Tiny Inflation Calculation Methodology Changes Are Going to Result in Billions of Dollars in Wealth Transfers

Politicians, central bankers, and academics around the world are engaging in a conversation that could have massive real-world consequences for both middle class families and retirees; conversations that could result in substantially higher taxes, and/or substantially reduced benefits for entitlement programs such as Social Security, depending upon how the matter is resolved.  The average American is not paying attention to this at all.  It matters.  This is a technical debate that will transfer huge amounts of wealth from various stakeholders depending upon who prevails.

It’s so important that I want you to understand it.  As a result, I’m going to try to streamline and simplify the heart of what is happening so that anyone, regardless of his or her background, gets it even if they have no exposure to economics.  To achieve that, we’re going to engage in a short exercise.

First, I’m going to have you watch four short videos from the history of this blog – those of you who have been around since the beginning should recognize them all (and, depending on how my schedule looks, you may see some of them come back from the private archives as part of the special project I’m working on for you) – and then we’re going to talk about why they matter.  For this to work properly, when you encounter each video, you must remember to adjust the quality of the video to the maximum setting by clicking the gear in the lower right corner (if on a desktop or notebook), switching to the highest resolution possible.  Ideally, you should watch on something with a Retina-quality screen, such as an iMac, iPad Pro, or MacBook Pro for the full effect.

Then, we’re going to discuss how what you just saw is related to something as arcane as inflation calculations.

Ready?  Let’s get started.

Video I – July 2010

This video was recorded on July 14, 2010.  It was taken down during the Great Purge I from a time when I’d post short clips for Aunt Donna about what I was doing during the day – in this case, I couldn’t make myself work so I was practicing chord runs and memorization of the old standard Summertime.  This from around a period when I’d put up videos of our little niece singing Sponge Bob Square Pants or watching Disney movies and baking pink cakes and cookies, which she loved; talk to you about the meetings we had at our sporting goods company or show you random clips of video games we were playing.  I re-uploaded it to YouTube so it is in the same format as the other videos.

Look at the quality.  It’s almost non-recognizable, especially in full screen on a high resolution monitor.  Of course better recording devices were available then, but that’s besides the point of what we are going to discuss, as you’ll discover later.

Video II – May 2011

Less than a year later, on May 12, 2011, Aaron and I were in New York City on a business trip.  We woke up one morning and wandered into a Bosendorfer piano store.  We were testing the different instruments and he sat down to an Imperial model where he started to play Erik Satie’s Gnossienne No. 4 (we were going through a Satie phase at that time).  Already, there is a massive improvement in video quality thanks to the new iPhones we were using.

Video III – February 2015

Go forward a few more years and you get to 2015.  This video, taken during that time, was on Captiva Island after our friends invited us down for a week to celebrate their wedding.  Again, it was the newest iPhone, which we had in our pockets and took out to film.  No special equipment, just a plain vanilla, upper-end consumer device.  The leap in quality is becoming so substantial you’re starting to get a feel for actually being there, not just watching old footage.  There is still room for improvement, though.

Video IV – October 2018

Finally, we get to the last video, the Corona del Mar State Beach clip I uploaded last year, in October 2018, filmed on an iPhone X.  Viewed in its highest resolution, on a Retina screen in full screen mode, it’s extraordinarily clear.  The advance in technology in less than a decade is truly a wonder to behold.  It will change the way information is archived and how future generations think about, and interact with, the past.

Why This Matters to a Policy Debate on Economics and Taxation

There is a strong argument being advanced right now that the way inflation is calculated does not adequately include all relevant and important information, making it a far less useful metric than it should be.  (In some ways this is similar to the argument that GDP is severely flawed because it doesn’t account for, say, the moral and spiritual value of cutting down a 100+ year old Redwood tree and turning it into firewood despite this action temporarily increasing the national economy.  It’s an attempt to figure out what we should be measuring – which is improvements in the way humans live.)  Namely, this argument states that technological gains mean that the real cost of many actual goods and services are collapsing, even if the nominal prices increase, and that fact should be incorporated in inflation calculations.

For example, if you have an iPhone in your hand and it doubles in processing power yet increases in price by 10% over the previous model, costs have dropped despite the fact the nominal price itself increased.  You aren’t buying an iPhone.  You’re buying processing power, memory, camera quality, audio quality, etc.  Those things just happen to be packaged in the form of an iPhone.  Similarly, and to use another example I’ve seen, when something like Google Translate comes along, prior to accessing it for free on the Internet, you would have had to pay someone to translate a passage for you, often quite a bit of money relative to the time involved, whereas now your expense for the service is essentially nil.  (I’m guessing that at least a few of you right now are recalling the events back in 2011 when the New York Federal Reserve President William Dudley ignited a firestorm of controversy when he, being an economist, told a group of people in the midst of the worst recession since the Great Depression that their cost of living was dropping dramatically, using the example that the then-newly-released iPad 2 had twice as much computing power as the iPad 1 yet cost the same.)

