Fundmastery Blog

Kurt Brouwer June 26th, 2008

This is the third post in a series on this question — does the government understate inflation?

If you have not read the previous posts, you may want to do so:

Part One: Does the Government Understate Inflation?

Part Two: Does the Government Understate Inflation? — Bill Gross Says Yes

Now, we are going to explore the arguments of two eminent economists who believe that the Consumer Price Index (CPI) compiled by the U.S. Bureau of Labor Statistics does not understate inflation. In addition, they believe the CPI actually overstates inflation. The two economists — Donald Boudroux and Russell Roberts — are both professors of economics at George Mason University. Boudroux and Roberts also are prolific authors and bloggers at Cafe Hayek.

The root of their argument that inflation is overstated has to do with how the CPI deals with two factors:

• Price
• Quality

They believe that the CPI does not adequately reflect lower-cost distribution outlets such as Wal-Mart, nor does it reflect consumer behavior changes such as buying items when they are on sale or substituting similar products when one is too expensive or even just adjusting the quantity of an item that is pricey. They also believe that the CPI does not adequately compensate for the vast improvements in the quality of the products and services we buy.

Here is a summary of their argument that CPI overstates inflation using excerpts from several posts and articles by Boudroux and Roberts [emphasis in the original]:

CPI Bias II (Cafe Hayek, October 9, 2006, Russell Roberts)

…I want to discuss the magnitude of my concerns about quality measurements and the surveys of inflation that miss the role of Wal-Mart and other discounters that make up an increasing portion of the marketplace.

How big are those effects?

… I should emphasize that these measures of the bias in the CPI are measured in percentage points per year. The CPI isn’t off by 1.6%. It is off by 1.6 percentage points a year. So that when measured inflation is stated to be 3%, it is actually 1.4%. This is a massive error that when cumulated over even a short period of time grossly understates the growth in real income and standards of living.

… The bottom line is that when inflation is overstated by at least one percentage point a year at a time when the overall rate of inflation is under 5%, the numbers are broken. They are unreliable. They are not good for measuring changes in standard of living over short periods of time or long periods of time.

Let’s assume for the moment that Professor Roberts is correct — that CPI does overstate inflation by 1.6 percentage points per year. That would mean that real (adjusted for inflation) economic growth has been severely understated for years. GDP is generally calculated on a real or net of inflation basis. So, for example if actual or nominal economic growth was 5% and inflation (CPI) was 3%, then real economic growth would be 2% (5-3=2). However, if CPI is overstated by 1.6 points, then CPI would have only been 1.4% and real GDP would be adjusted upwards from 2% to 3.4% growth (5-1.6=3.4).

Here is one example of what why Roberts believes the CPI overstates price inflation. This is from a paper he referenced in another post. The paper can be found here [emphasis added]:

...the current BLS procedure does not treat correctly outlet substitution bias and acts as if Wal-Mart does not exist. Yet, Wal-Mart offers identical food items at an average price about 15%-25% lower than traditional supermarkets. The BLS “links out” Wal-Mart’s lower prices.

Assuming this is correct, the net impact of ignoring Wal-Mart would be to inject upward bias in consumer prices. Incidentally, I recently saw an estimate of the savings consumers achieved by shopping at Wal-Mart and it was over $100 billion per year.

Professor Don Boudroux also weighs in on the issue of price bias in the CPI [emphasis added]:

Calculating Real Wages (Pittsburgh Tribune-Review, February 19, 2006, Donald J. Boudroux)

But can we trust the CPI? I think not. For a variety of reasons, it significantly overstates the amount of inflation we’ve suffered…

…To calculate inflation, statisticians cannot literally look at all goods and services that consumers buy. Instead, statisticians who compile the CPI choose a “basket” of goods and services that represents what the typical American family purchases. Changes in the prices of these goods and services are then used to measure inflation.

How, though, to select which goods and services to put into this basket? The obvious answer is to choose those items that ordinary consumers routinely buy. Putting in a loaf of bread makes sense; putting in a Tahitian vacation does not.

The problem arises because the set of things consumers routinely buy is itself affected by prices. The lower the price of something, the more likely is the typical American family to buy that something. In contrast, something whose price is quite high won’t be routinely purchased and, hence, isn’t a good candidate for inclusion in the CPI basket.

Prices, though, change over time. Because consumers can and do switch their consumption patterns to adjust for these price changes — buying lesser quantities of items whose prices rise and buying greater quantities of items whose prices fall — the CPI basket chosen today gives too little weight to items whose prices fall tomorrow and too much weight to items whose prices rise tomorrow.

The result — the CPI overstates inflation.

Here’s an example to make the point clearer. Back in 1972, basic pocket calculators cost $100. They were so expensive that ordinary Americans didn’t buy them. So statisticians at the Bureau of Labor Statistics understandably excluded calculators from the basket of items used to determine the CPI.

