A lot of questionable statistics is used to collect inflation data and to calculate stuff like CPI (consumer price index). Your mortgage and other interest rates and sometimes your rent are adjusted to this number; and this statistical trickery of taking data to find out the value of money and how it varies over time has a bearing on your everyday life.
Problems with how inflation is measured
Can we give a precise value for money (dollars) by measuring the value of all other things the way an index with the inflation basket does? I don't think so.
My inflation basket is not your inflation basket
The very fact that different baskets give different values for inflation shows that there's nothing real behind the headline inflation number, it is all noise. If there were a real inflation number, it would be independent of the basket design, would be more robust than only a tiny basket determining it's value. The basket is not representative of anything-it is noise being sold as representative data.
2. It does not consider the statistical deviation in prices. Whenever an inflation data is published, I would like to know the standard deviation (variance) of the data. No mention is made; to hide the fact that the prices vary all the time! For the basket used to measure this data, what is the standard deviation of the price of the basket? The inflation index covers prices consumers pay for services from medical visits to airline fares, movie tickets and rents-all kinds of variable things, and you just can't add the means and come up with a value without talking about the variability or standard deviation of these items. Note that variances of sums of variables add, and the overall variance of a sum is larger than the individual variances of the variables being added. Since prices of the inflation basket constituents are quite variable, an inflation basket derived by summing together these prices will be even more variable (assuming the co-variance terms being zero or very small).
3. Measuring the value of a basket in money terms, or a bunch of items in money terms, does not give you the value of money. The demand of money varies just like of other things (potatoes, electricity, whatever) and you cannot just average it out over a bunch of things and come up with "one value" of money, as a CPI calculation does. The natural variation of prices of everything, and of money (cash) in itself, is not considered at all. It also assumes that the reason the value of money is what it is is because of increase or decrease in supply of money; and does not consider that the demand and supply of money, just like of any other commodity (if you could treat it that way), is itself variable.
To explain this further-let's say we started measuring things in potatoes, and we could control the production of potatoes so that every year we would increase the potato supply by 2%. Can this be captured by measuring everything else in potatoes and coming up with something like "the supply of potatoes increased 2% in 1 year"? I believe it is impossible. With all things valued in potatoes, and because their value is itself very variable depending on the supply and demand, you will end up with a very noisy idea of the value of things in terms of potatoes. It is very unlikely that you will hit the mark of 2%. So even in a controlled environment, when you simply increase the supply of potatoes by 2% in a year, you will not be able to come up with the exact value by your statistical data taking of market prices. The same holds if you measure it in dollars or pesos.
The basic idea of measuring things to get the value of money is not bad-you can get an idea, a very rough idea about inflation, if EVERYTHING in your basket goes up in price by a significant amount (at least 10%). For small variation in prices, less than 5%, you cannot conclude that the price of things increased because you printed more money, or because of simply that the demand of money went down in relation to other things, etc.
If there was something real in measuring the value of money using things in the inflation basket-ALL items would go up with a very similar and significant amount e.g. 12%. Then you can say with confidence that it is the price of money which is changing and it is not the statistical variation in it which you are capturing.
Most transactions in almost all developed and developing countries are electronic-by checks, credit cards, etc. The printed currency is a small part of the overall money in the system and is responsible for a small dollar value of transactions. The biggest transactions are almost always 100% electronic- by direct bank transfers, by checks (checks are electronic in the sense that you don't need a wad of bills to pay, you write checks using your checkbook, and the depositor normally gets the money in their account electronically), by credit cards (purely electronic), etc. The idea of cash and printing money to cause increase in money supply has become obsolete in the last 50 years because of these developments.
Comparison to wage data
Just like the mean or median wage of a country doesn't tell you much, an average inflation of a basket doesn't either. Worse still, at least the wage is one number; the inflation basket is averaged over hundreds of products, and that makes it even more variable. No one made policy decisions on the basis of an increase of 2% in the median wage (or mean wage), because we all know that the distribution of wages is highly variable, and the mean or median does not account for what's happening for most people in real life. Strangely, we are made to believe that there is such a thing as an average inflation rate, and that that's representative for all the different ways consumers of a country spend their money.
