The Distress Index
I ran across the “Distress Index” today. It’s put out by the Foundation for Economic Education, an outfit I’ve never heard of before. They even have a nice chart showing how their index has performed over time.
I’m not a fan of indices. (Indices is preferred over indexes. Indexes proper usage is as a verb, its use as a noun being barbaric.) The problem with indices is that you can collect a set of statistics, put them together in a way that suits you, and you can create an index to support just about anything you want to say. The most egregious examples are the indices put out by various groups to identify the “Ten best places in America to live.” Of course, they are all crap. I could create an index that would show that Trona, California, is the best place in America to live.
For those who have never been to Trona, it is a small mining community located on one of the less convenient routes to Death Valley. It is nowhere, hot, dry, ugly, and covered with the white stuff they mine from nearby Searles Lake, a lake which hasn’t had standing water for at least 10,000 years. The white stuff is probably toxic. I figure living there must shorten your life expectancy by decades, but then if you are living in Trona, what’s to live for?
The point is that if you prefer Trona to almost anyplace else, your preferences qualify you as a certifiable nut, or you are a scorpion. Still, I could create an index that would rate it high. That index would have a high positive weighting for temperature and negative weightings for rainfall and population density.
In spite of my aversion to indices, I’m always drawn to them. I’m compelled to see how they are constructed. So, I followed a link to the Distress Index, and I saw how it is constructed. It turns out they have a problem with their index, and I offer my advice for free.
The Distress Index positively weights the Consumer Price Index (CPI), and high is bad here. This is just fine when we are having inflation. High inflation does lead to distress. The problem comes when the CPI is declining, as it is now. The result is that deflation is improving the index. Well, if inflation is bad, and it is, deflation is worse. As currently constructed, the index could report no distress in a highly deflationary environment. This is no good.
The correction is simple. Take the absolute value of the CPI and add it to the other indicators. The current index would then be 60.98, up from the reported 58.38. The index would still be below the high of 63.9 in 1975Q1 but it might help the Foundation for Economic Education people tell the story they are trying to tell.
First of all, thank you for looking at our index.
We did look into using the absolute value of CPI (also PCE and the absolute value of PCE) and the only time the CPI was negative since 1967 has been March 2009 – today. Other than that the graph is identical. We are not trying to say that this economy is the worst since any particular year, nor is there any agenda attached to the number.
Secondly, we take issue with the idea that deflation is worse than inflation. There are two types of deflation. Artificial deflation is when the Fed actively shrinks the money supply. The Fed created artificial deflation in 1929-1932 under the Real Bills Doctrine. This type of deflation is bad. However, the Fed has not been contracting the money supply! Falling prices are necessary for the liquidation of malinvestments to occur. The liquidation of malinvestments are necessary for realigning the capital structure. Without that realignment, then there is no chance for a real recovery.
Thus, we kept CPI in as is. If there is a point in time where the Fed is actively contracting the money supply, then I suppose we’ll have to revisit this issue.
Paul,
Thank you for reading our blog. I’m glad to hear you don’t have an agenda.
I still think you should use the absolute value.
I disagree with you on the idea that the source of deflation matters. Deflation discourages demand and is unequivocally bad, even in small amounts, regardless of cause. I would be a lot more sanguine about our economy right now if the CPI was a positive 1.3 instead of its current negative 1.3.
While I’m at it, I don’t believe the Fed is actively contracting the money supply, but monetary policy is not unambiguously expansionary. The money multiplier began its dramatic decent, and bank loans peaked, last October. It is no coincidence that last October was when the Fed began paying interest on excess reserves.
Scott Sumner presents what I consider the most thorough analysis of Fed policy at his blog. I recommend it:
http://blogsandwikis.bentley.edu/themoneyillusion/
Thank you,
Bill
“Deflation discourages demand and is unequivocally bad, even in small amounts, regardless of cause.”
Well I definitely see this line of thinking pervasive in the actions and justification of current monetary policy. The dreaded deflation must be stopped at all costs.
My one point is.. If you truely believe that.. you better be very right on your regulation and monetary policy to prevent large asset bubbles, especially those financed by the mechanisms that are the lifeblood of credit into the economy. Because if your policy is wrong, you get exactly what we have now, A lot of bad decisions trying desperately to prevent deflation and rewarding inefficient economic behavior.
Central banks are so powerful that they have to be very right (and I would think, very conservative) because the lag between being wrong and realizing it is long and the consequences are great. All it takes is one Greenspan-esque person to throw the whole thing for a loop. Reinterperting and lobbying for the repeal of Glass Steagal, fighting reforms of derivatives before they became the monster they are today, keeping monetary policy too loose for too long, etc.
I am a case in point where asset price inflation discouraged my demand (in particular homes and in some case, equities).When the numbers stop making sense rational people either have the choice to become irrational and join the malinvestment or withdrawing their demand. Prices of homes falling make me more likely to buy not less likely.
I agree, central banks should be careful. I was and continue to be critical of a Fed policy that kept money too easy for too long. Greenspanian (my term for economic policies of responding to all market stress by massive liquidity injections) economics also create the same bad incentives that too big to fail creates.
Dan has suggested that we toot our horn about our criticisms of Fed policy over the past couple of business cycles. We think we got that mostly right. I’ve refrained, because we didn’t get some other things right, and in this business it is a certainty we will be wrong at some point. We’re here to present our point of view. We hope people look at many points of view and make their own decisions.
Bill