Inflation illiteracy

Writing for the Wall Street Journal, Brett Arends argues that the current Consumer Price Index (CPI) understates the true rate of inflation, a conclusion that would have a significant impact on policies such as Social Security Cost of Living Adjustments, as well as on our views of the economy as a whole. Arends's argument runs counter to that of most economists, which is that the current CPI tends to overstate the true rate of inflation.

While Arends's whole article is worth reading (though not accepting at face value), one example Arends gives struck me as worth considering. It deals with so-called "hedonic pricing," which is a way of ascribing price changes to items whose prices haven't actually changed. Arends calls this method "chicanery," saying:

Consider the case of Apple computers. We all know Macs are expensive. And we know Apple doesn't discount. The cheapest Mac laptop today costs $999. A few years ago, it also cost $999. So the price is the same, right?

Ha. Not according Uncle Sam. Using a piece of chicanery called "hedonics," Uncle Sam calls this a price cut. His reasoning? You're getting more for the money. Today's $999 Mac is lighter, fancier and faster than last year's $999 Mac. So the government calculates that the "real" price has actually fallen.

How's that work in the real world? Try it. Go into your local Apple store and ask for 50% off thanks to hedonics. (If you do, please, please video the exchange and put in YouTube. We could all use a good laugh.)

Well, let's consider a different example: imagine that you have a Mac that's three years old, but unused and still in its original packaging—in other words, a brand-new Mac that just happens to use outdated technology. Do you think you're going to get $999 for it? Of course not, since for that same price you can get a truly new Mac that's much better on nearly every front.

Stretching things further, imagine the price that the old-new Mac might fetch. Let's just say that it's $800 (I think this is pretty generous, but we're just illustrating here). If so, then that means that the true rate of "inflation" on Macs over three years has actually been around negative 20 percent—you can buy the same computer today for $800 that would have cost you $999 three years ago.

I actually have several computers in my attic that I don't even bother trying to sell, since I figure that almost no one would want to buy them. They're no more than 3-4 years old and were decent enough at the time, but technology has moved so quickly and prices fallen so far that it's hard to see what anyone would use them for.

Actually measuring the effects of quality changes is hard and I can't say for sure that the Bureau of Labor Statistics is getting everything right. But if you consider a) how much we spend on technology, and b) how quickly prices drop for older technologies, you get a feel for how strong the negative inflationary forces may be.