We need to think of inflation like a wage data. Your wages are not my wages, and your inflation is not my inflation. Neither of us has anything to do with the basket based inflation data published by a government agency, which is the inflation of another imaginary human being who consumes the inflation basket goods, in the exact proportion the basket says.
The prices of all products go down with time, deflation is the norm. Wage increases are 100% realIf everyone is given 10% more money: the salaries of wage-earners go up by 10%, the capital returns of all capital owners go up by 10%, it cannot be said that the prices of all goods will go up. We hate to pay higher prices for the same product-and many times will simply not buy the product at all if prices are raised. The inflation proponents in this case will say that part of the rise in salaries (or capital gains) will go to raise prices (e.g. 3% of the gains will go towards raising prices, while the rest of 7% is the real wage increase (wage growth after accounting for inflation)). One can argue equally well that prices of the exact same products actually went down by 4%, and the real gain of wages is not 7% or 10%, but 14%. In the following paragraphs, I will try to show you that this is what happens in most cases; that prices of goods are generally falling with time, and the maxim "money saved is money earned" is as true today as it was five hundred years ago, without us needing to correct the buying power for inflation.
Inflation results (that it is generally a positive number, and that prices are going up with time) are contrary to what every human being tries to do in life-save money, get a better deal and a constant push towards finding the same product at a cheaper price. Deflation is the norm, consumers are always acting together to push down prices for the exact same products.
A rise in a salary will not cause you to run out and pay a higher price for the exact same product (only a fool would do that!)-and the natural desire of human beings to find better deals from several producers is always pushing prices lower for the exact same product. A corollary: buyers will pay higher prices for higher quality products in the same category. Inflation data does not consider the generally improving quality of all products as time passes.
Similarly, if by just having more money in your pocket you pay more for the same goods (and cause inflation), rich people are causing inflation all the time! They have more money..therefore they will pay more for the same goods than poor people? Rich people are not fools; and just because they have more money doesn't mean that they will overbid for stuff. Inflation caused by more money in the system assumes this behavior.
When you earn more money and go to a supermarket, you don't pay more for the same things. What you do do is to buy more things-in other words, you increase the volume of your purchases, but do not push up prices. The richest buy more volume of things; but do not pay more per unit for those things. Being richer really means that the shopping cart has more items in it; and it does not mean that you have paid more for the same items.
This essential thing about volume is lost in many other fields of life as well, not just in measuring inflation. When oil prices rise people who are long the oil market celebrate-not realizing that the net revenue of the oil producer is price multiplied by volume, and if you reduce the volume too much on increasing the price, your revenues are reduced. Or, similarly, many merchants celebrate when they can increase prices; not realizing that they are digging their own grave, because increasing prices leaves competitors a chance to get in, because they can offer goods at lower prices.
One must note that it is buyers who decide the final price in any transaction; sellers only make offers. Buyers enter into the transaction voluntarily (no one forces them to buy something, they can just sit with the money, or buy something else with the money) and are the final deciders of what all goods are priced at. Since buyers are always trying to lower prices, it follows that there is a constant pressure on goods to go lower in money price, or a constant tendency of deflation. Every man wants to buy the cheapest, and deflation is the norm in that sense. Buying is a voluntary act, and they can choose not to buy, with no one forcing them to go ahead with the transaction. Since most goods except basic foods are in reality luxuries, it follows that buyers are always exerting a downward pressure on the prices of goods, shopping between different producers to find a better deal on the same or similar products.
