The inflation-debt scam: a peek inside the unreal world of economic analysis.

• Author: Roberts, Paul Craig

The result of many years of changes made to the official inflation measures is a substantially understated inflation rate. John Williams of ShadowStats (www.shadowstats.com) provides inflation estimates based on previous official methodology, when the Consumer Price Index still represented the cost of a constant standard of living. The low percent inflation measure used to deflate nominal GDP in recent quarters is unrealistic, as Americans who make purchases are aware.

A reasonable correction to the understated deflator gives a much higher first quarter contraction in GDP growth than the 2.9 percent contraction released recently by the Bureau of Economic Analysis. The two main causes of inflation's understatement are the substitution principle introduced during the Clinton administration and the hedonic adjustments ongoing since the 1980s that redefine price rises as quality improvements. Correcting for excessive hedonic adjustments gives a first quarter real GDP contraction of 5 percent. Correcting for hedonic and substitution adjustments gives a first quarter real GDP contraction of 8.5 percent.

Realistic economic analysis is a rarity. The financial press echoes Wall Street, and Wall Street economists are paid to help sell financial instruments. Gloomy analysis is frowned upon. Even negative quarters are given a positive spin.

Years of understatement of inflation has resulted in years of overstatement of GDP growth. Thinking about the many years of misstatement, we realized that the typical computation in nominal terms of the ratio of debt to GDP is seriously misleading.

Consider that debt is issued in nominal terms and repaid in nominal terms (except for a few Treasury bonds with inflation adjustments). However, nominal wealth or nominal GDP overstates real economic strength. The debt is growing, but both the nominal and real values of the output of goods and services are not keeping up with the rise in debt.

To understand how risky the rise of debt is, nominal debt must be compared to real GDP. Spin masters might dismiss this computation as comparing apples to oranges, but such a charge constitutes denial that the ratio of nominal debt to nominal GDP understates the wealth dilution caused by the government's ability to issue and repay debt in nominal dollars. We know that inflation favors debtors, because debts can be repaid in inflated dollars.

Figure 1 shows three different debt-to-GDP ratios. The bottom line is nominal debt to...