You can come up with many, many examples … the development of energy efficient light bulbs means that the real cost of generating a given amount of light is falling off a cliff even if the price of the light bulb itself quadruples.  Farm equipment, coffee makers, automobiles … think of the sheer productivity and/or human happiness gains that could be achieved if cars truly could drive themselves and former drivers could spend their commute reading, sleeping, or working.  If the net productivity increase of an item exceeds its increase in nominal price, you can’t simply look at the price itself as a proxy for inflation.  It’s not.

If this view prevails – and I can’t argue with the accuracy of it because it is true – it could have massive ripple effects in ways most Americans do not understand.  Consider things like Social Security cost of living adjustments.  They are almost assuredly going to be lower than they otherwise would have been provided society is experiencing real standard of living improvements due to technological innovation; something that should be borderline axiomatic.  Think about debt instruments or contracts that reference a broad inflation metric.  Those will get pulled in, too, and have second and third order effects.

As a civilization, we’ve used this sort of maneuver in the past.  Think about the Advisory Commission to Study the Consumer Price Index, also known as the Boskin Commission, which was convened in the 1990s.  The commission found four possible biases in the way inflation was calculated.  As summed up over at Wikipedia, these were:

• Substitution bias – Which occurs because a fixed market basket fails to reflect the fact that consumers substitute relatively less for more expensive goods when relative prices change.
• Outlet substitution bias – Which occurs when shifts to lower price outlets are not properly handled.
• Quality change bias – Which occurs when improvements in the quality of products, such as greater energy efficiency or less need for repair, are measured inaccurately or not at all.
• New product bias – Which occurs when new products are not introduced in the market basket, or included only with a long lag.

Substitution bias was, and to some degree, is, relatively controversial.  In effect, it argues that if the price of beef is rising too quickly, people will simply eat less beef and substitute chicken, therefore inflation doesn’t need to be measured as having increased as rapidly as it otherwise would under a basket that looked solely at the price of beef.  Frankly, I think there is far less intellectual justification for that change than the technological productivity argument.  If you love steak and steak becomes too expensive to enjoy, substituting chicken makes your life less enjoyable.  If you love coffee and coffee prices rise to the point that you can’t afford the beans, swapping your preferred beverage for tea is not as satisfying to you.  In both cases, inflation occurred.  To say it didn’t is to deny reality.

When all was said and done, the Boskin Commission findings effectively led to a reduction in Social Security cost of living adjustments.  You can read the commission’s findings at the earlier link.

The Republicans in Congress Screwed with the Inflation Calculation to Increase Taxes on the Poor and Middle Class

Another example of a massive shift in wealth occurring due to a change in inflation calculation methodology happened recently when Republicans in Congress shoved through changes to the tax code.  These changes included modifications to the role of inflation in the tax system in such a way that, when all is said and done, the poor and middle classes are going to be subject to significant tax increases down the line, those net savings going into the pocket of the upper class.  This trick was achieved in two ways:

1. Tax brackets were expressed as fixed dollars subject to an inflation adjustment; and
2. The inflation methodology employed to make that adjustment was modified from the old standard, known as “CPI-U” (which stands for Consumer Price Index – Urban) to a different inflation calculation methodology known as “chained CPI”.  Related to what we were just discussing, chained CPI methodology results in inflation rising more slowly because the inflation rate is revised downward under the assumption consumers substitute different goods if a specific good becomes too expensive.

The net effect: According to the Congressional Joint Committee on Taxation, this accounting slight-of-hand will result in taxpayers being hit with an additional $133.5 billion in taxes over the next 120 months, with lower and middle income households suffering a larger portion of that as a percentage of discretionary income.

You can read more about this concept here and here.

Why All of This Matters

Small, technical matters can have disproportionate ramifications for a nation.  They can also help or harm your family’s pocketbook.  As the ratio of workers-to-retirees continues to collapse, and entitlement promises become increasingly unaffordable, I think you’re going to see a lot of tinkering with accounting methodologies, including inflation calculation calculation methodologies, with the net effect being that they strip away purchasing power, essentially lowering the real value of promises that were made.  On the far left, I think you’re going to see a push for severely regressive taxation in the form of uncapped payroll taxes (which harm self-employed entrepreneurs especially, giving large corporations and advantage).  I think one of the compromises you’ll see is an increase in the retirement age.

Some Additional Thoughts on Inflation Rate Estimates

When thinking about inflation, I am of the opinion that a single headline figure is only useful up to a certain point.  The Boskin Commission pointed out, for example, that different households are going to consume different baskets of goods and services; e.g., retirees are going to use a different basket of goods on average (more prescription medicines and travel, less education) than young people (more education and technology, less prescription medicines).  If the costs of prescriptions are skyrocketing, senior citizens are going to be experiencing real-world, on-the-ground inflation far in excess of whatever the baseline CPI is. The solution could be creating and implementing in some meaningful way a metric such as a CPI for Senior Citizens, such as the CPI-E.  Additionally, I feel like it can sometimes be useful to estimate the amount of time it would take a person to pay for a good or service at the median wage on an after-tax basis.