Thursday, March 29, 2012

Inflation: a thing that doesn't really exist

Well OK, saying that such and such a thing is really treading on unsteady epistemic grounds.  What does it even mean for a number to exist or not exist anyways?  One position that you can take is that things that can be directly measured, like a person's height, exist; but that things that can't be measured, like their height in inches plus their age, aren't things that really exist.  And though people tend to treat and talk about inflation as one of the former, it really matches the later category much more closely.

The indomitable Google lists inflation as being "3: A general increase in prices and fall in the purchasing value of money".  That's all well and good, but there's never any general level of prices that you can directly observer.   You always have to combine the increases and decreases in various prices with some system to produce something you can call a general level, and the process is actually very straightforward.

First, there is the selection of the goods and services that make up you index.  The easy solution here is to just try to average across everything that makes up a country's GDP in proportion to its contribution, but that makes scaling things like income to GDP problematic.  For the last few decades healthcare costs and higher education costs have been the sectors of the economy that have seen costs increase at the highest rate, but you median worker receives their health insurance from their employer and doesn't have a college degree.  What you really want to do when talking about how inflation has affected a given group of people is to look at the rise in the costs of the particular package of goods and services that that group consumes, and not the price level overall.

Does that mean that they've experienced less inflation than official measures would suggest?  Well, maybe, there are more factors at work here too.

For instance, how do you compare prices levels when some goods are no longer produced, and some have just been invented?  For instance, how do you compare the price of a color TV to an old black and white TV from back in the day?  You could look at the times when both were sold and look at the price ratios then, but those prices were a function of both supply and demand, and the ratio varied over time.  The people who look into the matter tend to say that we overestimate inflation due to technological change, but who knows by how much.

And on yet another hand (where did I get a third?), there are things that don't contribute to what an economist would call inflation, but are rising prices.  If there's a rebellion in Libya and the amount of gasoline produced in the world decreases while the demand for gasoline stays constant, that means the price of gas is going to rise.  But because the price change is due to real constraints on supply, this isn't actually a matter of "inflation" based on an economist's standard definition, so there's an unfortunate disjoint there.  And you can't really say that economists are totally wrong because the rising price in't a result of some mistake in Federal Reserve policy, the thing that economists usually consider inflation with respect to.  On the other hand (wait, I have four now?) you could say that you typical consumer is right in thinking of rising gasoline prices as inflation, since that is an increase in the price of the overall basket of good that people like them buy.

So where does that leave us?  Given all of that, I think that maybe we could do well to follow Scott Sumner's lead by just not talking about inflation much.  Inflation per se doesn't tell us much that's practical from a policy perspective by itself, though it is very useful from an investing perspective.  Maybe if we just tried to get into the habit of only talking about supply shocks and demand shocks we could have more sensible conversations about the economy.

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