Why it's so hard to measure inflation.

The economic mysteries of daily life.
May 27 2006 8:10 AM

The $10,000 Light Bulb …

Or, why it's so hard to measure inflation.

If you are lucky enough to visit the spectacular Kunsthistorisches Museum in Vienna, Austria, your eye may be caught by one of Pieter Bruegel's most famous works, "Peasant Wedding." The painting depicts a feast table packed with peasants fully absorbed with the task of eating and drinking while a vast stretcher of tempting 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 how prosperous life used to be. We do 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 something called the inflation rate, which is an attempt to adjust for the effect of increasing prices.

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But which increasing prices? Flipping through the Montgomery Ward mail-order catalog, which began publication in 1872 *, economic historian J. 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 actually cost more hours of labor 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 that of a typical bundle of goods in the past. But we do not consume the same goods today as we did in the past. 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 that this is an irrelevant intellectual game. You will not, of course, 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 not only become cheaper but dramatically better, and failure to fully adjust for the quality improvements would overestimate the inflation rate and underestimate how much better off we are compared with previous generations.

A highly influential paper by Yale economist William Nordhaus made the point forcefully. He studied not commodities like bicycles or spoons but a service: light. By tracking lighting technology from campfires to oil lamps to today's energy-saving light bulbs, he estimated that the real price of light had fallen 10,000-fold in 100 years. Partly because of Nordhaus' 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 different products. Economic historian Robert Gordon thinks that the focus on high-tech goods has distracted attention from two very important products for which inflation is higher than the official figures show. Women's clothes, for example, command high prices at the beginning of every 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 a statistical analysis 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. Gordon, a little more scientifically, used detailed listings from catalogs to measure both price and quality of clothes.

Many economists still think that inflation is overestimated and we have therefore 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. Gordon calculated that if the recent estimates of price bias are projected backward, Bruegel's peasant household would have had an income of less than $6 a year and been able to afford less than an ounce of potatoes a day back in 1569. That would have made for a different picture.

The Undercover Economist appears on Saturdays in the Financial Times Magazine.

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