The British government’s announcement that it intends to force a change in indexing of private sector pensions from the Retail Price Index to the Consumer Price Index, thereby making British pension schemes sounder while depriving aged pensioners of 25% of their expected income is typical of an unpleasant recent trend. Governments are manipulating official statistics and their uses to make themselves look better and in some cases renege on previous promises to their electorates. Apart from its ethical unpleasantness, this process carries an additional danger: governments, seeking to deceive their electorates, may end by deceiving themselves and dangerously distorting markets.

The first major instances of this unhappy trend were in the United States, and related to the consumer price index. In 1980, Carter administration policymakers were annoyed that rapidly rising house prices were playing a major role in reported “headline” inflation. They therefore removed house prices from the index and substituted “owners’ equivalent rent.” This did not do much for the inflation rate in the short term, since housing almost immediately went into one of its periodic slumps. It however made the CPI unduly optimistic as a barometer of inflation in the late 1980s. Since the Fed was following published rather than true inflation rates, this made monetary policy excessively loose in 1986-89, when the reported CPI rises were artificially low and unduly restrictive in 1991-92, when the housing bubble had burst and the CPI was correspondingly overstating inflation.

The distortion became greater in the housing bubble of 2002-06. During this period, the Fed constantly assured the country that inflation was low and controlled, and indeed that deflation was a major potential problem. In reality, inflation in some years during the period soared above 10% when housing costs were accounted for properly. Thus the Fed’s interest rate policy, which had already become excessively stimulative during the stock market bubble years of 1995-99 became hopelessly so in 2002-06. The debacle of 2008 should thus have come as no surprise.

The effect of statistical fiddling in the US price index was exacerbated by two further changes made during the 1990s. First, instead of the CPI representing an arithmetically weighted fixed basket of goods, geometric weighting was introduced, so that a sharp increase in the price of particular goods would be minimized. Goods whose price continuously declined, in the tech sector, would have an artificially large impact on the indices.

Then following the report of a commission headed by Michael Boskin and with the enthusiastic support of Fed chairman Alan Greenspan, the Bureau of Labor Statistics introduced the concept of “hedonic pricing,” under which quality improvements would supposedly be taken into account in calculating price statistics. In its application, there were two major flaws in hedonic pricing. First, the Moore’s Law doubling of computer processing power every two years was taken as a linear improvement in quality, whereas in practice each doubling in processor power produces nothing like a doubling in functionality. Indeed the Law of Diminishing Marginal Returns set in many years ago with respect to processing power, so that the improvements produced with recent doublings of processor power have been derisory. Nevertheless, combined with geometric pricing this change has produced a marked downward bias on the CPI, reflecting no decrease in costs paid by any consumers in the real world. Second, equally perniciously, the hedonic pricing system takes no account of extra costs imposed on consumers by such Satanic innovations as automated telephone answering systems, robocalls and spam – in other words the hedonic pricing system is dishonestly used only in one direction.

In the last couple of years, the two effects of housing distortion and hedonic pricing have approximately cancelled out in the United States. In 2006-09, the US inflation rate was truly low, as the grossly distorted housing market collapsed, restoring consumer purchasing power in the housing sector. Since the housing market stabilized in early 2009, the inflation rate has once again been understated, and Fed policy has been correspondingly too loose. In general, in a reasonably free housing market (albeit with excessive and growing subsidies) like the United States the housing price distortion should be nearly neutral over the long run, while the hedonic adjustment will consistently cause inflation to be understated..

In Britain, the government in 2003 made a change in Britain’s price statistics similar to that of the 1980 US change – Britain has not yet experimented with the joys of hedonic pricing. In times of rising house prices – endemic in Britain with its land shortage, overpopulation and socialist planning system – the post-2003 Consumer Price Index understates true inflation substantially. In the latest month of June 2010 the CPI was 3.2% up over the past year, whereas the old Retail Price Index was up 5.0%.

