The past is a foreign country
As you might have read in an English class (at least if you’re old) “The past is a foreign country: they do things differently there.” In particular, they buy things differently.
We often want to compare prices between the present and the past. To compare prices between here and actual foreign countries, we use the exchange rate and find, for example, that the US cost (from Amazon) of Sennheiser CX 3.0 earphones, US$29.99 is equivalent to about NZ$40, or about NZ$46 with tax. We can then straightforwardly say that Harvey Norman is charging 60% more than Amazon for the same item, and force them to make unconvincing excuses. Comparing foreign prices can get complicated if you’re interested in affordability relative to income, or if you’re looking at a country with very restrictive border controls but the existence of two-way trade with many foreign countries means there is a single, well-defined exchange rate.
The equivalent conversion for past prices is an inflation adjustment. If you’re comparing past and current prices without an inflation adjustment you’re not even trying to get the numbers right (with a few very limited exceptions such as bracket creep). There should be an automatic presumption of dodginess for any `nominal’, unadjusted comparison of amounts of money at different times — especially as this is something that’s really easy to get (approximately) right. So, go and fix it now.
I said “approximately right”, and those of you still with me will note that we don’t have extensive two-way trade with the past. Inflation isn’t as simple as an exchange rate.You can’t buy Sennheiser CX 3.0 earphones with 1997 dollars, and even if you could, Amazon would have difficulty shipping them to 1997. Inflation adjustments are more like the Economist‘s Big Mac purchasing-power index. The magazine decrees that Big Macs have the same true value everywhere in the world, and so can estimate the relative value of different currencies. That’s not ideal when comparing countries, and it’s even harder when comparing with the past.
Economists and official statistics agencies make up ‘baskets’ of items and decree these to have the same value over time, carefully making sure that the items are defined narrowly enough for ‘the same value’ to be reasonable, and broadly enough that you can still find ‘the same item’ a year later. They also make complicated adjustments for changes in quality of the ‘same item’ (math is hard even if you go shopping). That’s really the only way you can do it, and it works ok for many purposes, but there isn’t just one inflation rate the way there is one exchange rate.
Macroeconomists use this thing called ‘core inflation’, which leaves out items that vary a lot in price and which they say predicts macroeconomic things better. There are indexes based on baskets of items bought by NZ producers, or sold by NZ producers. There are indexes based on baskets of items relevant to different sorts of households: Graeme Edgeler has a nice post pointing out that there is an inflation index targeted to beneficiaries, and that it would make sense to use this to index benefits (he also drafted a bill).
The other tricky part of the basket approach to comparing past and current prices is the huge differences between items. The prices of computers, washing machines, t-shirts, and old-enough medications are increasing more slowly than the average inflation rate; they are getting systematically less expensive ‘in real terms’. By simple arithmetic, that means the prices of other things must be rising faster than the average inflation rate; they must be getting more expensive ‘in real terms’.
It sounds odd to say that primary schools or health care are getting more expensive to run `in real terms’ because computers and t-shirts are cheaper — but it’s partly true. Some sort of currency conversion is always necessary when comparing different currencies — the 2001 dollar and the 2017 dollar — but it’s not always sufficient.
Thomas Lumley (@tslumley) is Professor of Biostatistics at the University of Auckland. His research interests include semiparametric models, survey sampling, statistical computing, foundations of statistics, and whatever methodological problems his medical collaborators come up with. He also blogs at Biased and Inefficient See all posts by Thomas Lumley »
As a schoolboy I would measure how rich I was by how many Mars Bars I could buy. As an undergraduate I switched to pints of best bitter.
As a technology journalist in the 1980s, I used to convert international prices to how many hours a bus driver needed to work in order to buy the product in question. This was before the internet, but library research found the after tax pay for bus drivers in, say, Wellington and Los Angeles and the price of say, an Apple Macintosh in both cities.
From this you could work out how many weeks each would work to buy the same product. I thought this was a useful guide to how much more we had to pay in New Zealand.
The other calculation I did at the same time was that you could fly Wellington to LA, buy a Mac, spend a week in a swanky hotel, go to Disneyland, eat nice food and still have cash left over when you got home.
While I suspect none of this would satisfy an academic economist, these approaches are a great way to get a feel for relative prices.
7 years ago
Yes, that sort of thing works well in most circumstances. Comparing Mars Bars in the Soviet Union or pints of best bitter in Dubai (or Los Angeles) would be a bit more difficult.
It’s harder to do that over time, because one of the questions you want to ask is whether bus drivers are better off or worse off than they used to be.
7 years ago
Thanks for this.
Looks like per-cap health spending has more than kept up with CPI inflation, but not with health group cost inflation (SE906 series).
But I don’t know enough about the construction of that series.
It looks like the main cost inflation is on out-patient services and on hospital services. Out-patient services are costed mainly on things like GP fees. So if the government sets a policy that increases the GP fee for people not on community services cards, then it looks like health cost inflation but it’s really just a shifting of who’s paying for it.
And hospital service cost inflation tracks costs in private hospitals – which you’d think would correlate with costs in public hospitals, but would also reflect what proportion of the population is willing to pay for private care and what they’re expecting. So if rich people decide that they now want private rooms and are willing to pay for them, that CPI figure blows out – even if nothing’s changed in public hospitals.
7 years ago