Photographer: Susana Gonzalez

The U.S. twenty-dollar bill: A widely accepted tool for everyday transactions.

Last month, I wrote a post titled “Sorry, Bitcoin Isn’t a ‘Currency’” pointing out that whatever the merits of Bitcoin as an investment, its use as an actual currency useful for buying and selling was minimal. I wrote it thinking that I was largely reminding folks of an obvious point. Apparently not. The post elicited more than 200 comments. Maybe there were two or three people who agreed with me in there; I might have missed them.

By and large, the comments insisted that actually there were plenty of people doing real business using Bitcoins. They pointed me toward retailers like Bitcoinstore.com, a retailer of electronics and other goods that did more than $500,000 of business in March. So far this month, Bitcoinstore, according to its website, has sold $142,250 worth of products. Good for them: hats off to anyone willing to experiment with new business models.

What really matters though is that it’s a tiny fraction even of the $42.7 million in Bitcoin trades conducted in just the last 24 hours at the biggest Bitcoin exchange. There are folks who make purchases with Bitcoin (one commenter claims he now buys all his pizza with bitcoin; yes, it can be done, but it’s faster and cheaper to call Domino’s directly). In the main, though, the folks making purchases with Bitcoin seem to be those using it as an investment.

Listen to Tony Gallippi, the chief executive and co-founder of BitPay, a Bitcoin payment processor. Bitpay last month processed $5.2 million worth of Bitcoin purchases. He contacted me, through his PR folks, after my earlier post and kindly volunteered to walk me through the Bitcoin transaction process. Merchants who use Bitpay generally set prices in dollars or euros. Bitpay then converts that to a price in Bitcoins.

One striking part of this process: Gallippi’s company guarantees a dollar or euro to Bitcoin conversion rate … for 15 minutes. Yes, 15 minutes. That’s what pricing is like when you’re talking about a currency that fluctuates in value the way that Bitcoin does. If you want to know what you can buy tomorrow for the Bitcoins you have stored today, forget about it. Your two Bitcoins might be enough to buy a cheap laptop today, and maybe a powerful computer next week … or maybe just a box of cookies.

Gallippi himself came to Bitcoin as an investor. He saw the value of Bitcoins rise when it first made the news and fall back down again. Says Gallippi: “You had guys like Chuck Schumer going on national TV saying, ‘You can buy drugs with this.’ All that did was drive up the price.” Like many Bitcoin investors, Gallippi himself is now spending some of his Bitcoins, which he got at prices were as low as two dollars. Gallippi calls that a “wealth effect,” in which investors who got Bitcoins at five or ten dollars are now toting up some of their gains. Gallippi thinks that “not a single one” of those is ready to sell all his investment.

Source: Mt. Gox.

In 24 hours, the value of a single Bitcoin on the biggest exchange, Mt. Gox, has gone as high as $266 and as low as $105.

And that’s precisely the problem. Gallippi points out a few uses in which Bitcoin fills a void, like secure international transactions from countries like Indonesia from which merchants are unwilling to take credit cards because of fraud. We can grant that. Is that likely the main clientele for Bitcoinstore.com? I seriously doubt it. I think Gallippi had it right with the wealth effect and the investors cashing in a bit of their winnings. Gallippi’s biggest client? An outfit that takes Bitcoins in payment for precious metals.

It makes sense that one of the few ways folks actually spend their Bitcoins is exchanging them for gold, another investment. In the short term the value of Bitcoins isn’t driven in any way by the actual use of Bitcoin in trade. It’s driven by speculators who see it as an investment that’s going to rise in value. The main interest in Bitcoin comes from people holding a lot of them as an investment–which, come to think, might explain why they’re so loud in insisting on Bitcoin’s many uses.

After the last few hours of Bitcoin trading, it’s hard to imagine that anyone can really imagine that the Bitcoin market is driven in any way by long-term demand for an anonymous currency. The last few hours provide an excellent demonstration that what we’re seeing here is entirely a speculative mania. Yesterday, when I started writing this post, the value of a Bitcoin spiked up as high as $266. Then it fell as as low as $105, and as of this writing trades at about $151. Mt. Gox, the biggest Bitcoin exchange couldn’t keep up with the demand–or, worse, with the selling.

If you bought Bitcoins a month ago, you’ve done very well. If you bought in yesterday it hasn’t been a very nice ride. The Mt. Gox press release explains the sudden drop as a combination of panic and technology problems. People, the release says, “started to panic, started to sell Bitcoin in mass (Panic Sale) resulting in an increase of trade that ultimately froze the trade engine!” Does that sound like a currency you’re eager to switch to for their everyday business dealings?

Photographer: Stephen Hilger/Bloomberg News.

Unlike Bitcoins, real currency can be used to buy stuff.