The statistics-fiddling becomes more serious when real contracts involving real money are based on the figures. British index-linked gilts, instituted in 1981, are based on the Retail Price Index, so provide a true protection against inflation. Conversely, US Treasury Inflation Protected Securities, instituted in 1997, are indexed only to the hedonically adjusted CPI, so trail true inflation by some unknown but significant amount. In 2008, before the market collapsed TIPS yielded about 0.8%-1% more than index-linked gilts, indicating that the market estimate of the US fiddle was about 0.80%-1% per year. To me, given both the housing and hedonic fiddles, that looks like a market underestimate of the true distortion. The website Shadow Government Statistics www.shadowstats.com suggests the true distortion is as high as 6-7%. That appears to me to involve some double-counting but I’d be surprised if the distortion averaged less than 2.5-3%.

Since the market collapse, both index-linked gilts and TIPS have benefited from the “flight to quality” in different degrees, so the differential between their yields has fluctuated. Now the British wish not only to link pension contracts to the CPI rather than the RPI (ripping off pensioners by denying them the benefits to which they are contractually entitled) but also to issue index-linked gilts based on the CPI, thus providing two securities trading simultaneously, a truly indexed one and a falsely indexed one.

Meanwhile in the United States, social security payments are already linked to the CPI, so they already swindle social security holders by the amount of “hedonic pricing” plus any shortfall in housing inflation. However in this case no contract is being violated, only a government promise — notoriously unreliable at the best of times.

Even more dangerous than statistical fiddling to make their budgets balance or eliminate actuarial deficits is the effect of fiddled statistics on monetary and fiscal policy. Alan Greenspan’s enthusiastic support for the gross distortions of US inflation statistics in the 1990s appears to have been predicated on the idea that he could avoid the high inflation and painful monetary remedies of the 1970s and 1980s by the simple expedient of making sure that the consumer price index figures never reported high inflation, whatever the reality.

Ben Bernanke has continued and even intensified this approach, also making sure that monetary economists were also unable to criticize his policy through the simple expedient of ceasing to report broad M3 money supply in February 2006. M3 is acknowledged by the European Central Bank, the Bank of England and most other authorities to be the best measure of monetary sloppiness, and has increased about 40% more rapidly than money GDP in the period since 1995. Thus its abolition has given the Fed even more undesirable policy flexibility than it already had.

Fiscally, we saw in Britain the attempt to push long term borrowings off the government balance sheet through the private finance initiative. In the United States the entire Fannie Mae and Freddie Mac saga has been a consistent and very expensive attempt by government to avoid owning up to its policy misdeeds. Budget hawks are wrong when they claim US Federal obligations to be some figure such as $75 trillion, five times GDP, because that figure includes 75 years’ inflation in medical costs without consideration of the longevity effect that those medical advances would bring. However the budgetary shenanigans of the Bush and Obama administrations, together with their stooges in the Fed, have truly eaten the seedcorn from future generations. The polite fiction by which social security payments were invested in phantom Treasury bonds and the net surplus counted against the budget deficit has reached its sell-by date in 2010, seven years earlier than expected, as the social security trust fund swung into deficit.

There were signs at its formation that the British Coalition government would put an end to the self-delusions of fiddled statistics, and run the public sector on the basis of straightforwardness and honesty. However the change in the pension indexation is a very bad sign indeed; it suggests that within two months of taking office, the feeble fiscal integrity of the Coalition has broken, and that shenanigans similar to those of New Labour and the Clinton, Bush and Obama administrations will now continue in full force. In the United States, no relief from deception is in sight; there would need to be a complete turnover in all three economic branches of government, Congress, the Administration and the Fed, before such relief could be imagined, let alone implemented.

Needless to say, policies of self-deception are in the end very painful, albeit more for the populace as a whole than the mandarins who implement them. Once need only look at Argentina, among the world’s richest countries in 1910, in 2010 a serial bankrupt with an impoverished populace reduced to mortgaging its future to China in order to repair its decrepit railroad network, to see the damage that can eventually occur.

No short-term relief can be expected in the United States, but one can at least hope that in Britain the government realizes the mistake it is making and reverses its attempt to subvert the economy through mis-measurement. Economies cannot be successfully managed through such deception and illusion; in the end it is necessary to deal with objective reality.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)