Noah Smith doesn’t like my post on including housing in the CPI and provides a really excellent rebuttal (damn him!). That’s not surprising and he’s basically right. Well, at least from his perspective. See, the thing about the CPI that’s annoying is that they try to only include what is viewed as “consumption”. Housing is widely viewed as “investment” so including it in the CPI is kind of like including the price of new IPO’s in the index, which doesn’t make a lot of sense since IPO’s don’t reflect the cost of things that consumers actually consume. But I don’t think housing is the same as an IPO. In fact, I think a house is the thing we consume the most throughout our lives.
But Noah’s critique is broader than that. He says:
“Suppose we did include house prices directly in the CPI. They would still be only a small part of the CPI. Suppose house prices were 10% – a hefty chunk – of the “market basket” that is used to calculate the CPI. And suppose house prices went up by 10% while the rest of the price index remained unchanged. That would increase inflation by only 1 percentage point.
Most of the increase in house prices (9/10 of the increase) would not represent inflation. It would represent a rise in the relative price of houses. It would mean that people are willing to (implicitly) give up a larger quantity of back rubs, iPads, cars, and meatloaf in order to obtain a house. It would not indicate a change in the unit of account. The unit of account would remain relatively constant, changing by only one percent, even as house prices rose very substantially.
So to point to an increase in the price of houses and to call that “asset price inflation” is just as misleading as it would be to point to an increase in beef prices and call that “beef inflation”. There’s only one kind of inflation, and that is inflation itself. You have to add everything in before you can tell me how much inflation there is.”
I have two issues there. First, as I mentioned before, I think Noah is right. From HIS perspective. But what if we consider that housing is not just investment. What if we consider that housing is actually consumption as well as investment (which is the purpose of my Housing Adjusted Price Index)?
If you live in a house, you probably know what I mean by “consuming” your house. You see, homeowners don’t just buy their house and be done with it. Well, at least most of us don’t. Most of us who buy a house end up with a mortgage (otherwise known as a “death contract”) where you pay for the house bit by bit over many years. In other words, you’re actually consuming the house every month of your life so long as you have a mortgage. But more importantly, a house is a depreciating asset. Yes, the land you own underneath the house is likely to appreciate, but the actual physical house itself is falling apart every single day. And that means you need to consume its upkeep. And if you want to keep your house up to date then you need to be constantly buying things that are essentially in-line with the cost of current new production. That’s a real expense. Ever redone your kitchen? Or a bathroom? Or a floor? Or a roof? If you do then you know what I mean. This is a real increase in the cost of living for people who own their home. And the cost of new construction reflects this aggregate increase.
Noah makes a more important point which shows that a price increase in housing is not necessarily inflation because it’s only the price increase of a house relative to other assets or the price basket. That’s fair. But I would argue that housing is an inordinately important asset. Not only does real estate debt account for 75% of all household debt, but homeowners equity also accounts for about 15% of the consumer’s total equity. That’s an important asset. For most of us it is, by far, our most important asset. It’s not a coincidence that this asset was the central component of the recent collapse. It’s really that important. Much more important than “back rubs, iPads, cars, and meatloaf”. So yes, I think it’s appropriate to focus on housing not only as consumption AND investment, but I also think it’s fair to weight housing disproportionately relative to other components of a price basket. Of course, the BLS doesn’t do that. They just consider rent to be consumption so the actual price of a house gets left out and isn’t even reflected in the index. I think that’s a little misleading.
On terminology, well, I don’t know what to say. Assets inflate in price sometimes. We shouldn’t confuse that with inflation, as occurs in a price basket like the CPI, but I think the thing that bothers Noah is that “inflation” is a pejorative term. It implies that something is going up in value and thereby hurting our standard of living. And that’s exactly what happens to a portion of the population when asset prices increase. You see, all securities issued are always held by someone. And that means “someone” doesn’t own the assets. So while some people benefit others are losing in relative terms. That’s why we all hate to see the stock market go up when we’re not involved. We are really falling behind. Your balance sheet is deflating relative to someone else’s (deflating, as in, not going up relative to someone else’s that has improved). But we have embedded this belief in policymakers that asset price appreciation or inflation or whatever you want to call it, is necessarily a good thing. That might be true to some extent, but it could also reflect an underlying deviation between the “haves and the have nots”. After all, we don’t all own houses and stocks so when those assets increase in value it doesn’t necessarily mean the entire US population is better off. It just means that the people wealthy enough to own those assets are better off. Maybe we shouldn’t make that sound bad, but then again, maybe we should? I don’t really have a clear answer for you there.
Still, Noah is right that the price basket wouldn’t rise that much even if house prices boomed. Which they have. And my index is up just 4%. That’s not a huge change from the CPI, but that’s not really the point. The point of the index is to provide an alternative perspective to what the BLS has provided. I’m not providing a black box Shadow Stats alternative that says the government has defrauded us and is manipulating the data. I think I am adjusting the index in a rather rational way to reflect the cost of housing. Maybe some people don’t see it that way. Oh well. Can’t please everyone, right? The BLS certainly knows that’s the truth!
*Update – The BLS does account for some of the costs of home maintenance.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.