However, buyers will pay higher prices if the product improves; which is really the best use of their increased wages (or capital gains). This explains why over long periods of time (several decades), when you can see that wages do go up, why goods seem to go up in price. Many goods are now better quality than before, and comparing even simple products at two different points in time, the points separated by several decades-will make you realize how much their quality has improved. The quality, includes durability and packaging of vegetables in much better today than 50 years ago. The price of carrots seems to go up in 50 years; but if you consider how much the quality of carrots has gone up, you will realize that the gain has been nothing more than an adequate compensation for better quality, better packaged, cleaned, ready to eat and nice looking carrots rather than the same carrots being sold at higher price. In real life at a certain point in time, when we go to a supermarket, we do pay slightly more for a better product (you will pay more for cleaned, ready-to-eat carrots than unwashed carrots with their leaves attached to them). Accumulate this preference over several decades and you will see why carrots today are much better than carrots 50 years ago. I chose carrots as an example of a simple good; the real quality improvement in complicated machinery, electronics goods, etc. is much larger over a period of decades; $1000 would buy you a 2MHz Processor, 200KB RAM computer 20 years ago, today it gets you a 2GHz processor, 5GB RAM. Or in other words, the computer of 20 years ago will cost you pennies-because of the improvement in the production technology of computers. I remember paying $500 for a 1.2M pixel camera 15 years ago, today a 10M pixel camera is a standard, free feature in all smartphones which cost $200. Improvement in digital camera technology has been very rapid, and the costs of the same product have dropped down exponentially. It is the slow accumulation of higher prices for better products by consumers which caused the elimination of the 1.2M pixel camera. Let me explain this further.
Cost of Hard Drive (per GB) Source Mkomo.com
The chart above shows the cost of storage in computers (per GB). The same curve is seen for DRAM prices, CPU prices, display prices, etc. (per unit). You can see that the cost has collapsed exponentially, and computers are much cheaper today than they were some years ago. A great reduction in prices, but maybe not as dramatic, has happened for car and truck parts, the washing machine, microwave ovens, and all sorts of machines and finished goods.
Fifteen years ago, when the 1.2M pixel camera was launched, it cost US $500. In one year after that, the price of 1.2M pixel camera was $400, but a 1.5M pixel camera was $500 (the manufacturers lowered their cost and because of competition, prices of the exact same camera of 1.2M pixel went down) . I chose to pay $500 for the 1.5M pixel camera. Do this successively for a few years and you will realize how it was consumer preferences together with better (cheaper) technology which caused the elimination of the 1.2M pixel camera from the market.
Inflation baskets and measuring inflation using them do not consider the improving quality of products, i.e. they do not control for product quality. While some exact products might really increase in price with time, for most products, there is constant improvement going on in quality. Most price increases you see in life on products is because of a real improvement in the quality of these products. In the United States, the cheapest car might have cost US $5000 in 1965 and today in 2016 it costs US $15000, but the increase in price is not because of inflation or more money in the system; it is a real improvement in the quality of the car in this period. Wage increases are also completely real-and inflation doesn't "eat away" into wage increases as often quoted.
What happened to the $5000 car of 1965, why is it not available in 2016? That's because there has been a real improvement in the US (and the same goes for most other countries) in these years, and people earn enough money to not have to buy the $5000, 1965 type car anymore. In poorer countries, you will find a car for $5000; because society there has not improved to an extent that everyone can afford a $15000 car. A $5000 car today in a poor country is much inferior in quality than a $15000 car in the US, as anyone can plainly see. It is normally much smaller in size, power, sturdiness, etc. The $5000 car of today, which is available in poor countries, is the same as the US $5000 car in 1965. But the US has become a much richer country in these years, and people have completely stopped buying the $5000 car, because they can afford to trade-up, or buy the $15000 car. Spatial comparison can be extended to the temporal dimension as well; and you will come up with the same conclusions-a product which is cheaper in Bulgaria today than in the US, in general, is worse quality than the US product, and is comparable to a previous generation product in the US which was the same quality and price as the present data Bulgarian product.
Within the same country, if a product costs X in Baton Rouge, Louisiana, and costs Y in Manhattan New York, and if the price of Y is substantially greater than X, then we can safely say that Y is better quality than X. Because within the country there is clear arbitrage-same quality products cost about the same within the country (easy shipping-X will cost the same everywhere in the country, approximately speaking). Shipping is not easy internationally, but even so, if the difference in price between two products in two different countries is very large and they are about the same quality, products will be imported from where they are cheaper and brought to where they are dearer. This is the whole reason for importation-because it is cheaper to import than buying it from a domestic supplier, who for whatever reason is not able to bring the product to market at the foreign supplier's price (including cost of shipping, customs, etc.).
