Trying to Address Two Questions With One Answer

In today's Slate, Tim Harford attempts to explain the difficulty of measuring inflation.

The official inflation rate tries to compare the price of a typical bundle of goods today with that of a typical bundle of goods in the past. But we do not consume the same goods today as we did in the past. How many Walkmans in an iPod? The question has no sensible answer, but an answer, nevertheless, is codified in the official inflation rate.

You can be forgiven for thinking that this is an irrelevant intellectual game. You will not, of course, be thinking that if your pension or salary is linked to the inflation rate.

In recent years, received wisdom among economists has been that the inflation rate has been overstated because of unmeasured improvements in quality. Home computers have not only become cheaper but dramatically better, and failure to fully adjust for the quality improvements would overestimate the inflation rate and underestimate how much better off we are compared with previous generations.

Fact One :

Any even slightly free market economy will tend to produce and diffuse enormous improvements in living standards over time due to the increases in productivity from the widespread division of labor and the use of money, even if the money were not to evolve beyond goats or seashells.

Fact Two:

For a given money, the trajectory of its unit purchasing power over time depends on the changes in its supply and demand, and on the changes in the supply and demand of and for all the goods that can be purchased with money.

Trying to integrate these two facts by 'calculating' a single rate of inflation is a self-serving, immoral attempt of government to promise to re-imburse you for today's thefts at some later date without allowing you to fully benefit from the inherent and ongoing advances in the standard of living that a free market economy inevitably produces.

The idea that the purchasing power of money can and should be adjusted for quality improvements in the goods available for purchase is absurd. Yes, if the number of strawberries in a carton changes over time, then it is appropriate to make adjustments for the price of a carton. But that is just about where it should end.

If there are no particular trends in the supply or demand of or for money, then improvements in the quality of goods results in changes in relative prices between the goods, not inevitably in overall price levels.

If there are no changes in money supply or demand, then an imagined comparable improvement in the quality of all goods that keeps all relative prices the same would tend to result in constant absolute prices as well, assuming no increase in the variety of goods. All goods have improved and have resulted in an increased standard of living, but it is NOT appropriate to confuse this fact with deliberate attempts to modify the unit purchasing power of money. If you take $10,000 from me today, it doesn't give you the right to return $5,000 in 40 years if the quality of cars has 'doubled.' Especially if the improvements are of the sort that only are meaningful to statisticians, such as an increase in the top speed of a car trapped in a traffic jam, or an increase in the speed and memory of a computer used for word-processing and checking email.

If Ticonderoga #3 pencils have improved to the point that they can operate in both a vacuum and under the pressure of 2 miles of Pacific Ocean, how much more should I really be willing to pay for one?

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Not to say I disagree with

Not to say I disagree with the thrust of your post, but how about this?

How much more would you be willing to pay for a car that is expected to travel 200,000 miles without any major mechanical problems (as most of today's cars do) compared to a car that is expected to travel 70,000 miles before major mechanical problems. There is a question of value to be had here.

Your analogy would be more akin to performance motorcycles, the vast majority of which are destroyed by crashing them, not due to mechanical failure. I.e. how much more willing am I to pay for a bike that will travel 100,000 miles without mechanical problems when the average owner is going to wad it up in a crash in less than 20,000?

Trying to integrate these

Trying to integrate these two facts by ‘calculating’ a single rate of inflation is a self-serving, immoral attempt of government to promise to re-imburse you for today’s thefts at some later date without allowing you to fully benefit from the inherent and ongoing advances in the standard of living that a free market economy inevitably produces.

What theft? What promise to reimburse you? What are you talking about?

The government steals from me all the time - it's called "taxes". But I don't recall anyone promising to pay me back for them. Unless you count Social Security, which of course isn't really even a promise to pay me back, certainly not one that I would believe, or even accept if I had a choice in the matter.

Trying to integrate these

Trying to integrate these two facts by ‘calculating’ a single rate of inflation is a self-serving, immoral attempt of government [etc]

Do you think that if inflation weren't calculated by a government agency there would be no calculation of inflation? If the Fed didn't care about inflation and just set the interest rates by random die roll, don't you think someone somewhere would be interested to know how much more expensive things things had gotten lately? (Or less! Random die rolls might sometimes be deflationary!) Don't you think banks and businesses and investors would want to know what the inflation rate was and want to take the inflation measurements into consideration when making their plans?

