[Speaking of James the Bear . . . The part where the Bundesbank calculates how big its economy would be if they used American IT price indexes is near the end.]
Financial Times ; 04-Sep-2000
COMMENT & ANALYSIS: America's hedonism leaves Germany cold: US methods of price indexing, particularly for computer-related products, exaggerate output compared with European rivals
By JAMES GRANT
Formerly reserved for shopping, Labor Day has more and more been given over to celebrating the triumphs of American productivity growth. Higher output per hour of toil has been the story of mankind since the invention of the plough and the battering ram. What ostensibly sets the millennium apart is the productivity miracle of the computer.
But the US has brought forth another miracle - the statistical method by which productivity gains are computed. By a process called "hedonic" price indexing, the fruits of the information-technology revolution are made to appear even plumper, riper and juicier than they actually are.
To a lay investor, the debate over the validity of hedonic adjustments may seem as irrelevant as it is obscure. However, the consequences of the real-life application of these adjustments are significant and far reaching. Citing the alleged outsized gains in productivity growth, the US Federal Reserve has pursued a less restrictive monetary policy than it might otherwise have done. Crediting published US productivity data, currency traders have bought the dollar and sold the euro. Believing in a uniquely productive "new economy", bondholders have entered no meaningful protest against Dollars 30-per-barrel oil prices.
The idea of hedonic price indexing is deceptively attractive. A price is assigned not to a particular product but to each of that product's characteristics. Say this year's computer sells for the same nominal price as last year's but this year's model is faster and more versatile than the 1999 edition. Is not the newer model actually substantively cheaper than the older one? Indeed it is, US government statisticians have long since decided.
But the computation is not at all straightforward. "While the validity of the technique depends on having the right set of hedonic pricing characteristics," observe James Medoff and Andy Harless, respectively professor of economics at Harvard and a private-sector econometrician, "the choice of characteristics is essentially a subjective one. Also, the technique is not well suited to discontinuous technological change: it relies on the premises that this year's goods and last year's goods can be described in terms of the same characteristics, and that the characteristics mean the same thing this year as they did last year. In a world of dramatic innovation, rapid obsolescence and compatibility constraints, the applicability of the hedonic price concept is dubious."
Dubious or not, the use of hedonic adjustments has so far been bullish. Imputed price declines across the gamut of the information technology product line tend to enlarge reported output - ie, inflation-adjusted, or "real" output - and to damp reported price inflation.
The US is the world leader in this form of hedonism. Although France, Sweden and Denmark are said to employ some form of hedonic indexing, the euro-zone's biggest economy does without. The changes made by Germany's statisticians to reflect improvements in product quality are relatively small.
Yet the currency markets seem to make no allowances for the profound differences in transatlantic accounting practices. In a talk at the recent Federal Reserve synod at Jackson Hole, Wyoming, Fed chairman Alan Greenspan reiterated his oft-expressed view that the US economy is, with regard to technology-generated productivity growth, on its own digital planet.
Less enlightened countries have set up barriers to the operations of free markets, observed Mr Greenspan, but those policies have costs: "A recent manifestation of these costs can be seen in the lower level of high-tech capital investment in continental Europe, on average, and in Japan, relative to that in the United States. Arguably, this outcome has resulted to an important degree from the particular legal structures and customs that govern labour relations in much of Europe and Asia." Statistical customs, not least.
But the eerie official silence on hedonic indexing has at last been broken. The Bundesbank devotes five weighty paragraphs in its August report to the unlevel statistical playing field on which Germany competes. The Bundesbank makes a stab at reconciling Germany's national accounts with America's. In the US, it observes, the hedonically adjusted average prices for computers and peripheral equipment declined by 80 per cent from 1991 to 1999. Yet "over the same period, the German statistics show prices to have eased 'only' by one-fifth".
Next, the bank ventures a guess at how the application of US-style hedonic indexing would have changed German economic data. After adjustment using the US deflator, "German IT investment amounted to an estimated DM64bn (Dollars 29bn) in 1998, more than twice as much as the amount of real investment cited in official statistics. In fact, in 1999, the divergence increased to slightly more than 170 per cent. For the years since 1991, on a US price basis, real IT equipment investment in Germany swelled at an average rate of 27.5 per cent a year, compared with 6 per cent by the conventional method."
Obviously, the bank concludes, hedonic indexing would confer on Germany a more robust capital investment account - and therefore a faster-growing GDP - than Germany has conferred on itself. Exactly how much better the German economy would look, it is impossible to say. Without hedonic assistance, growth in the second quarter surged 3.6 per cent from a year earlier.
Mr Greenspan is therefore only partially forthcoming when he urges backward Europe to take a page from the best-selling US book on the new economy. He should specify the relevant chapter - Wealth through Accounting.
The writer is chairman of grantsinvestor.com
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