This becomes easier to see when you look at everything from the producer's side. The producer C1 has a product A selling in the market, and they improve on the product to launch a better product, product B (can be better durability, better aesthetics, better resolution, better efficiency, etc. or a combination of these). They will price the product B at a slightly higher price than product A, in money terms. As the market realizes that product B is really better, and worth the higher price, it will start buying B. In a few years, as everyone earns more money, they will stop buying A altogether, and the market will only have product B from company C1. This is how lower quality products get phased out-if new products of better quality are launched, the lower quality products go away from the marketplace, as long as people have enough money to pay for them (which they earn by selling better quality products themselves wherever they work). If you have the means to buy better quality products, or have more money, you will buy better quality products. This is why in a rich country products are generally of better quality than in a poor country; and within a country, people who are richer have better quality products.
We must remember that money is just an instrument to facilitate the trade of goods and services-the real value of goods and services always being measured by labor or man hours. In the example above, the real exchange going on is as follows: Imagine the marketplace with only two companies, C1 and C2. The company C1 produces products A and B, where B is an improved version if A. The company C2 produces products X and Y, where Y is the improved version of X. The money price of B is more than A, and that of Y is more than X (that's how the companies will price them when B and Y are launched-improved versions are launched at higher prices than existing versions). Employees of company C1 initially exchange their product A with product X of company C2. When the improved versions B (by company C1) and Y (by company C2) of these products are launched, that exchange starts to take place more and more, eventually completely replacing the original exchange of A with X. Note that to be able to buy an improved product, you must be able to sell an improved product yourself. This is how you "trade-up" in daily life-you buy better quality products, but you must have the means to buy them, and those means or money to buy better quality products you acquire by yourself selling better quality products to the market. You purchase with you labor what other purchase with theirs; is the real exchange going on in society (adjusted for skill and natural ability). Improving quality of products is the real reason you see increases in price over several years, and inflation data fails to account for this.
You can see how over a period of 20 or 30 years the quality of simple products like shoes, furniture, household appliances, building materials, automobiles and motorbikes, etc. has improved. I remember that 20 years ago shoe laces used to break-but in 2017, when I am writing this part of the article, they don't break anymore. Nor does the plastic at the tip of the shoe lace, which holds the shoe lace in-tact, come off. The soles don't give that easily. These are real improvements, and many are captured by increase in the price of these shoes, as I showed you above when you look at things from the producer's side. Nike has been a major shoe supplier for many decades-and if you look at the improvements in shoe quality (including options in colors, aesthetics, in addition to durability, etc.) you will realize that a lot of the price increase is but a fair payment of the better quality of the shoes. Note that competition always brings prices down (for the same quality, i.e. for the same quality of product), and this means that if something seems to be going up in price in money terms, it is even more likely that it is higher quality. Products like shoes and furniture do not improve as fast as electronic goods or mobile phones, but they do improve. These things are not caught at all in inflation measurements, who will compare the price of an average shoe in 1980 vs today (2017) and say that shoe prices have gone up a lot-attributing it to inflation, and not to improvement in product quality.
Consider another example-a McDonald's burger. Inflation proponents can clearly say that the price of a McDonald burger has gone up so much in time! But anyone can see how much better McDonald's has become over a period of 30 or 50 years. See graphic here to realize how much these burger chains have improved over the decades. The service is faster, more machines are used to make the products cleaner, packaging has improved considerably especially if you consider take-out menus, and the McDonald's restaurants worldwide are much more comfortable and nice looking than what they were a few decades ago. All these are improvements which have resulted in good returns for McDonald stock investors, and again looking at things from the producer's perspective, you can see that the stockholders and management have been working to improve the food and the overall experience, and the higher prices of a burger are but a fair recompense for a job well done, and not because of inflation! Competition in the market forces them to do that-if they offer the same product for 10 years without improving its quality, it a certain that competitors will come-in to take away market share. Burgers are a commodity business-and competition is intense in such sectors, with little possibility of monopolies. This is a great recipe for improvement in the products-lots of competition is the surest way to improve products in any category.
A rich country has people who are producing better products, which are exchanged for other better products being produced by other people in the country. The higher prices of products in a rich country are a direct representation of a better quality, and not due to inflation or more money in the system. Same goes for a rich neighborhood in a city in a poor country (e.g. Mumbai, India) -the products in such a neighborhood are generally better quality than in the poorer parts of the city, which command a higher price.