The most recent permutation of the euro crisis seems to have enlivened a renewed interest in Bitcoin, the artificial “currency.” Since Monday, the value of a single Bitcoin has shot up to $72.50, a gain of more than 50 percent.  Businessweek‘s Bernhard Warner reports on the surge in Bitcoin interest as Europeans wonder if their money is safe in the wake of the Cyprus deposit tax fiasco.

One place where it’s not safe is in Bitcoin. Bitcoin is generally referred to as a “digital currency” or “virtual currency,” a form of cash that doesn’t need government backing. Unfortunately  it’s missing the most essential aspect of money: it’s not useful for buying anything. Bitcoin’s rise as a tool for financial speculation underlines the failure of the virtual currency idea.

The original pitch for Bitcoin was that it could be used for real-world transactions. In practice, it seems to have seen minimal use outside of the tiny Silk Road marketplace, largely devoted to illegal drugs. In the last two months, the value of Bitcoins has more than tripled (see the chart below). If you like you can download all the encryption software needed to access Silk Road to your computer and try to figure out if that’s the result of some new flood of activity.

I won’t bother, because I’m pretty sure that by far the main use of Bitcoins is trading them back and forth and converting them into dollars or euros. If you have done that recently, congratulations, you may have made a lot of money. Keep doing it and you could get richer still (take note, withdrawing your money is not an instant process) — or you may lose a lot of money in the future. You might go to the daily data at Bitcoincharts.com, look at the five day chart and see how prices have spiked on just a few high-volume trades.

That times of economic turmoil lead to a surge of gambling and cons and shoot-the-moon investments isn’t a surprise; think of Eastern Europe in the 1990s. That some of those, like Bitcoin, spiral upward isn’t evidence that we should dump our current monetary systems. On the contrary, it’s evidence of how hard it is to make a real currency work.

Photographer: Chris Ratcliffe/Bloomberg

Cyprus in April, 2012. Looks like everyone’s already left to line up at the ATM.

Update: Boom! With 36 votes against, the Cypriot legislature nixed the deposit tax. Let’s see if the alternative is any kinder to ordinary Cypriots. And if foreigners take out their cash anyway when banks reopen.

Every nation, no matter how small, eventually gets a minute in the spotlight. Usually it’s not for good news. So it with Cyprus, where the plan to pay for a bailout by taxing bank deposits has elicited outrage among everyone from Cypriot citizens to Vladimir Putin to kibitzers who could barely find Cyprus on a map.

The photos of long lines at empty ATMs haven’t been great PR for the government of Cyprus or for European policy-makers. Nothing says Coming Depression as crisply as a bank run. The early consensus is that taxing bank deposits shakes the very core of the financial system.

Economist Tyler Cowen says this could go down as a blunder of historic proportions. At Reuters, Felix Salmon notes that the vow that your bank deposits are safe is one of a government’s most important promises. “Botched and improvised,” is how one expert characterized the plan to Bloomberg’s James G. Neuger. The only people who don’t seem to hate the plan are those who are just left speechless. The New York Times’s Paul Krugman confesses he didn’t see it coming — a moment for the record books.

This wasn’t a well-thought-out plan. Nonetheless, it’s worth considering whether what Cyprus is doing is worse than what other governments have done in similar circumstances. There’s a case to be made that (a) for most Cypriots it beats the alternatives and (b) a devastating run on the banks as soon as they reopen isn’t the sure thing many commentators assume.

Ultimately, taxing bank deposits (or, as Caroline Baum at Bloomberg View says, “confiscating” them) has many of the same effects as a currency devaluation. Whether the devaluation happens overnight, as it did in Argentina in 2002, or over an extended period of inflation, the ultimate hit to savers of all kinds is the same as a tax on deposits.

Devaluation has always been the final, and often not-so-final, resort of governments unable to pay their debts. In the euro zone, it’s no longer an option. But a deposit tax punishes savers just as a devaluation would. By taking money out of the economy, it makes Cypriots relatively poorer, and less able to afford goods from abroad, (eventually pushing the balance of payments in favor of domestic industry: the upside of devaluation).

These are the same effects as Cyprus would face if it left the euro zone — except that would be a much, much bigger and more sudden shock. Citigroup estimated last year that Greece would face the equivalent of a 60 percent currency devaluation if it got kicked out of the zone. You can assume that the consequences for Cyprus would be similar. By that standard, the deposit levies that Cyprus is considering — whether 9.9 percent or 6.75 percent — are a bargain.

So why the outrage? I would venture to say that the real difference between the bank levy and other solutions is that the levy is transparent and obvious, while the wealth effects of devaluation or inflation are hidden.

That would seem to be an argument for the levy, except that optics do matter in these cases, and, as Cowen notes, there seems to be great resistance to a transparent wealth tax. It’s possible that cutting the rate on smaller deposits, something that Cyprus is already contemplating, could remedy that.

