Friday, February 04, 2011

Inflation and the Hedonic Factor

Our CPA sent me a link to a Wall Street Journal article: Why You Can't Trust the Inflation Numbers by Brett Arends.

In general, I absolutely agree with Arends: "In the past 12 months the Consumer Price Index has risen just 1.5%—a remarkably low rate"--a statistic that Arends says (and I agree) "should be taken with a fistful of salt."
Over the past 30 years, the federal government has made a lot of changes to the way it calculates inflation. It's taken place under presidents of both parties. Each change in methodology has come with plausible-sounding justifications. But, as if by magic, each change has had the effect of flatte[n]ing the numbers. Funny, that. . . .

According to [economist John] Williams [of Shadow Government Statistics], if we counted inflation under the old system the official rate wouldn't be 1.5%. It would be closer to 10%.
And again, I agree with him.

I agree with him that the government economists engage in horrendous chicanery when--like Arends alleges--"if steak prices boom, the government just assumes you buy cheaper hamburger instead. Presto--no inflation!"

On the other hand, it was "funny" that, just a couple of days before I saw the link from my CPA, I happened to see an article by economist Gary North who, without specifying the article to which our CPA directed me, referenced the article . . . critically.

What is interesting--and I said this to our CPA--Gary North was the first person I ever read--way back in the early '80s--who was screaming bloody murder about the government's spendthrift ways and how it was going to destroy the dollar, wipe out Social Security, and send us into hyperinflation.

Yet North, last week, wrote an article that severely criticized Arends' article, especially Arends' comment about hedonics.

Arends wrote,
Or 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.)

Instead, the government is worrying about deflation, partly because of all the "cheap" MacBooks out there.
In his semi-weekly newsletter Reality Check, North replies,
My daughter owns a 2005 Mac. It is slow. It is barely functional. So, I bought her a new PC for Christmas. It cost $500. It is vastly more powerful than the 2005 Mac. But so is the 2011 Mac. The Mac Air is a dream machine.

Mr. Arends' version of rhetoric is to ask us to try to get a discount Mac -- today's Mac -- based on hedonics. But you can surely get a discount on a 2005 Mac. My daughter will sell you hers for only $800. And if you are dumb enough to pay that much, I will put your story on YouTube, as he suggested.

Here is my challenge to Mr. Arends. I challenge him to find a YouTube video posted in January 2005 describing the 2005 Mac.

Problem: there was no YouTube in January 2005. The site did not exist.
And North uses that last reference--to YouTube--to make some rather mind-bending observations about the entire concept of hedonics.

I thought they were worth passing along.

Here North maintains integrity by arguing against one of the points people of his persuasion often use as one of their strongest pieces of evidence for their position.

North hasn't abandoned his conviction that the dollar is heading toward the incinerator. But he wants to make sure that the arguments he and others of his persuasion use are valid. And so he writes:
[I]n the world of Brett Arends, YouTube would not be in the hedonics formula. After all, YouTube is free today. It was free in January 2005, since it did not exist. Conclusion: there has been no economic change. After all, zero is zero. Right? We should compare numerators with numerators. Forget about denominators: the products. They are irrelevant. Price is all that matters.
That last sentence actually went on for a colon and one more word. The full sentence reads, "Price is all that matters: numerators." I cut that last word out of my quote because North had previously explained his meaning, and I have not.

So let me go back several paragraphs in North's email to explain the point. He writes:
Let's say that you were hired by the Bureau of Labor Statistics to compare encyclopedias at the end of 2000 with those at the end of 2010. You are asked to calculate the cost of information. You go to the "Encyclopedia Britannica" in 2000. There were about 15,000 articles. Do you calculate cost per article? Go ahead. Put 15,000 as the denominator. Do you calculate Wikipedia's cost per article with a denominator of 3.5 million or 17 million? Remember, there is translation software that did not exist in 2000. Is a translated article worth (say) 70% of an English language article? Or maybe only three-fifths? It does not really matter. The numerator is zero.

It will be zero next year and the year after. Then what? How should you calculate the price effects of (say) 7 million English-language articles with 3.5 million, when they all cost zero? This is not a trick question. It is a real-world question.

If the numerator is zero today, and it will be zero in ten years, but the supply doubles, is that relevant? Of course it's relevant. You get twice as much for free. I reply that the price has not fallen. It is still zero.

"But," you reply, "we have to do something with that doubled supply. We can't just pretend there has been no change. More is better than less, right?"

So, you propose a modification of the formula. You insist that there has to be an implicit price adjustment based on doubled output. The price per article remains the same -- zero -- but there has to be an implicit reduction of price. Otherwise, the public will be misled. People will think that things have not gotten better, when in fact things are twice as good. Well, not really twice as good. The next 3.5 million articles will be on less important topics. There is a declining rate of return. Economists say that the marginal value of each additional article falls.

Now what should you do? Things are obviously better by 3.5 million articles. But how can we estimate how much better? There is no theoretically valid answer. We cannot come up with a formula that estimates the collective value of those extra 3.5 million English-language articles. We cannot scientifically measure the subjective valuation of any reader, let alone all readers. That newly posted article on your brilliant career may not be worth much to the rest of us, but you will surely be ecstatic -- if it's nice. You will be outraged if it isn't. How do we measure the marginal value of that article? We can't.

Yet we have to say something relevant. After all, 7 million articles are better than 3.5 million. We just do not know how much better.

So, you will have to fake it. You have to do something that reflects the newer, better state of affairs. Even if you use some simplistic formula -- "articles cost half as much apiece" -- meaning half of zero, this still conveys a more accurate picture than if you say that nothing has changed: zero is still zero.

Do you agree so far?


There is such a formula. The Bureau of Labor Statistics applies it. The rest of us really don't know how it works. Face it: we don't know much about how anything works.

The important thing is this: the formula does not change. We can see the trend, even though we cannot be sure if the formula is accurate. The fact is, no formula is accurate. But a formula that acknowledges that 7 million at zero price is better than 3.5 million at zero price is better than a formula that doesn't.

A hedonics formula says that improvements in quality count for something. Yes, we can always reply: "Count for how much?" The statistician replies, "I don't really know, but something." He is correct. If there is no implicit deflationary formula that reflects the fact that we are getting more than before at zero monetary price, then we cannot begin to understand economic history.
North concludes his article like this, and I will do the same here:
To get some idea of what Mr. Arends is ignoring, read my article on Moore's law and the other parallel laws that are transforming our world. Output in the realm of silicon and fiber optics is now doubling every 12 to 24 months in two dozen fields. This is transforming our world as never before.

These changes will create a new world -- hopefully brave, but unquestionably new. The BLS is trying to deal with this statistically. If it did not, it would be ignoring the most important development in the last 4,000 years.

Let's [hear] it for hedonics! More free Wiki articles, more free YouTube videos, more free articles, more free books in's Literature section. At zero price, I want more, more, more. I am not insatiable -- my time has value -- but I want lots of producers trying to meet my demand. Give it a shot, guys! See if I overload.
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