It follows from this that all wage increases are 100% real. It is a real improvement in the buying power of labor which shows as an increase in wages. You do not need to correct wages for inflation. The standard nominal vs. real wages (corrected for inflation) comparison is therefore invalid-the nominal wage increase is the real wage increase in the buying power of labor. When you get a raise of 5% from your boss, you increase your buying power by 5% (your real buying power will increase more than 5% because you are able to bring down your costs every year even if you do not get an increase in salary).
The US median household income data shows an increase in annual income from about $5K in 1950 to $50K in 2015. An improvement of about 10X in wages over 65 years is not a surprise, and is a real improvement in wages of about 3.6% per year. If you have $50K today and could somehow bring all the products of US in 1950 to 2015, you will find that those products from 1950 are much inferior in quality than 2015 products, and in reality, will cost 1/10th of your earnings, i.e. you will pay $5000 for those 1950 products in the US. This is a hypothetical experiment, but a similar situation exists is if you take your $50K to a poor country, a country which is 10X less wealthy on an average (e.g. India, Bolivia). You will find that the products in India on average are about the same quality in 2015 as the US products in 1950, and you will find that you will spend only $5000 for acquiring those products in India. You can't go back in time and do time travel; but going with your dollars to a poorer country is a very similar thing . In a very crude approximation, you can think of India and Bolivia in 2015 as where the US was in 1950 in terms of general economic state of society (measured by GDP/capita, or median earnings). These numbers are very approximate, but you can get an idea of progress by traveling all over the world, and an approximate comparison like this helps you realize the large difference between the standard of living (or quality of products and services, which is the same thing) in different countries. You can't go back to what the 1950's US life was; but traveling to Bolivia or India today in 2015 is a good proxy for it.
Similar quality products costs about the same worldwide (from the arbitrage reasons mentioned above-if they didn't, importers and exporters will ship them where they are cheaper to where they are dearer, and they do) and what makes a country different from another is the general quality of products and services, which is much better in a rich country than a poor country. This includes services of the government, monopolies like utilities and telecoms, etc...all these services are much better quality in a rich country than a poor country, and you pay more for them in a rich country because of this. There are some exceptions, but in most cases, you get what you pay for, worldwide.
The wage data in the US (which shows that the median annual wages of US households have gone from $5K in 1950 to $50K in 2015) when corrected for inflation data, as the economic experts like to do, shows that real wages have been stagnant since about 1970. According to these experts, the US worker hasn't seen her lot improve in 45 years...she works harder to consume the same amounts of goods as 45 years ago. The US worker is painted as an idiot by these experts, who apparently know more about real life than her. It is my belief that the US worker knows far more about economics than most economists and financial types, and knows well that their real buying power has improved considerably every 5 years (allowing for year over year fluctuations), and over a period of 45 years, the American worker is far wealthier. They have more goods to consume, more choices, better quality products, better services; and the 'correction due to inflation' is a foolish exercise. The real improvement is not just 3.6% per year, but more, because of the constant pressure on prices from consumers on producers, importers, etc. which pushes the price of products and services downward constantly. The nominal wage increase is 100% real, and the increase in the real buying power is more than the nominal wage increase because of this reason. If wages were not to increase at all for 5 years, in a period of 5 years the US worker would still be better off than before. From personal experience, I am able to constantly drop my costs by finding better deals, and if my income remains the same, I am certainly better off this year than the year before. This is true for most of humanity.
Some people have shown me examples of the exact same products going up in price. While this may be true for some products, for every one product like this, there are ten others whose price has gone down. The weighted average of these products will see a reduction in price. In other words, prices of the exact same product going up with time is an exception rather than the rule. One should not base their judgement on exceptions-and overall you must realize that the same amount of money gets you more of the exact same products with time, i.e. for most products, the price goes down with time.