That finally brings us to point (b): An immediate general run on the banks isn’t the certainty the empty ATMs might suggest. Of the 40.1 billion euros in deposits at Cyprus’s banks, 8.8 billion euros — about 21 percent — are immediately redeemable. If you look only at the 30 billion euros in household (ie. non-business) accounts, the share is even lower. The rest is tied up in time deposits of up to two years.

That means that if Cyprus goes through with the tax on deposits, there’s plenty of opportunity to cool off before every penny gets pulled out of the banks. Yes, foreign depositors, including the oft-mentioned Russian oligarchs, will pull out their money. But with the shakiness of the Cypriot financial system, you can bet that was going to happen anyway.

Given the choice of a tax on wealth or half-baked European austerity measures to achieve raise the same 5.8 billion euros, TMN would be inclined to go with the deposit tax. At Marginal Revolution, Tyler Cowen says the tax reflects the deeply anti-democratic impulses of European policy-makers. It doesn’t take a Machiavellian command of politics to see that taxing bank deposits isn’t an easy sell to voters anywhere. Fair enough.

But at least with a bank deposit tax, Cypriots get to see exactly what money is getting taken from them and where it’s going. That’s more than can be said for most other austerity plans.

Update, March 19: The bank levy now looks like it won’t pass the Cypriot legislature, even with the sweetener of exempting deposits under 20,000 euros. That would mean no deposit tax revenue — while very likely still leaving plenty of foreign depositors jittery enough to withdraw their money at the first opportunity. It seems to me that means much of the pain, and none of the benefit. That’s happening just as a few commentators seem to be turning around on the plan. Andrew Ross Sorkin at the New York Times also defends it, and points out that despite dire predictions, there’s certainly no Europe-wide bank run. That said, if you want to recap all the mistakes that policy makers have made in the last days getting to this point, and all the ways this makes Cypriots feel their national policy has been hijacked by Germany, make sure to read James G. Neuger’s masterful story about the negotiations.

Photographer: Price Chambers/Bloomberg

Mountain ranges like the Grand Tetons took millennia to grow to their present size. Wall Street bonuses? More like 25 years.

New York State yesterday released its annual report on Wall Street pay, reporting that the average New York City securities industry bonus went up eight percent last year, to $121,890. Surprised? Didn’t think so. That Wall Street bonuses went up is roughly as unexpected as an airplane getting delayed at O’Hare: it doesn’t happen every time, but you can usually bet on it.

That climb has made Wall Street bonuses the focus of the current debate about inequality. The $121,890 average includes bonuses for everyone from secretaries to traders and senior executives. For those last categories alone, the numbers would be much, much higher. I’ve taken the New York State Comptroller’s report, which lists bonuses all the way back to 1985, and adjusted the numbers to 2012 dollars, to account for inflation.

The result: Since 1985 the average securities industry bonus in the city has risen about four-fold. There’s a big jump from 1990 to 1991, when bonuses went from about $27,000 in real-dollar terms to $52,000, and a series of further increases from there. Bankers and traders in a bad year now earn much more than they did in a good one. You can see the chart to the right.

So what accounts for the rise in Wall Street pay? Defenders of the compensation status quo tend to point to increased productivity. Foes ask, reasonably, what the heck folks on Wall Street do that makes them worth so much more. There’s some data in the report that goes a long way toward explaining the increase — though probably not nearly as far in justifying it.

The next chart uses the numbers from the state report and the Securities Industry and Financial Markets Association to compare the total inflation-adjusted bonus pool for New York City to the number of industry workers in New York. You’ll see right away that the second part just doesn’t change much. In 1985, the industry had about 130,000 employees in New York. Last year, that number was 169,200 (fewer than in 1997, and barely more than the 163,000 workers in 1987).

Meanwhile, the bonus pool has risen in real-dollar terms from $4.1 billion to $20.1 billion. The industry and its profits have grown with the economy, which has roughly doubled in size since 1987 (and financial services has grown more). The number of highly-paid New York-based employees has not.

The economists Robert H. Frank and Philip J. Cook anticipated this kind of trend in their book “The Winner Take All Society.” For a long time, I resisted the idea that the economy had changed in ways that brought the big rewards to the top of the pyramid. For one thing, I thought, every superstar, whether in banking or movies, creates work for many other folks. In addition, I assumed that if fewer highly skilled employees were needed to do the same job, then supply and demand should dictate that those employees would earn less.

The New York City data, though, are compelling. University of Chicago economists Steven N. Kaplan and Joshua Rauh have theorized that the main reason for the rise in Wall Street pay is that “asset managers, investment bankers, lawyers, and top executives now apply their talent to much larger pools of assets.” The bonus charts support that explanation.

You can argue about whether there’s something special about those folks, or whether they’ve just gotten lucky. You can’t argue with the math, which shows unequivocally that income at the top is growing because essentially the same number of people are splitting greater profits.

