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Inflation, and history

Summary:
Phil Gramm and John Early have an excellent WSJ oped on inflation measurement. Many conventional inflation measures are  overstated by around 1% per year, because they don't capture quality change well. When the iPhone 22 comes out, and costs (say) the same as the iPhone 21, that looks like there is no inflation. But the ...

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Phil Gramm and John Early have an excellent WSJ oped on inflation measurement.

Many conventional inflation measures are  overstated by around 1% per year, because they don't capture quality change well. When the iPhone 22 comes out, and costs (say) the same as the iPhone 21, that looks like there is no inflation. But the iPhone 22 has dozens of new features, so you're really getting "more phone," and there is deflation. Think of all the things like mapping that are now free. It's not just tech. Houses are bigger and better, cars are much better and safer, and lots of services are now free
No price index takes account of the fact that each month more than twice as many people get medical advice from WebMD as visit the doctor’s office in America. 
The people who make price indices try hard to account for quality, but the result is still biased.

Now for many uses we don't get too upset about this, just as a clock that's always 5 minutes fast is still useful. In particular, for spotting trends in inflation, is it rising or falling, a steady 1% bias doesn't make much difference.

Where it does make a big difference is when you cumulate inflation over a long period of time. We  do that in the politically charged question, is the average American better off now than his or her parents were in 1975, and if so how much? Now whether 1% per year times 44 years is more inflation or better stuff matters a lot.
When corrected for documented price overstatements, real average hourly earnings from 1975 to 2017 are shown to have risen some 52%, not 6%—an additional $6.77 an hour. Real median household income increased 68%, not 21%—$17,060 more annually. 
And published poverty incidence fell by almost half. Combined with the 67% drop in poverty that comes from accounting for all government transfers, poverty incidence sank from 12.3% to about 2%. 
In the political debate over the fate of the "middle class" these are huge differences. The mantra-repeated narrative that the "middle class" hasn't advanced at  all  since the 1970s is simply not true. (Quotes because I reject the idea that we are a class society,  and hence the use of this word.)



Gramm and Early emphasize the other long-run issue: when one uses 1% cost of living adjustments in government payments, that too cumulates to dramatic numbers over long time periods
By overstating inflation, CPI indexes inflate real spending in Social Security, federal employee retirement, military retirement and poverty programs like Supplemental Security Income. Overstating inflation also overstates the minimum-income threshold to qualify for Medicaid, food stamps and other subsidies.  
If the tax code and transfer payments had been indexed to an even more accurate index embodying all known price-index overstatements, revenues since 2000 would have been more than $1 trillion higher, transfer payments $2.6 trillion lower, and the national debt 23% lower
Gramm and Early's main point: better indices exist. Why don't we start using them?
Since PCEPI and C-CPI-U overstate inflation less than other official indexes, it would seem reasonable to adopt one of them immediately for all historical comparisons, official statistical estimates, and inflation adjustments for taxes and spending
You know the answer, right? Because a lot of voters' checks depend on using an inflated number.

The other issue not mentioned is the great puzzle of our current monetary policy, inflation, and interest rates. Why are interest rates so persistently low? Well, if inflation were really two percent overstated, the world would make a lot more sense. Then we would really have positive two percent real interest rates, because inflation is really zero. I don't see evidence that it's that large, but it sure would make a lot more sense.

The next issue, that I think is much under-studied: the huge local variation in prices, and, via huge variation in what we consume, the inflation experienced by people in different parts of the country. Living in California and especially the Bay Area is like living in a different country with a different currency. Even gas costs twice what it does in the rest of the country. A lot of what appears to be income inequality is just different prices, and especially land prices. (Much of the productivity of tech workers went in to the pockets of existing land owners.) If you get paid 100 yen in Japan, you're not 100 times wealthier than someone who gets paid 1 dollar in the US.  Being paid $100,000 per year in San Francisco is something like that -- and being paid $20 per hour in much of the US is nowhere near the disaster than being paid that much in San Francisco would be.

How much local variation in prices is really variation in quality, and how much is just higher prices? Like the slow 1% bias in national inflation rates, local variation likely doesn't matter for short-run issues, but cumulates over time, so local  variation in the price level is large. And local variation in typical consumption baskets even larger. In my last look at this I could find local inflation rates, but not good price level  comparisons. But I haven't looked that hard.

(Gramm and Early write
Two recent studies, one by Bruce Meyer and James Sullivan and another by Brent Moulton, combine more than 50 credible studies documenting specific overstatements in consumer price indexes.
but the WSJ does not have links.  I can't quite figure out which of the many excellent Meyer and Sullivan papers they have in mind. Be prepared like me to lose some time browsing Meyer's website and Sullivan's website. I think this is Brent Moulton's article.)
John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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