Precise inflation figures ignore evolutions in product quality and consumer choice

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Nathan Rothschild was the richest man in the world when he died in 1836. A list compiled by Forbes magazine, ranks him as the second richest man who ever lived – ahead of John D Rockefeller, and way ahead of Mexican telecoms mogul Carlos Slim and Bill Gates of Microsoft. (The richest was a Roman general who was the power behind Julius Caesar’s throne.) The figures used by Forbes are, of course, adjusted for inflation.

But what does “adjusted for inflation” mean? Rothschild died of septicaemia following an abscess, and in spite of buying the best medical attention available in Europe at the time. He had never been in a car, a train or an aircraft, nor visited the Taj Mahal, heard recorded music, seen a film, made a phone call or used electric light. Nor (despite the legends about the killing he made from inside information) could he have heard about the outcome of Waterloo until many hours after the battle was won. And he was dead at the age of 58 from an illness that could today be cured by an antibiotic costing a few pence.

Was Rothschild really the second richest man in history? Was he, in fact, richer than me? True, he could hire a fleet of carriages and eat off gold plate; but I would happily trade both for still being alive , and I suspect that Rothschild would have felt the same.

The question is prompted by a considerably more mundane event. Inflation in the eurozone has fallen to 0.3 per cent, arousing concerns that there might actually be deflation in the months ahead – and that Eurostat, Europe’s statistics agency, will soon declare that prices in Europe are lower than a year earlier.

That worry is premised on the existence of a qualitative difference between inflation – that is, prices rising, even if slowly; and deflation – prices falling, however swiftly. It is also premised on an assumption that deflation is undesirable and that the goal should be gently rising prices; and on the belief that we are able to tell which state we are in.

Contemplation of the antibiotics not available in 1836 casts doubt on all these premises. It is generally accepted medical costs rise faster than general inflation – and in the US, where they represent more than 20 per cent of consumer spending, they have contributed significantly to that general inflation. But medicine has become better – quite a lot better, even if too late for Rothschild.

Price indices are compiled by measuring the changes in the cost of buying a fixed bundle of goods chosen to represent the consumption of an average household. But what the average household buys changes with the arrival of new goods; and with changes in relative prices; as well as with variations – good and bad – in quality. Antibiotics replace leeches, carriages become more expensive, computers become more powerful, and the service from a call-centre deteriorates. That is how modern economies evolve and grow.

But price indices are ill equipped to cope with these changes. The bundle of goods Rothschild bought in his day might now be prohibitively expensive, even for him – the carriages, the plate – and is certainly very different from the bundle of goods Mr Gates would want to buy. The difference in consumption patterns of an average household is more dramatic still.

There are techniques for measuring and incorporating quality improvements, which are used for many consumer goods – but in the case of medicine, it is the amount of attention received that has increased rather than the price of treatments.

Overall, there are probably more upward than downward biases in the way inflation is calculated. But to claim that we know that prices have risen by 0.3 per cent in the past year implies a degree of precision in our estimates to which we cannot lay claim nor realistically aspire.

 

This article was first published in the Financial Times on November 5th, 2014.

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