Next week I expect I’ll take a more careful look at this, moving beyond New York City. There are other factors to consider, like the drop in the city’s share of industry employment from about 30 percent in 1992 to 21 percent now. Nonetheless, I suspect the general principle that the jobs at the top of the economic ladder are becoming ever more lucrative as their industries scale up without adding staff will hold up. If so, that reveals some truths uncomfortable for both sides in the debate over incomes at the top. For the harshest critics of Wall Street. the fewer employees/more profits explanation isn’t exactly the cloak-and-dagger conspiracy they might wish for.

On the other hand, for those who think that all is just hunky-dory on the inequality front, this isn’t exactly a pleasing result either. Fewer people sharing more profits means Wall Street employees may be more “productive” — but not in any way that non-economists understand that word. It’s not that they work harder or have somehow gotten vastly smarter. It’s just that it doesn’t take many more people to do a $300 million deal than a $50 million. That basic fact does a lot to explain why incomes on Wall Street have grown. It doesn’t do anything to make it seem fair.

Photograph by Christian Heeb/laif/Redux

The San Remo apartment building, on New York’s Upper West Side.

The most expensive apartment in the twin towered Art Deco masterpiece looking out over Central Park, the San Remo, rented for $900 a month. The tenant was a stockbroker named Meno Henschel who, according to what he told the Census Bureau, lived in his apartment together with his wife, a cook and two maids. Henschel had one of only two apartments that rented for more than $600. Another, with room for a family of five, plus the requisite cook, butler and maid, rented for $540.

The year was 1940, and that $540 is what would now generally be referred to as about $8,850 in today’s dollars. Except it’s  almost impossible to find an apartment like that to rent today. Like most  of the great prewar luxury Manhattan buildings, the San Remo has long since been converted into a co-op, owned by the residents.

Very rarely an apartment there will come up for a short-term rental. There is one listed now. The asking price is $29,750 a month.

At first glance, this may strike you as the kind of problem that rich people file under “even richer people’s problems.” So the price of Central Park views has gone up? Feh, probably you can find yourself another park to look at. You might assume that the price of living in one of New York’s most expensive buildings tells us nothing of value to most Americans, who (a) don’t live in New York, (b) don’t live in rentals, and (c) couldn’t come close to affording that kind of price.

In fact, it tells us a lot. Extraordinary as a rent of $29,750 a month may seem, the rise in the price of a rental at the San Remo is not exceptional. You can find similar or even bigger increases at every level of the market, down to the most ordinary middle-class apartments. Looking closely at rents at the San Remo and other places in New York opens up questions about whether we’re measuring inflation accurately. And those questions, in turn, have big implications for how we understand the cost of living and quality of life—not only of those who live in the San Remo, but of the middle class.

Nationally, according to U.S. inflation data, since 1940 rents have risen 1,014 percent, so they have gone up about 11-fold. For the New York area alone, the increase is a little higher, 1,250 percent. Though those are big numbers, they’re actually lower than the overall 1,536 percent rise in prices reported by the Bureau of Labor Statistics, the agency that gauges inflation.

Most New Yorkers, however, would guess that the price of housing has risen much faster. Diving deep into old records bears that out. The 1940 census found the median rent in New York City to be $38.10. In 2011, that was $1,100. That’s an increase of 2,787 percent—close to twice the rate of inflation. And when you start comparing specific apartments, delving into the newly released 1940 census forms in which I found how much Meno Henschel paid for his apartment, the differences are even starker.

At the San Remo the price increase is greater than 50 times. It’s a good example, because the San Remo is one of very few buildings not to have changed in character over 70 years. It was, as Dennis Hughes, the real estate agent handling the listing puts it, an “iconic” building then, and it remains so now. It’s a time capsule of luxury living. But that kind of increase hasn’t happened just at the top. You can see the same pattern in much more modest places.

One is the one-bedroom apartment I lived in from 2004 through 2009 in Williamsburg, Brooklyn. Back in 1940, as I found from the handwritten (and recently digitized) census forms, most of the tenants were Italian. Several were truck drivers; it’s not hard to imagine that one settled there and his friends followed. The rent was $18 to $24 a month. The upper end of that is $369 in current dollars. When I moved in late in 2004, the real estate broker cautioned me that it “wasn’t a luxury building.” Indeed, it wasn’t, as the broken front door lock suggested and the heat inspectors could confirm, but the rent was $1,500 a month, and later it rose to $1,615.

So what’s happening here? Most conventional stories of inflation hold that the consumer price index tends to overestimate how much prices rise. For a long time, the index, the government’s main inflation yardstick, didn’t adjust for changes in quality, and many economists believe that it still doesn’t do it enough.

With rent, it’s a different story. Rent is a particularly important piece of the consumer price index. The government uses data on rents not only to estimate inflation for those who actually rent their homes, but also to separate out the investment value of homes and derive a measure of how much homeowners pay to keep a roof over their heads. Together, “rent” and “owner’s equivalent rent” make up about 30 percent of the inflation measure.

