by Russ Roberts on October 9, 2006

in Standard of Living

In an earlier post, I wrote about the biases in the CPI. I focused on the difficulties in taking account of quality change and the failure to account for Wal-Mart’s impact on lowering food prices. Therefore inflation was overstated and improvements in standard of living, understated.

One reaction, (from Spencer, who is a reliable skeptic whose skepticism enhances these pages) was that these effects were relatively small potatoes. Food and consumer durables (the example I used of mismeasuring the impact of quality improvements) are too small a proportion of total spending to make up much of a difference. Besides he argued, while quality of consumer durables might have improved, the quality of service had declined.

I’m going to leave the latter point for another discussion. Here, I want to discuss the magnitude of my concerns about quality measurements and the surveys of inflation that miss the role of Wal-Mart and other discounters that make up an increasing portion of the marketplace.

How big are those effects?

So I poked around in the literature on CPI bias. Jerry Hausman at MIT has a nice paper
(this is the NBER version–it was published a year later in the Journal
of Economic Perspectives) that examines the theory behind the different
kinds of biases. Here is his summary of the magnitude of those errors:


Using data from 1972-1994 Costa finds that cumulate CPI  bias
during this period was 38.4% with an annual bias of 1.6% per year.
Hamilton  (2001) also estimates CPI bias to be 1.6% per year during
this period, using a similar  econometric approach on a different data
set. This sizeable estimate of bias demonstrates  how the BLS procedure
over estimates the COLI.  The actual bias would be even greater  if the
effect of new goods bias and quality change bias were included.   A
recent estimate of quality growth by Bils and Klenow (2001) finds a
significant  estimate of quality bias over the period 1980-1996. 66
They estimate that the BLS  understated quality improvement and
overstate inflation by 2.2% per year on products  that constituted over
80% of US spending on consumer durables.  These more aggregate  studies
along with my (and other) micro studies on particular goods demonstrate
that CPI  bias is likely to be substantial.

I should emphasize that these measures of the bias in the CPI are
measured in percentage points per year. The CPI isn’t off by 1.6%. It
is off by 1.6 percentage points a year. So that when measured
inflation is stated to be 3%, it is actualy 1.4%. This is a massive
error that when cumulated over even a short period of time grossly
understates the growth in real income and standards of living.

Robert Gordon at Northwestern comes to a similar conclusion in this paper:

Current upward bias in the CPI is
estimated to have declined from the revised 1.2 to 1.3 percent in the
Boskin era to about 0.8 percent today. Yet the Boskin report, like most
contemporary studies of quality change, failed to place sufficient
value on the value of new products and on increased longevity. Allowing
for these, today’s bias is at least 1.0 percent per year or perhaps
even higher.

David Leonardt has a nice article in the New York Times from a few weeks ago, on Gordon’s view:

A decade ago he served on a government-appointed group known as the
Boskin Commission. It argued, as Mr. Gordon still does, that the
government exaggerated inflation by more than one percentage point
every year.

Some other economists think the skew may be
somewhat smaller, but there’s broad agreement, even at the Bureau of
Labor Statistics, that the Consumer Price Index has its weaknesses.
”Use of the C.P.I. over extended periods of time,” Patrick C.
Jackman, a government economist, told me, ”is much more problematic
than using it over short periods of time.”


By overstating
inflation, the official numbers understate the country’s wealth, since
every meaningful calculation of income subtracts inflation. The Census
Bureau, for instance, says that the median-earning man who works full
time — the one in the dead middle of the earnings ladder — made
slightly less last year than in 1977. It is one of the main numbers
cited by those who say life isn’t much better now than 30 years ago.


Mr. Gordon’s adjustments show that men actually got a 27 percent raise
in this period and women 65 percent. The gains are not as big as those
of the 1950’s and 60’s, but they do sound far more realistic than the
official numbers. Think about it: we live longer than people did in the
1970’s, we’re healthier while alive, we graduate from college in much
greater numbers, we’re surrounded by new gadgets and we live in bigger
houses. Is it really plausible, as some Democrats claim, that the
middle class has made only marginal progress?

Leonhardt concludes by arguing that the Republicans are equally
crazy to argue that the last few years have been good for workers.

Forget Republicans and Democrats. The bottom line is that when
inflation is overstated by at least one percentage point a year at a
time when the overall rate of inflation is under 5%, the numbers are
broken. They are unreliable. They are not good for measuring changes in
standard of living over short periods of time or long periods of time.


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