The case of Panama and Ecuador
The futility of inflation measurements is best illustrated by countries like Panama and Ecuador, which use the US dollar as their currency. Since they have no influence or control over how US dollars, a foreign currency there, is valued, or is brought into their country, their inflation measurements are nothing but noise-in the sense that there can't be regular pattern to it. Amazingly, they do have inflation measurement departments...where dozens of statisticians and bureaucrats are employed to come up with this data. Link for Panama here and Here for Ecuador. Since they can't do anything if the inflation is high or low, why measure it at all!
In Ecuador, the reported annual cumulative inflation was 3.38% in 2015, and 3.67% in 2014. The geniuses in Ecuador and Panama who are reporting these numbers, massage the data to make it look like a nice number, instead of saying it is statistical noise. They publish this number to keep the banking community and financial guys happy. As long as it is between 0 and 5%, everyone is happy. Data which will make it go beyond these is readily discarded.
Digression 1-As a general comment, I think most people, including Scientists, will make up or polish data to prove what they want to prove-because their jobs, their funding, etc. depends on it. In the end, for most people, it is just a job; and a bit of data jugglery is a part of their job, just as it is for people who work in Sales and Marketing-who will make up data to sell their products. Not more than 5% will publish the data as it is, and agree that it might just be noise (and this is in all walks of life, not just Economics, Medicine and Global Warming; subjects I have covered in this blog to show you how a lot of what you see is noise disguised or polished as data).
Digression 2-As I grow older, I realize that a lot of data we have around is is just noise, and a large amount of foolishness of humanity is to confuse this random data as relevant. This is how stuff like the existence of God and astrology was born. Even though Science has advanced greatly in the times since we invented the idea of God and planetary movement affecting our daily lives, I still find that a lot of humanity still confuses noise with data. Wherever people see patterns, I generally see noise. And as Nassim Taleb said so well in one of his books-good data shouts at you, you don't need to look for it or justify it by long arguments.
There are a lot of holes in the basket measurement of inflation. Any number which is less than 5% and is quoted as inflation is but noise-and they are careful to hide the noise by not publishing the standard deviation of data.
Other holes in the measurement of inflation: a) they invented something called "core inflation" to remove the volatile parts of the inflation basket, food and energy. A real statistician never discards any data, here it is being discarded on purpose to remove the deviations and noise in the data, to make the inflation numbers "smooth" and b) a small change in the composition of the inflation basket will lead to an entirely different number for inflation. If the real value of money was being measured, a change in just the composition of the inflation basket should make no difference.
Inflation measurements which are increasing steadily at say 2 or 4% per year are in reality a clever way of defrauding the persons who borrow-who almost always see their interest payment go up with time, because they measure the index in a peculiar way to make it increase slightly almost every year. The noise of the measurements is removed carefully to always come up with a slightly positive number between 0% and 5%, to give the banks a license to increase interest payments on the borrowers. Or rent payments, which are also adjusted to inflation in most big cities. The inflation data publishers meet the needs of the market well-the massage the data to come up with a number of between 0 and 5%, and get to keep their jobs. But the real value of all this data is zero, for the reasons mentioned above.
Inflation feedback loops
Here's what Smith said about increase of paper money possibly causing inflation (which seemed to be a theory in 1760 as much as it now!) in Book 2 of the Wealth of Nations, chapter on "Money Considered as a particular Branch of the General Stock of the Society"
"The increase of paper money, it has been said, by augmenting the quantity, and consequently diminishing the value of the whole currency, necessarily augments the money price of commodities. But as the quantity of gold and silver, which is taken from the currency, is always equal to the quantity of paper which is added to it, paper money does not necessarily increase the quantity of the whole currency. From the beginning of the last century to the present time, provisions never were cheaper in Scotland than in 1759, though, from the circulation of ten and five shilling bank notes, there was then more paper money in the country than at present. The proportion between the price of provisions in Scotland and that in England is the same now as before the great multiplication of banking companies in Scotland. Corn is, upon most occasions, fully as cheap in England as in France; though there is a great deal of paper money in England, and scarce any in France. In 1751 and in 1752, when Mr. Hume published his Political Discourses,*36 and soon after the great multiplication of paper money in Scotland, there was a very sensible rise in the price of provisions, owing, probably, to the badness of the seasons, and not to the multiplication of paper money."
Related post: Central banks have no influence in jobs creation, unemployment or real interest rates. Here's the post explaining this.