Changes in rent, though, are not easy to measure. Rents tend to rise slowly over time, and a lot of what makes a home desirable changes, too—think “location, location, location.” Those difficuties have led to some awkward results. Mike Shedlock, a well-regarded blogger who looks at economic trends, has tracked how the rents the government measured barely budged during the housing boom and rose afterwards even as real estate agents wrung their hands over falling prices.

Perceptive recent work on rent comes from three economists who worked together at the Philadelphia Federal Reserve, Theodore Crone, Leonard Nakamura, and Richard Voith (Nakamura is a vice president of the Philadelphia Fed). Their research makes a good starting point for figuring out the rent puzzle.

The most important insight in their work is that for decades the inflation measures skipped over the cases in which a tenant moves out. Think about that for a second: A landlord avoids raising the rent for a decade for a good tenant, then when the tenant moves, ups the rent to a market rate. Or, as is common in New York, rent regulations keep rent from rising until a tenant moves out. Those are precisely the units in which the rent is most likely to rise, and for some four decades they weren’t counted in inflation.

Crone, Nakamura and Voith estimate that this and other problems bring down the government’s measure of rent increases by about 1.4 percent a year for the whole period that runs from 1942 to 1985. Nakamura outlines these findings in a very readable paper published by the Philadelphia Fed. Over such a long period, 1.4 percent into a really big number. Add that in, and instead of falling 20 percent in real-dollar terms over six decades, rents rise 50 percent.

Think about what that means for the middle class. Since 1970, the average hourly earnings of American workers (excluding managers) have stayed almost exactly flat by the official inflation measure. If, however, the cost of housing has risen faster than those measures say, then that means that many folks are actually worse off than they were then. You can see how that matters, and not just to the people in the San Remo with Central Park views.

Source: Google Street View

The building in Brooklyn I lived in from 2004 to 2009. Not exactly a model of luxury.

The reason I started with the San Remo wasn’t just to get you to marvel at how much a fancy apartment in New York costs these days. OK, that was part of it; it’s not an accident that Robin Leach’s show wasn’t called “Lifestyles of the Average to Upper Middle Class.” The other reason for focusing on the San Remo, though, is that in most buildings and neighborhoods, so much changes that it’s hard to compare prices over extremely long periods of time.

Often when you read stories about the economy they’ll translate a price from decades ago into “today’s dollars.” By that measure, the $540 that a San Remo apartment rented for in 1940 is $8,856 in today’s dollars. Except that it’s clearly not: If you’re talking about rent, it’s $29,750 in today’s dollars. We know that because that’s what a San Remo apartment rents for today.

If we work off that $540 price for a San Remo apartment (one of the more expensive ones then; many rented for less than $400), that’s an increase of 5,409 percent.

Notably, that number is a lot higher the calculations of Leonard Nakamura and his collaborators. By their measure, rents from 1940 to 2000 increased about 15-fold. That would make the increase in rent higher than the overall inflation rate—but still well below the change in median New York City rents. Even with this effort to fix the data, we still don’t get close to the kind of inflation you see for many New York apartments, those long turquoise and magenta lines at the bottom of the chart.

So what else is at play here? We just don’t know. It’s tempting to explain the San Remo by looking at the rise in income at the top. That’s the market for four bedroom apartments with park views. Strangely, however, the change in the price of a fancy Manhattan apartment is actually lower than the 67-fold increase in the price of the underheated Brooklyn walkup I lived in for five years.

It’s difficult to judge the degree to which that Brooklyn apartment—unlike the four-bedroom in the San Remo—is “the same” as it  was in 1940. The heat may have worked more reliably then, and the building had not yet been blessed with its current asbestos-shingled facade. On the other hand, it wasn’t within throwing distance of about half a million trendy restaurants, as it is now. How do you calculate the value of those kinds of changes and plug them into the inflation model?

“The main thing we cannot take into account [in measuring inflation],” says Leonard Nakamura, “is how a city changes over time.” That’s certainly part of the rent puzzle. In the post-war years there has been a major national transition from renting to home ownership. In New York, as in many parts of the country, many of the most desirable properties in most desirable neighborhoods can no longer be rented at all. This is essentially the case with the San Remo. As the San Remo and buildings like it turned owner-occupied, they’ve dropped out of the inflation measure.

That may have pushed down measured rent in New York and many other places as well. As the upper and middle class have moved to home ownership over the last decades, it’s possible that the the homes and neighborhoods that have stayed rentals are the ones that have been less desirable in hard-to-measure ways. That might help explain the enormous divergence between New York rents and the inflation yardstick, but it’s hard to test without a much deeper dive into real estate records.

1940 census forms from tenants at the San Remo. You can see Meno Henschel’s $900 rent at the left, the highest at the time.

