Poor Comparison

27th May, 2006

The Undercover Economist – FT Magazine 27 May

If you’re lucky enough to visit the spectacular Kunsthistorisches Museum in Vienna, your eye may be caught by one of Pieter Bruegel’s best known works, the “Peasant Wedding”, which depicts a feast table of peasants absorbed in eating and drinking while a vast stretcher of pies is carried past.

It seems that the lives of our 16th-century forebears were not always cripplingly harsh. Economists, being economists, wish to know just how poor or prosperous life used to be. We have historical information about how much money people earned, but that is no use unless we know how much things used to cost. So economists calculate the inflation rate, which is an attempt to adjust for the effect of increasing prices.

But which increasing prices? Flipping through the Montgomery Ward & Co mail-order catalogue, which began publication in 1893, the economic historian Bradford DeLong calculates that a simple bicycle cost 260 hours’ wages for the typical worker in 1895, and just 7.2 hours’ wages in 2000. But silver spoons cost more hours of labour today than in 1895. Your personal inflation rate depends on whether you are spending your money on bicycles or spoons.

The official inflation rate tries to compare the price of a typical bundle of goods today with the past equivalent. But we do not consume the same goods as we used to. How many Walkmans in an iPod? The question has no sensible answer, but an answer, nevertheless, is codified in the official inflation rate. You can be forgiven for thinking this is an irrelevant intellectual game, but you will not be thinking that if your pension or salary is linked to the inflation rate.

In recent years, received wisdom among economists has been that the inflation rate has been overstated because of unmeasured improvements in quality. Home computers have become much better, and failure to fully adjust for the quality improvements would overestimate the inflation rate and underestimate how much better off we are. A highly influential paper by the economist William Nordhaus made the point forcefully. He studied, not commodities like bicycles or spoons, but a service: light. By tracking technology from campfires to oil lamps to energy-saving lightbulbs, he estimated that the real price of light had fallen 10,000-fold in 100 years. Partly because of Nordhaus’s work, many economists believe that the official statistics on wages underestimate how much richer we have become.

Light and computers are getting better at a rate unmeasured by inflation figures, but perhaps those figures err on the other side for other products. The economic historian Robert Gordon thinks so, particularly for clothes and housing. Women’s clothes command high prices at the start of each season, before finishing the season in the bargain bin and being replaced by new fashions, once more at high prices. It would be easy for an analyst to mistake that pattern for a year-in, year-out dramatic fall in the price of women’s clothes. My wife testifies that they are not as cheap as I seem to think.

Many economists still think inflation is overestimated and that we have been getting richer faster than the official statistics show. But Gordon must have a point: if we have been getting rich that quickly, then our ancestors were impossibly poor. If the recent estimates of price bias are projected backwards, Bruegel’s peasant household would have had an income of ₤3 a year and been able to afford less than an ounce of potatoes a day in 1568. That would have made for a different picture.

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