Han Dieperink: The illusion of inflation
This column was originally written in Dutch. This is an English translation.
Official inflation figures measure what is becoming more expensive, but fail to take into account what is improving. Anyone who takes an honest look at the long history of prosperity will see not net inflation, but net deflation: for the same amount of money, or even less, people are getting more and more. This insight is almost entirely absent from the public debate.
By Han Dieperink, written in a personal capacity
A medieval lord in a stone castle, with damp walls and draughty corridors, was regarded in his day as the height of luxury. In winter, he shivered by an open fire that sent half the heat up the chimney. He ate game and porridge, drank water that was often contaminated, and died, on average, well before the age of fifty. His library contained perhaps a hundred handwritten books, an unaffordable luxury. Pain was treated with herbs and prayer. A journey from Amsterdam to Paris took several days and was a dangerous adventure.
Nowadays, the average resident of a terraced house in Amersfoort or Breda is better off. Central heating keeps every room at exactly the desired temperature. The fridge contains produce from all corners of the globe: mangoes in January, Norwegian salmon on Wednesdays, Italian olive oil all year round. A doctor can be reached within fifteen minutes and prescribes medicines that cure illnesses that used to be fatal. On a screen the size of a hand, he carries the entire body of human knowledge with him: millions of books, scientific articles, music from every century, maps of every place on earth. Paris is only a few hours’ journey away. The lord of the castle had sacrificed his entire fortune for all these privileges, and yet he could not have bought them, for they did not yet exist.
What the price index does not measure
Statistics Netherlands, Eurostat and the US Bureau of Labour Statistics measure inflation by comparing a fixed basket of goods and services year on year. This is methodologically understandable, but it produces a fundamentally distorted picture. The price index measures only what has become more expensive, not what has improved. A smartphone that cost 800 euros last year and 820 euros this year counts as inflation. But if that smartphone now processes data four times faster, takes photos three times better and has gained ten new features, then there is deflation per unit of performance. The consumer gets more for their money, but the statistics record the opposite. Whereas people used to have to pay one euro to send a letter, nowadays they can send thousands of emails for free.
Economists call this the quality adjustment problem. Hedonic price indices attempt to take this into account. The Bureau of Labour Statistics partially adjusts the prices of computers and televisions for quality improvements, but the application is limited and inconsistent. For most product categories, and certainly for the most significant gains in prosperity of recent decades, no such adjustment is made. How much is free access to Wikipedia worth? How much does it cost to be able to listen to all the music ever recorded for ten euros a month? How much is a sat-nav worth that used to be available only to the wealthiest motorists? None of these amenities are reflected, or hardly at all, in the inflation measure, simply because they are largely free or because the price has fallen dramatically.
The technological deflation machine
Moore’s Law – the doubling of computing power per chip every two years – has unleashed an unprecedented deflationary force over the past fifty years. Computing power that in 1970 required an entire university computing centre now fits into a watch. The price per calculation has fallen by a factor of billions. The same applies to data storage, communications, DNA sequencing and solar energy. In all these sectors, the real price per unit of useful output has fallen by tens of per cent annually, a deflationary rate that no official index records, because prices are measured in nominal euros per product rather than in euros per unit of value.
Take healthcare. In 1960, an appendectomy cost roughly the same as it does today, adjusted for general price inflation. But in 1960, the risk of a fatal complication was considerably higher, recovery took weeks, and there was no anaesthesiology to make the procedure virtually painless. The price has remained the same, but the quality has risen dramatically. Measured per unit of survival probability or per day of recovery, medical care has become cheaper, not more expensive. The same applies to aviation, food, clothing and cars. In almost every sector, the price is rising less quickly than the quality. And there is much more to come; we have only just begun the chapter on artificial intelligence.
Information as the greatest free lunch
MIT economist Erik Brynjolfsson has calculated that consumers derive thousands of euros in consumer surplus annually from free digital services that do not appear in the gross domestic product. Facebook, Google Maps, YouTube, WhatsApp. These are formally free, and therefore statistically invisible. Yet they represent enormous economic value. A medieval merchant would have paid a fortune for reliable maps of Europe; we use more detailed navigation for free. The Library of Alexandria was considered one of civilisation’s greatest treasures; today’s smartphone user has access to an archive of information that surpasses every library in history a thousandfold.
This is the crux of what is wrong with the way we measure prosperity. Gross domestic product counts what is paid for, but not what is enjoyed. Inflation measures what becomes more expensive, not what becomes worse. And because prosperity increasingly consists of quality improvements and digital abundance rather than more physical goods, the gap between the statistics and reality widens with every decade.
The political economy of inflation figures
There is a reason why governments and central banks do not thoroughly reform inflation figures. Higher measured inflation justifies higher wages, higher benefits, higher pensions and higher interest payments on index-linked government bonds. An inflation measurement that fully accounted for quality improvements would likely yield a structurally lower, and if applied fairly perhaps even negative, inflation figure. Deflation instead of inflation. That would be politically unacceptable. Not because it would be incorrect, but because the entire architecture of social security, collective labour agreements and budgetary policy is built on the existing methods. A little inflation is seen as a lubricant.
At the same time, there is a psychological mechanism that distorts public perception. People notice that bread has become more expensive; that is concrete and painful. But they do not notice that the smartphone they buy for the same price is five times as powerful as it was five years ago, or that a flight ticket to Barcelona is cheaper in real terms than it was ten years ago. Gains in purchasing power are taken for granted, whilst price rises are felt as an injustice. Human psychology is asymmetrical, and that asymmetry colours the entire inflation debate.
Conclusion: a fairer compass
That does not mean that inflation is a fiction. The price rises in recent years for energy, rent and food were real and hit vulnerable households hard. The monetary and fiscal policies that contributed to that inflation therefore deserve critical analysis, as Harry Geels argues in his column of this week. But the debate on inflation is incomplete as long as it looks back solely at what has become more expensive, without doing justice to what has become better and cheaper.
In the long term, the direction of real purchasing power is unambiguous. The occupant of the terraced house in Amersfoort lives more comfortably, more healthily, with greater access to information and more safely than the wealthiest monarchs in history. That is the great achievement of capitalism, technology and trade, which official statistics systematically undervalue. A fairer purchasing power index would not only measure what has become more expensive, but also recognise what the economy gives us for free or at a lower cost year after year. Only then will we see the true direction of prosperity, which, in the long term, undeniably points downwards in price and upwards in value.