As time passed, of course, the price of calculators plummeted. A calculator similar to one priced at $100 in 1972 sells today for about $7.95. (In real terms, this is a price decline of about 98 percent.) So, ordinary Americans now routinely buy calculators. But because calculators weren’t suitable to be added to the basket of items used for calculating the CPI until their prices dropped and they became affordable, much of the price decline of calculators was ignored by the CPI.

Relatedly, as consumers substitute away from goods whose prices rise and into goods whose prices fall, the relative importance to consumers of these higher-priced goods declines as the importance of the lower-priced goods rises — but the weights that the CPI gives to these goods aren’t immediately adjusted.

The result is that, in the CPI, items whose prices rise are weighted too heavily while items whose prices fall are weighted too lightly — or (as in with the calculator) not at all.

Boudroux and Roberts also believe that the methodology of the CPI undervalues quality improvements over the past 30 years and, therefore, CPI overstates inflation. Here is Boudroux on this point [emphasis added]:

Beware of Official Data On Inflation (Pittsburgh Tribune-Review, February 26, 2006, Donald J. Boudroux)

…A major problem with this [CPI] data is that adjusting prices and wages for inflation is a surprisingly tough challenge. In addition to the difficulty that I discussed in my earlier column, an even bigger problem with the way statisticians adjust prices and wages to account for inflation is that quality changes are often ignored.

In 1976 a mid-priced new car cost about $5,000. A mid-priced car today costs about $20,000. We all know, though, that the dollar bought more in 1976 than it buys today. So everyone agrees that it’s wrong to say that a mid-priced car today is four times more expensive than was such a car in 1976. Before determining how much a car today costs compared to a car in 1976, we must adjust prices to account for the inflation that took place since then.

The most common way to do this adjustment is to track changes in the Consumer Price Index (CPI). The CPI shows that it takes $3.55 today to buy what $1 bought on Jan.1, 1976. So the “real” price of that new car today, expressed in 1976 dollars, is $5,633.80.

Although not four times more pricey than its 1976 counterpart, today’s new car, according to official data, nevertheless does cost more in “real” dollars — an additional 633.8 1976 dollars, to be precise (or an additional 2,250 2006 dollars).

So official data conclude that Americans today pay more real dollars for automobiles.

The problem with this conclusion is that the thing we today call a “car” differs vastly from the thing that we called a “car” in 1976. Unlike a mid-priced car today, the mid-priced car in 1976 had no air bags, no power windows, no power door locks, no heated seats, no tilt steering wheel, and no CD player. It got fewer miles per gallon, needed tune-ups much more frequently and was more likely to kill its occupants in collisions. Its exterior rusted sooner.

This point is irrefutable. Cars are better today than they were 30 years ago. For example, consider maintenance and reliability. Today, cars routinely go 40,000 miles on a set of tires. In the 1970s, a set of tires lasted perhaps 20,000 miles. Similar improvements have been made in brakes, engines and other areas. Back then, after 100,000 miles, a car was worn out. Today, a car with 100,000 miles on it has plenty of life left in it. In addition to being safer and more reliable, today’s cars pollute significantly less than the cars of the 1970s. That certainly is an improvement we all value.

But, compared to gas or groceries, we buy cars infrequently and when we do buy them, we do not really factor in the quality improvements. In fact, I suspect most of us actually take the improvements for granted. Here is an interesting chart that shows the average annual increase in gasoline, overall CPI and new cars for the past 30 years:

Source: Carpe Diem

As we see from the chart, the price of new cars has not kept up with inflation even in terms of actual price. No telling what the impact would be if the CPI adequately factored in the known improvements in automotive quality we discussed above.

But, what about improvements in quality, not just in cars, but across the spectrum of things we buy? Boudroux continues:

…the quality of almost everything we buy today is much higher than in the past. For example, houses are larger and better equipped, the returns to higher education have increased substantially (see Higher Education Means Higher Income — Chart of the Day) and medical care is less invasive, less painful and more successful than 30 years ago. Because procedures for adjusting for inflation largely ignore these quality improvements, official data on prices and wages significantly underestimate the improvements in our living standards.

I would agree with this point as well. Whether we are thinking of computers, cars, cameras or even cardiac care, most goods and services are better today than they were 30 years ago. In many cases, particularly consumer goods, products are cheaper today too.

For these reasons, Professors Boudroux and Roberts believe that the CPI substantially overstates inflation. Their arguments are meatier than the arguments from Bill Gross in our previous post on this topic. Yet, the argument that the CPI understates inflation has merit too. Obviously, both sides cannot be correct. It cannot be that the CPI both understates and overstates inflation, can it?

Inquiring minds want to know. However, that will be the topic for our final post in this series. Stay tuned…

• Business , Economy , Geopolitics , Money , Personal Finance
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