Why debates over inflation are pointless
By Scott Sumner
In a recent post I suggested that one could argue that the entire increase in per capita income over the past 50 years was pure inflation (and hence that real GDP per capita didn’t rise at all.) But also that one could equally well argue that there has been no inflation over the past 50 years. The official government figures show real GDP/person rising slightly more than 150% since 1964, whereas the PCE deflator is up about 6-fold.
Some people believe that inflation is a fairly straightforward concept—the average percentage rate of increase in the price of good and services over a specified period of time. Unfortunately, this definition becomes very ambiguous as soon as product quality starts changing, and new products are introduced. The government tries to use “hedonics” to adjust for quality changes, but in truth there is no solid theoretical support for their attempts. It’s all a big mess.
What does it mean to say that product X is 47% higher quality than product Y? Does it make you 47% happier? Perhaps at a moment in time you could compare what people will pay for each product in the marketplace, at least if their sales overlap somewhat. For instance, how much more were people willing to pay for fancy HDTVs, compared to the old boxy sets, while they were still being offered? But this method doesn’t really work, because the early adopters of the new technology tend to be rich, with a much higher willingness to pay than the average person. There’s no shortcut, they really have to figure out how much better something is, and no one has ever defined “better” adequately.
Economists tend to ground everything in utility theory. So one fairly standard approach is to ask how much someone living today would have to earn to achieve the same level of utility as a person making $100,000 back in 1964. The US government seems to think the answer is $600,000. But the actual number could just as well be $100,000 or $1,500,000. It’s not a clearly defined question. Consider the following two ways of thinking about inflation.
1. Here’s one thought experiment. Get a department store catalog from today, and compare it to a catalog from 1964. (I recently saw Don Boudreaux do something similar at a conference.) Almost any millennial would rather shop out of the modern catalog, even with the same nominal amount of money to spend. Of course that’s just goods; there is also services, which have risen much faster in price. OK, so ask a millennial whether they’d rather live today on $100,000/year, or back in 1964 with the same nominal income. Recall the rotary phones and bulky cameras. The cars that rusted out frequently. Cars that you couldn’t count on to start on a cold morning. I recall getting cavities filled in 1964, without Novocaine. Not fun. No internet. Crappy TVs, where you have to constantly move the rabbit ears on top to get a decent picture. Lame black and white sitcoms, with 3 channels to choose from. Shorter life expectancy, even for the affluent. No Thai restaurants, sushi places or Starbucks. It’s steak and potatoes. Now against all that is the fact that someone making $100,000/year in 1964 was pretty rich, so your social standing was much higher than that income today. So it’s a close call, maybe living standards have risen for people making $100,000/year, maybe not. Zero inflation in the past 50 years may not be right, but it’s a reasonable estimate for a millennial, grounded in utility theory. In which period does $100,000 buy more happiness? We don’t know.
2. Now let’s make the exact opposite argument, that all nominal income gains since 1964 have been pure inflation. In this view the government has grossly understated the inflation rate. It’s actually a pretty easy case to make. Start with the fact that surveys seem to suggest that Americans are not significantly happier than in 1964. Then consider that people’s happiness may depend on how well they do relative to expectations, or compared to their neighbor. Utility is a social construct. People are embedded in society, and judge their situation relative to others. The guy with a color TV in 1964 felt on top of the world, ahead of his neighbors. Now that sort of set would be so junky that it would be out at the curb. Someone on welfare could pick it up and take it home for free. But they’d feel miserable, wondering why they had to end up with such a junky TV. So if your income rises at the same rate as the rest of society, you feel neither more nor less happy.
One reason these two thought experiments lead to such radically different conclusions is that we are not holding other things constant in the same way. Do we consider a case where only the individual in question sees a big nominal pay increase? Or where everyone does? It makes a big difference.
The public and media think of the “cost of living” in a much different way from economists and bureaucrats at the BLS. Here’s an article entitled “Basic Costs Squeeze Families” in the WSJ:
Spending on mobile-phone service, meanwhile, has soared, rising nearly 50% since 2007, the year the iPhone came out and data plans became more commonplace.
In Kansas City, Mo., Dawn Miller said her family’s cellphone bill has grown from $35 a month years ago to more than $350 some months today, depending on whether someone in the family blows past their plan’s monthly data limit.
“Because the Verizon bill is so expensive, and because it changes month to month, you have to cut back,” said Ms. Miller, a police dispatcher.
Two months ago, she and her husband postponed an anniversary dinner after their Verizon bill eclipsed $500. “I can’t tell you the last time I went out to a movie,” she said.
Similarly, spending on home Internet service has soared by more than 80%. Last year, it made up about 0.8% of spending for middle income households, up from 0.4% six years earlier. Despite talk of “cord cutting,” spending on cable and satellite television is still up 24% from 2007.
The article suggests that inflation might be higher than official government estimates. But they also define the concept differently, more like the increasing cost of “the way we live now.” But if we use that definition then inflation will always equal the growth rate of nominal income, and real income will never rise. As we earn more, we buy more, and our “cost of living the way we live now” will go up.
In contrast to inflation, NGDP growth is a very useful concept for studying business cycles, financial crises, the deadweight cost of taxation, lender/borrower unfairness after nominal shocks, and lots of other purposes.
PS. I’m not trying to criticize the actual government estimates. I have no problem with the claim that prices have risen 6-fold since 1964 and RGDP/person is up 150%; it’s no worse than any other number pulled out of thin air by the BLS. My point is that these numbers aren’t worth arguing about. There is no right answer, and inflation is not a useful concept.
Update: Did King Louis the 16th of France (who was probably the richest person in the late 1700s) have a lower or higher living standard than an average American today? It depends on what you value. If you have a big ego, and like to live in a big house and be surrounded by people who flatter you, then you’d say he had a higher living standard. But he only lived 38 years (not untypical of that period) and lacked cell phones, TV, films, jet trips to exotic locales, Japanese and Thai restaurants, the internet, fast cars, etc. In some ways his life was quite monotonous. You can probably tell which life I’d prefer. On the other hand, if you read Thomas Piketty you might come to the conclusion that he’d make the opposite choice. 🙂
However, I don’t think antibiotics would have saved Louis XVI’s life . . .