How much can we trust the price indices (e.g. CPI)?

November 5th, 2007

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The measurement of the general price level is a very important statistical measurement in economics. Statisticians have reduced all the various prices of various goods and services in the economy into an index number (e.g. CPI). This number in turn is used by central bankers to determine the level of price inflation, which in turn influences monetary policy. This in turn has a great effect on the economy. This number is also used in various economic calculations, from the amount of money in a pension cheque to determining real economic growth.

But this idea of price index is flawed and is easily subject to manipulations. You can be sure that if manipulations can be done, then it will be done to satisfy some other vested interests.

First, the definition of inflation by mainstream economists’ is flawed. As we said before in Cause of inflation: Shanghai bubble case study,

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money [and credit], in which the effect is the rise in the general level of prices. For the sake of discussion, let us call the mainstream definition as ?price inflation? and the Austrian School?s definition as ?monetary inflation.?

In other words, the Austrian School‘s definition of inflation implies the debasement of fiat money, which is a monetary phenomena (unlike the mainstream economics’ view of inflation being either cost-pushed or demand-pulled).

Now, if the mainstream economics’ definition of inflation is flawed, then the whole idea of the price index is flawed too. Therefore, no matter how much ?enhancement? that statisticians and economists can think of to improve the ?accuracy? of the price index, it is an exercise of futility. As Ludwig Von Mises wrote in Section 4, Chapter 12 (Stabilization) of Human Action: A Treatise on Economics,

The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred. In periods of slow alterations in the relation between the supply of and the demand for money they do not convey any information at all. In periods of inflation and consequently of sharp price changes they provide a rough image of events which every individual experiences in his daily life. A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell. She has little use for computations disregarding changes both in quality and in the amount of goods which she is able or permitted to buy at the prices entering into the computation. If she ?measures? the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less ?scientific? and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

So, what is Ludwig Von Mises’s objections to the price index? At the root of the problem, as Mises said,

All methods suggested for a measurement of the changes in the monetary unit?s purchasing power are more or less unwittingly founded on the illusory image of an eternal and immutable being who determines by the application of an immutable standard the quantity of satisfaction which a unit of money conveys to him.

So, for example, if the CPI (or whatever price index) rises by 4%, does it mean that the value of every dollar has fallen by 3.8% for each and every individual in the economy? This is what the idea of price indices implies. But in reality, every individual has his or her own preferences, desires and values that will result in subjective changes to each dollar’s purchasing power due to inflation.

Therefore, what is the implication of this? As Mises said,

People began to devise methods for working up complexes of commodity units to be contrasted to the monetary unit. Eagerness to find indexes for the measurement of purchasing power silenced all scruples. Both the doubtfulness and the incomparability of the price records employed and the arbitrary character of the procedures used for the computation of averages were disregarded.

So, what are our reservations on the validity of price indices?

  1. Price indices cannot account for the differences in quality of goods and services. In the US, attempts have been made to adjust prices according to the ?changes? in the quality of goods and services. For example, if a 1 Ghz computer costs $1000 this year and a 2 Ghz computer costs $1000 next year, the price of the computer can be said to have fallen (i.e. the price level of computers have fallen). But the problem is, who is the judge and arbiter in deciding how to adjust the price according to changes in quality? Remember, the perception of quality is subjective. A person using a computer mainly for emailing and word-processing will much less appreciate the increase in clock-speed of a computer (from 1 Ghz to 2 Ghz) than a person who uses it for high-powered video editing.
  2. Is there such a thing as the average prices of disparate and distinct goods and services? As the late Professor Murray Rothbard wrote in Man, Economy, and State

    Thus, any concept of average price level involves adding or multiplying quantities of completely different units of goods, such as butter, hats, sugar, etc., and is therefore meaningless and illegitimate. Even pounds of sugar and pounds of butter cannot be added together, because they are two different goods and their valuation is completely different

  3. What is the standard used in deciding the various weightings in a price index? Here, Mises wrote,

    As it is impossible to establish the total amount of money spent at a given fraction of time for consumers? goods, statisticians must rely upon the prices paid for individual commodities. This raises two further problems for which there is no apodictic solution. It becomes necessary to attach to the various commodities coefficients of importance. It would be manifestly wrong to let the prices of various commodities enter into the computation without taking into account the different roles they play in the total system of the individuals? households. But the establishment of such proper weighting is again arbitrary.

  4. Who is the judge and arbiter in deciding how to calculate the price index? Here, Mises continues,

    Secondly, it becomes necessary to compute averages out of the data collected and adjusted. But there exist different methods for the computation of averages. There are the arithmetic, the geometric, the harmonic averages, there is the quasi-average known as the median. Each of them leads to different results. None of them can be recognized as the unique way to attain a logically unassailable answer. The decision in favor of one of these methods of computation is arbitrary.

  5. What is the basis of deciding what is to be included into the basket of goods and services used in the calculation of the price index? Again, this is subjective and arbitrary. The exclusion and inclusion of various goods and services can affect the outcome of the calculation.
    • For example, central bankers see the difference between ?headline? and ?core? (or ?underlying? in Australia) inflations. The latter, which excludes the more volatile food and fuel prices, affects monetary policy. But in reality, which human being in this world does not consume food and fuel? Furthermore, the changes in the prices of goods and services do not occur independently and in isolation from changes in prices of fuel. As we all know, oil is an crucial ingredient of the modern economy. Any change in the price of oil will affect the prices of everything else to different extent and different time lags. Therefore, the concept of ?core? inflation is flawed.
    • Another example: As we said before in Epic, unprecedented inflation, the world is experiencing unprecedented asset price inflation. In Australia, it is the housing price bubble (see The Bubble Economy). Since the Reserve Bank of Australia (RBA) does not have the mandate to prick asset price bubbles, then can we give them such a mandate by merely redefining houses as consumer durable goods and include them in the basket of goods in the price index calculation?
  6. Changes in purchasing power of money affect goods and services differently and to different extent. Here, Mises continues,

    As will be shown later, changes in the purchasing power of money must necessarily affect the prices of different commodities and services at different times and to different extents; they must consequently bring about changes in demand and supply, in production and consumption. The idea implied in the inappropriate term level of prices, as if ?other things being equal?all prices could rise or drop evenly, is untenable. Other things cannot remain equal if the purchasing power of money changes.

    Let’s say the CPI index increases by by 4% but the price of rent increases by 6%, does it imply that something unethical or unjustified has happened to the price of rent?

  7. Changes in the methods of price indices calcuation invalidate economic calculation. If you use the 1970s’ method of calculating CPI and apply it today, you will get a far higher readings of price inflation. The excuse is that today’s method of calculation is far more ?accurate? than in the past. But that would also mean that comparisons of real economic growth between time periods have become invalid. That in turn will derange economic calculations unless there is a way to reapply comprehensively and accurately past price data using today’s method.

Therefore, beware of price indices! It is not as ?scientific? as you think!