Complaining about inflation can seem like an old person’s diversion; yes, at some point a steak dinner did cost three bucks and penny candy was a penny. So what?

With rent, however, the intuition that prices have risen faster than the inflation data appears very robust not only to laypeople, but to professional economists as well. Robert Gordon is an economist known for his pioneering work on how we’ve overstated inflation in durable goods, such as cars, which have improved over time. He suspects that housing may be different. As Gordon writes in an e-mail, ”the low prices my parents paid in the 1950s for a lot, a house, my Harvard education … seem unbelievably cheap by today’s standards.”

If rent has indeed risen more than the usual inflation measures indicate, it would help explain why many families have the sense that they are working ever harder to afford to live in what they think of as a nice neighborhood. More generally, understanding what’s happened to the price of shelter is key to the current debate on inequality and how we answer the question that gets asked (rightly) in every election year: “Are we better off?”

The other takeway from New York rents is that when you think about inflation, you may consider asking “inflation in what?” and “inflation for whom?” We are so used to talking about the headline inflation number that comes out each month that we tend to forget it includes changes in literally thousands of prices. The increase in rent at the San Remo is not the same as the increase at a new college grad’s shared apartment across the river in Brooklyn, or at a public housing complex in the Rockaways—or in a different city. Nor is it the same as the change in the price of steak or childrens’ clothes.

And because inflation isn’t the same for different items in the consumer basket, it’s not the same for different people, either. It may, for instance, be higher for the wealthy, who are competing for the same few ultraluxury properties. It may be lower for older people, who don’t worry about moving. And it may be higher for those who have to move often. Measuring inflation accurately is a hard problem, and over the years economists both inside and outside the government have made great efforts (and strides) to get it right. The evidence of New York is that we’re not there yet.

Already the national discussion has turned from talking about inflation in general to focusing on specifics, like the costs of education and health care. It may be time to start cutting up the data in even more granular ways to get more specific answer to those questions of “inflation in what?” and “for whom?” That may pose some questions for government policies. In return, it’s likely to offer up some answers to why we live the way we do up and down the economic ladder.

Photograph by American Stock/Getty Images

Deflation isn’t always accompanied by Depression-style soup lines.

“Deflationary spirals” have been a major subject on the economics agenda since the financial crisis hit. While the theory here is clear — falling prices lead consumers and businesses to hoard cash — there are few actual examples of deflation to study. The Great Depression in the United States is one, and the current long period of slow deflation in Japan is another.

In a surprising article, Bloomberg’s Toru Fujioka reports on the response of Japanese consumers and businesses to deflation, finding a startling face: many of them like it. The elderly benefit from savings and pensions that go further. And while deflation may harm the young by keeping wages stagnant in the long term, it’s also the only de facto wage increase they’ll see with businesses unwilling to raise salaries. Economist Tyler Cowen notes that though the Japanese economy has been stagnant, the unemployment rate is still 4.1 percent, a number that other countries must find enviable.

Over the past decade, Japan has seen the consumer price index for most periods hover just below the zero-percent inflation line (chart’s above). The notable exceptions were in 2008, when inflation rose as high as 2 percent, and late 2009, when prices fell at close to a 2 percent rate. The rise in inflation coincided a crash in capital spending. The worst period of deflation preceded an upturn.

This isn’t enough data to infer causal effects. It does seem, though, that the relationship between growth and Japan’s mild deflation may be more complicated than the Great Depression-inspired deflationary spiral narrative suggests.

A version of this post appeared in the Market Now newsletter. Click here to register at Bloomberg.com and subscribe to The Market Now daily email.

Last week a startling number ricocheted around the web, from CNN to the New York Times Economix blog: More than 60 percent of cigarettes smoked in New York State, which has the highest tobacco taxes in the nation, are “smuggled” in from out of state and consumed tax free. The smuggling number originates with an an anti-tax-leaning think tank in Michigan, the Mackinac Center. If that number is right, it would give pause to advocates of cigarette taxes.

Figuring out just how much cigarette taxes lead to tax evasion, though, is harder than the initial reports make it sound. It’s clear that higher taxes — New York raised its excise tax from $2.75 a pack to $4.35 in 2010 — cut cigarette sales. The difficulty with this, as with other sin taxes, is in understanding how much of the decline in sales comes from tax evasion and how much from changes in behavior.

Similar questions come up in almost all tax discussions, and they’ll be high on the political agenda. Think about the debate over “carried interest.” Will higher taxes make hedge funds pay more, or just send them overseas? The answers to such questions tend to line up along party lines.

The analysis that drove the new findings comes from Michael D. LaFaive and Todd Nesbit of the Mackinac Center, who have looked at cigarette smuggling in several reports over the years, the first issued in 2008. Nesbit, a senior lecturer in economics at Ohio State University, developed a model that analyzes the flow of tobacco sales from high-tax to low-tax states. In the Mackinac Center’s previous study, based on 2009 data, Nesbit calculated the share of untaxed cigarettes smoked in New York at 47.5 percent.

