, the Wal-Mart crowd and the boutique crowd no longer mix on the cash register line.

As they acquire greater assets and attain higher incomes, upper-middle-class consumers face runaway inflation. Meanwhile, limited income gains for the lower middle class and the poor have created intense competition for the consumer dollar, feeding a drive toward greater production efficiency and a shift to cheaper production venues. Wal-Mart has staked out the lower rung of the consumer segment by relentlessly pressuring its suppliers to cut prices. This model now dominates mass-market retail.

The official rate of inflation is calculated using the basket of generic goods and services, while higher inflation at the top goes unreported. Low reported consumer price inflation has allowed the Federal Reserve to move cautiously in raising its interest rates, despite strong economic growth since 2003.

Best of all Possible Worlds?

So far, this has underpinned the current success of the U.S. economy. Domestic consumption has been sustained by gently falling prices of generic goods on the one hand and low interest rates on the other. With mortgage rates still low, and creative lending practices exploding, home ownership has been broadened and consumer credit escalated, since much of it is implicitly secured by equity in private homes.

Users of capital, including corporations and wealthier individuals have benefited even more from low interest rates. Generous rewards at the upper end of the income pyramid created the kind of spectacular stimuli that economists say America's dynamic, entrepreneurial economy needs to keep going. Corporate profits have also rocketed, rewarding those individuals whose incomes have been one way or another linked to corporate performance, such as shareholders, senior management, bankers, etc. The Fortune 500 largest companies based on revenues had collective profits of $785 billion last year, up 29 percent on the year before.

The picture looks good at first glance, but not if you consider its implications. One way of looking at low headline inflation is to realize that global productive capacities have been growing faster than consumer demand. The United States continues to pace global demand growth, but even the stunningly resilient American consumer may simply run out of means for funding his buying spree. A recent report showed that a third of U.S. workers earn $11 per hour or less. At the mass market level, we may be witnessing a slowly unfolding overproduction crisis.

At the top, meanwhile, significant asset price bubbles have developed, which could deflate with damaging consequences. Stock prices may be one such example. Unprecedented amounts of cash on corporate balance sheets have fed an M&A frenzy, bidding up company prices and contributing to the stock market rally. The surfeit of cash is seen by investors as a source of future dividend increases and share repurchases, also boosting share prices.

Finally, private equity firms, corporate raiders and hedge funds routinely accumulate multibillion dollar war chests. The kind of profits regularly made by private equity funds through takeover schemes that seem to work time and again and provide easy double-digit returns are a sure sign of a bubble.

Pension Woes

But even if an overproduction crisis does not come to a head in the near future, high-income individuals may not escape scot-free. One reason is that retirement income is habitually calculated using the overall CPI, which is quite low. Yet, in each individual case, the rate of inflation during retirement is likely to vary greatly.

Individuals with substantial assets put aside for retirement are likely to be in the higher-income bracket and are already experiencing higher inflation. If a retired couple moves to Wisconsin to fish and hike, their inflation will be close to, or even below, government figures. But if they maintain an active lifestyle, insist on living in a major metropolitan or suburban area and continue to enjoy various luxuries, their retirement benefits will not go quite as far.

The situation may be compounded by the fact that prices of goods and services typically consumed by retirees are likely to be bid up as more and more baby boomers reach their golden years and crowd the market.

People may not be inclined to commiserate with an upper-middle-class couple who all of a sudden find that their retirement expenses are rising more rapidly than they planned. However, since longevity and income levels are positively correlated, this greatly increases the risk of outliving one's retirement savings -- not something you would wish even on your worst class enemy.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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