I don't see how attempting to measure inflation, even given the many limitations inherent in the process, all of which are known about by economists and are discussed at great length, can possibly be a government conspiracy to keep us poor and stupid.

If there are no particular

If there are no particular trends in the supply or demand of or for money, then improvements in the quality of goods results in changes in relative prices between the goods, not inevitably in overall price levels.

Here's a thought experiment for you (I know, I've been ragging on Patri for thought experiments, but cut me some slack here). Imagine a barter economy - no money, no money prices, but for some reason people can still efficiently transact businesses (everyone is really good at doing price conversions). Imagine that only one good in an economy had a substantial improvement in quality, such that people buying it were willing to pay twice what they were before relative to all other goods and services. Cars just doubled in price relative to pigs, sheep, shoes, and bread.

Things remain that way for a while, then suddenly shoes improve in quality. The price of shoes as measured in cars, pigs, sheep, and bread doubles. As time goes by, each good in turn has a sudden improvement in quality with a resulting increase in demand and doubling in relative price. Eventually, relative prices are where they were to begin with.

Now: same scenario, but this time with money. When cars double in price relative to everything else, is it not reasonable to think that "price level stability" would mean that the goods which have not changed in quality would not change in price, either? If so, then the money price of cars will double. Once each good has had its improvement, we're back to the relative prices being the same but the monetary prices having doubled.

eddie, I don’t see how

eddie,

I don’t see how attempting to measure inflation, even given the many limitations inherent in the process, all of which are known about by economists and are discussed at great length, can possibly be a government conspiracy to keep us poor and stupid.

It is the deliberate distorted understatement of inflation provided by the hedonic quality adjustments, using the inherent rise in living standards to mask the degree of credit and monetary expansion that is the problem. "Inflation is always and everywhere a monetary phenomena." --M. Friedman.

In your example, with no money, the only prices are the exchange ratios between every good and every other good. It is a mathematical impossibility for any price increase to not be matched by a corresponding price decrease.

With money, the same thing applies except for the possibility of a change in the supply of money or a change in the demand to hold money.

Regards, Don

It is a mathematical

It is a mathematical impossibility for any price increase to not be matched by a corresponding price decrease.

Well, yes, in that when the price of cars as measured in shoes, ships, and sealing wax doubles, then the price of shoes, ships, and sealing wax as measured in cars is halved. But that's a tautology.

The shoe/ship/wax price of cars can double while the shoe-ship, ship-wax, and shoe-wax prices all stay the same. That's not a tautology.

Put money back into it, and the money price of shoes, ships, and wax can stay the same while the money price of cars doubles. Then the money price of shoes can double while all other prices stay the same. Then ships, then wax, and now all prices have doubled because of quality increases.

The monetary authority (assuming there is one) has a choice. They could adjust the money supply so that when the relative price of shoes doubles due to the quality of shoes improving, either the money price of shoes stays the same or the money price of everything else stays the same, or perhaps something inbetween (the money price of shoes goes up, but not double, and the price of everything else goes down, but not by half). Any of these contradicts your contention that price changes should only be determined by money supply and demand and not by changes in the quality of goods. Keep the price of shoes the same, and the price of everything else changes for no reason. Keep everything else the same, and the price of shoes changes for no reason other than their quality improvements.

It is the deliberate

It is the deliberate distorted understatement of inflation provided by the hedonic quality adjustments, using the inherent rise in living standards to mask the degree of credit and monetary expansion that is the problem.

Mask to whom, and how? Are you saying that the economic and financial data being used to produce the inflation numbers are fraudulent? Is there some great credit expansion that everyone who would care about such things is somehow unaware of?

If the inflation numbers are understated, I'm confident that nobody who pays attention to the numbers (businesses, banks, investors, etc) is unaware of how they are collected, how they are calculated, how they are reported, and what their deficiencies may be.