Now that’s gone up to 61 percent, the headline number for “smuggled” cigarettes (for the Mackinac Center that includes not just commercial smuggling, but bringing cartons or packs in from out of state). What happened in the interim was a big New York State tax increase. LaFaive and Nesbit argue that the “harsh and unintended consequence” of tax increases is to create a black market for untaxed tobacco.

Delve more deeply, though, and you’ll see that the story is more complicated. Because New York raised its taxes on July 1, 2010, you can get some really interesting information by looking at cigarette tax revenue from 2009 and 2011. From the publicly available New York State tax data you find:

Jan – Dec 2009 tobacco tax revenue: $1.37 billion
Jan – Dec 2011 tobacco tax revenue: $1.65 billion

The tax on each pack of cigarettes went up from $2.75 a pack to $4.35, an increase of 58 percent. Tax revenue, though, went up much less, only 20 percent. So with a bit of arithmetic:

Change in taxed packs sold: -24 percent

What accounts for the drop in legal cigarette sales? Nesbit argues that the overwhelming majority of the decrease came from untaxed smoking. “When you raise taxes to a prohibitive level,” Nesbit told me in a phone conversation, “it doesn’t really prohibit consumption. It prohibits legal purchases.”

The difficulty comes in how Nesbit’s model accounts for the possibility that the drop in sales came from smokers cutting down. In a word, it doesn’t. As Nesbit explained, according to data from the federal government, overall smoking rates in New York actually rose very slightly, from 18 percent to 18.1 percent, from 2009 to 2011.

But what about folks who kept on smoking cigarettes, just fewer of them? Nesbit told me that his model does take into account a steady decline in what he calls “smoking intensity,” the number of cigarettes a smoker lights up in a year. The big caveat here is that it  assumes a slow decrease over many years; as Nesbit says, it’s hard to find reliable data that would quickly reflect changes in a single state. If there is a sharp drop in a single year — say, from smokers cutting down because prices jumped — the model wouldn’t show it.

When you think about that, you’ll see why it’s not at all surprising that the model would find an increase in smuggling. There’s a 24 percent drop in legal sales and the model attributes essentially all of that to smuggling. It’s not a coincidence that by Nesbit’s calculations the proportion of cigarettes that are not smuggled drops from 52.5 percent to about 39 percent, a drop of about one-quarter that mirrors the drop in legal cigarette sales.

Is that valid? Nesbit says that his model has been good at predicting the effects of taxes on sales. And make no mistake: that taxes cause some shift to smuggling is clear. That has concerned New York’s budget-makers for a long time. Other studies also come to the conclusion that New York’s high cigarette prices drive purchases from out of state (this one finds that close to 7 of the 15 cigarettes the average New York smoker consumes each day come from out of state).

But you can’t really decide how much of the tax effect lies in smuggling and how much in behavioral changes  unless you can reliably measure not just how many people in New York smoke, but how much.

Untangling those kinds of effects is a major concern in every tax debate. Sin taxes are very much on the agenda now, with supporters on both the left and the right advocating taxes that raise revenue while cutting harmful behavior. The problem is that supporters of taxes tend to look at the numbers and see changes in behavior, while opponents see tax evasion and all the consequent downside of pushing folks into a black market.

On that, the Mackinac Center has been pretty breathless, pointing to dangers from counterfeit cigarettes “adulterated with fillers containing anything from sawdust to human excrement.” So it often goes in tax debates. Though they’re chock-full of data, much of it gets marshaled to support partisan interests, and buried under rhetoric.

Bloomberg News/ Laura Segall

A development in Gibert, Arizona, in the Phoenix metro area

Welcome to the Phoenix, Arizona, edition of The Market Now. Two Bloomberg stories in the past two days included powerful on-the-ground reporting in Phoenix. They make for a telling study in contrasts.

Today, Heather Perlberg reports on the Phoenix homeowners emerging from underwater mortgages. Perlberg kicks off the narrative with a homeowner who finally saw prices recover enough that she could sell the house her family had outgrown, pay off the mortgage and upgrade to a larger place. Though prices are still well below their 2006 peak in Phoenix, they’re recovering fast.

Also from Phoenix comes yesterday’s article by Jeff Green and Amanda J. Crawford about the increase in the payroll tax. They pull in tight on a high school teacher whose $60 a month payroll-tax increase means cutting bills by shopping for groceries in the junk-food aisles of the dollar store. Dinners out are out of the question.

The two stories together neatly sum up the mixed economy. Investors and homeowners have benefitted from low interest rates and the Fed’s efforts to jump-start the housing market. Big investors in Phoenix have known that for a while, as this Bloomberg story noted in October. Those improvements in the investment climate haven’t been matched by gains in middle-class income.

The chart above, using Phoenix data from the St. Louis Federal Reserve, gives you some idea of the long-term trend in incomes and home prices. The black line in Phoenix’s per capita income, the red is home prices. You can see just how far home prices outstripped incomes in the boom. There’s room for a recovery, but not to anything like those boom-era levels.

That’s the reason that, as regular readers know, The Market Now has been skeptical of the housing rebound. Low rates will boost housing, and perhaps easier mortgage standards may too as banks turn on the lending spigot. Over the long term, though, home prices will keep rising only if disposable incomes do, too.

A version of this post appears in the Market Now newsletter. Click here to register at Bloomberg.com and subscribe to The Market Now daily email.

Photographer: Angel Navarrete/Bloomberg

Lower bond yields won't placate Europeans angry about unemployment and austerity.

Europe hit an important milestone today as the difference in yield between Italian 10-year bonds and the German bund fell to 250 basis points. In other words, the premium that Italy must pay to borrow money is now just 2.5 percent above the rate paid by the solvent, upstanding Germans, indicating that lenders feel a default from Italy is substantially less likely.

That follows a strong statement yesterday from European Central Bank President Mario Draghi indicating that the credit crisis was ebbing. “We are now back in a normal situation from a financial viewpoint, but we are not at all seeing an early and strong recovery,” Draghi said. As Bloomberg’s Simon Kennedy explains, “policy makers are shifting focus from a financial crisis to an economic growth crisis.”

The “normal situation” is certainly good news. The chart of bond interest rates below, taken from Bloomberg’s Euro Crisis data page. Not long ago that would have been covered in red and yellow.

As for the part about not seeing a recovery, you don’t say. You’ll find all the red that’s disappeared from the bond yield chart in the map of economic contraction below and see just how dire that growth crisis is.

The message coming from the ECB seems to be that the debt crisis has passed and the time for austerity is finally over. It’s not at all evident that this was ever the right approach. As Bloomberg View’s Mark Whitehouse and the Atlantic‘s Derek Thompson point out even the International Monetary Fund, long associated with austerity prescriptions, now thinks it was the wrong one.

The problem with crises is that you can rarely afford to take the time to solve them in sequence — say, debt crisis first, growth crisis next. As you’re working on the first, the second gets worse.

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Photo: Hasbro Inc.'s Monopoly: Here & Now edition. Hunter Public Relations via Bloomberg News.

Game theory sheds light on the fiscal cliff battle.

Markets are way up today on the news of the budget deal, as everyone breathes a sigh of relief that we’ve averted big tax hikes and indiscriminate cuts to federal programs. The bad news: there’s still plenty of opportunity for a budget disaster as Congress takes up the debt ceiling and other issues in the next months.

A great number of pixels have already been spilled, and are yet to be spilled, about the economic and political implications here. Instead of adding to this storm of analysis, it’s easier to focus on an element here that’s relevant to both markets and politics: the interplay of incentives and game theory.

In the House of Representatives the vote on the budget measure was 257-161, with Democrats providing most of the votes to get it passed. House Republicans voted 151-85 against the measure. This outcome–a budget compromise backed by the Republican leadership passing over the objection of most GOP house members–is not one many would have predicted.

From a game theory standpoint, however, it looks like an excellent deal for Republicans. As the New York Times‘ Nate Silver has pointed out, the objectives of the national party on the budget differ from that of many rank-and-file members, who fear attacks from the right. This deal satisfies both constituencies. It lets most House Republicans make a stand for budget cuts without actually producing the cuts (is anyone really eager to cut Medicare reimbursement 27 percent across the board?), or opening the party to accusations of torpedoing the economy.

So despite 151 Republicans voting against the measure, it’s not clear yet whether what we’ve got is an ingenious feint, or a genuine revolt of the rank-and-file against the House Republican leadership. We’ll have an important data point on this soon enough. If John Boehner keeps his job as Speaker of the House in the incoming 113th Congress, which still appears likely, we’ll have an indication that many of those 151 Republicans tacitly support the deal they voted against. If he doesn’t then it’s a sign that there’s a bona fide revolt, and that the next months could be even more rancorous than the last.

PS: Lots of other folks have tried to play out the incentives in the fiscal cliff debate, from academics to the New Yorker‘s John Cassidy. It looks now like what most of the analysis missed was that this wasn’t a two player contest, but one with several parties (the Democratic administration, the national GOP, Tea Party-backed House Republicans) aiming at somewhat different outcomes.

Update, Jan. 3: Boehner was indeed re-elected Speaker–with the votes of 220 out of 233 Republicans in the new House of Representatives. So that’s one question answered, isn’t it?

A version of this post appeared earlier in the Market Now newsletter. Click here to register at Bloomberg.com and subscribe to The Market Now daily email.