If you think the average man on the street is being deluded by our government about just how bad inflation really is, then I think you are being deluded about how much the average man on the street knows or cares about the inflation numbers. In fact, the average persons are probably the hardest of all to fool about inflation, because they measure it directly through their own experiences rather than paying any attention whatsoever the official numbers from the government.

eddie, Put money back into

eddie,

Put money back into it, and the money price of shoes, ships, and wax can stay the same while the money price of cars doubles. Then the money price of shoes can double while all other prices stay the same. Then ships, then wax, and now all prices have doubled because of quality increases.

Listed prices could be anything, but you can't continue to buy all the same things at their higher prices without

a) refraining from buying some things, reducing their prices

or

b) borrowing money

or

c) reducing your holding of money unless someone has presented you with new money.

It all comes down to the fact that, economy-wide, all prices cannot go up without an increase in the supply of money and/or a reduction in its demand to hold. Everyone cannot spend more on everything without a monetary shift.

If all prices are going up, you would normally want to hold more money, not less, unless you have suffered a major increase in your rate of time preference for present consumption over future consumption. But the quality increases are unlikely to only affect present goods, so this is also unlikely.

Regards, Don

On further review, perhaps

On further review, perhaps it is your adherence to the MV=PT nonsense that's the root of the problem?

Don: it is conceivable that

Don: it is conceivable that after the price of shoes doubled, the total quantity of money remained the same and the total demand for holding money stayed the same, and that the quantity of goods purchased changed in order to allow MV to still equal PT.

Yes, it's unlikely - this is a contrived scenario, after all. But the point is that it's entirely reasonable for an increase in the quality of some good to produce an increase in its monetary price even while the money prices of all other things remain the same. Furthermore, this phenomenon can occur across all goods in an economy, staggered over time, which will result in an increase in the general price level due to nothing more than an increase in the quality of everything in the economy.

In the real world there would not be a decrease in the quantity of goods purchased, so there would also be an increase in either money or velocity... but that's beside the point. Even in the real world with fluctuating M and V, increasing product quality is a real phenomenon and is a component of the general price level. It's not at all unreasonable to try to account for the phenomenon in assessing various measures of inflation.

Yes, it’s unlikely - this

Yes, it’s unlikely - this is a contrived scenario, after all. But the point is that it’s entirely reasonable for an increase in the quality of some good to produce an increase in its monetary price even while the money prices of all other things remain the same.

Perhaps, but for how long?

Furthermore, this phenomenon can occur across all goods in an economy, staggered over time, which will result in an increase in the general price level due to nothing more than an increase in the quality of everything in the economy.

Prices are an outcome of market activity, not an input. A change in prices means (absent money supply changes) that consumers are buying more of something and less of others (i.e., demand has shifted between goods, or between periods of consumption), or input costs have increased and people will simply buy less of the produced good and more of others (i.e., supply has decreased). In other words, Don's list above was correct, and the only way to achieve sustained higher prices overall is to fiddle with the quantity of money.

The various agencies that

The various agencies that rely on these statistical contortions are required to do so by law, and therefore its irrelivent whether the 'man on the street' understands or does not. he gets the number on his cheque they contorted, not the number intelligent insightful people KNOW it should be. THEY hold the power by forcing Veterans Affairs, Social Security et al to legally adhere to a blatantly false premise. the numbers are not jigged to fool smart people, they can never do that.

its no different than the

its no different than the government of Russia telling its citizens they invented the light bulb. tell em all you want.

The government pays out

The government pays out social security benefits based on the inflation rate. If the government last year owed $400 billion in benefits and the reported inflation rate was 3%, this year's benefits would be $412 billion. If the actual rate was 10%, the benefits should be $440 billion or a savings of $28 billion.

Even though inflation has been tinkered with for many years, the 1995 switch to a hedonics based methodology was the last major change. Let's assume that over that 10 years, the annual social security savings was $20 billion based on inflation underreporting. That means the government would have cheated seniors out of $200 billion. Pure heresay, but that is why they would do it.

Every time I read one of

Every time I read one of these "well informed" treatises on the causes of inflation, the pressure to write the "probligo theory of inflation" increases. :lol::lol: