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Monday, May 10, 2021

Cost of Living Versus Inflation

One thing I have discovered when discussing inflation is that discussions very rapidly get derailed into discussions of the “cost of living.” I take a view that is conventional within market and economic discussion: inflation is a macroeconomic concept, and the consumer price index is one way to measure it. However, many people view inflation as rising cost of living.

There is a link between these two ideas, but they are not the same thing. It is entirely possible that the reader might disagree with my views on the distinction, but if they are to get any value from this book at all, they need to understand what I am referring to.

For readers who are familiar with the economic theory on this topic, there is a technical concept of a “cost of living” index. I defer that discussion to a technical note since it rarely comes up in discussion outside of technical statistical discussions.

Note: This article is an extremely rough draft. I am not polishing it, as I expect that it will be re-written heavily.

Inflation as “Rising Prices”

The first variant of the cost of living perspective is to just note some prices that have risen. For example, whenever I write about inflation being low, I get comments about rising prices for listed items (food, insurance, etc.). In many cases, they ask me whether I have seen the prices of these items, ignoring the fact that I probably live in a different country from them. A variant of this is the following logic: “the price of (something) rose by 10%, how can inflation be 2%!”

The answer to this is straightforward: developed countries by and large do not control prices. (There are exceptions. For example, Quebec controls the retail price of milk.) Different prices go up and down by different percentage amounts.

Back when I was a young in the 1970s, peacetime inflation was still seen as an unusual thing. Old people were notorious for constantly making complaints of the form “Back in my day, chocolate bars were a nickel (or whatever)!” If you want to sound like an old crank and complain about individual price changes, feel free to do so. (I will probably pay as much attention to those anecdotes as I did when I was a kid.)

When we discuss inflation, we are discussing an overall price change. Individual prices can change for any number of reasons, and there may be no overall pattern. To get away from discussing anecdotes, we need to systematically measure prices – which national statistical agencies do. I discuss the limitations of inflation measures in this book, but no matter what their flaws are, they are better than picking price changes on a whim.

Falling Standard of Living

Another way of getting side-tracked is to discuss what might be termed the standard of living – how have the fortunes of an average person changed over time? A typical phrasing is something along the lines of noting that a single worker household could afford a certain lifestyle at some point in the past.
The problem with this angle is that it ends up mixing up two sets of prices: the prices of goods and services workers buy, and the price of hiring workers (wages and salaries).

To see the problem with this, let us imagine what happens if the prices of all goods and services rise by 2% per year.
  • If workers’ wages do not rise over time (0% wage inflation), then they can buy 2% less goods every year. Over time, that would represent a serious loss of purchasing power.
  • If workers’ wages rise at 3% per year, then they can buy 1% more stuff every year. Their standard of living is rising.
As we can see, workers can have a rising or falling standard of living at the same rate of inflation of the prices of goods and services. What matters for their standard of living is whether their wages are rising faster or slower than the prices of what they buy.

Whether or not wages rise faster or slower than the prices of goods and services depends upon their bargaining power of firms, as well as institutional factors (minimum wage rate setting, etc.). To what extent workers’ standard of living has fallen behind in recent decades, we need to look at the overall structure of capitalist society. This is a complicated question – and the answers may depend upon the country. In any event, trying to pin the blame on “inflation” is just a way to deflect attention away from policy failures. (From my perspective, I think the living standards story is more mixed than many critics suggest.)

Tied to this logic are complaints about house prices leading to a falling standard of living. I discuss this in Section 4.2. To quickly summarise my points, it is unsurprising that shelter costs (especially house prices) have risen faster than other prices. How we might measure this is a tricky question.

Completely Random Anecdote

Before I go further, I just want to offer a personal anecdote that outlines the difficulties involved in personal definitions of the standard of living.

Starting 2013, I moved to work part-time (writing and consulting). This gave me more time to spend shopping, and looking at the living expenses of my family. I have not bothered to calculate a personalised inflation rate, but I believe it is safe to say that our expenses rose less than whatever Statistics Canada said was the rise in the CPI in Quebec during that period.

One common reaction to my earlier writing about inflation is that the official statistics that I use do not reflect the personal situation of the person commenting, and they have the air of being offended by this. However, if we use personal experience as the benchmark, why cannot I be offended by suggestions that the "true" inflation rate is higher than CPI inflation in Canada?

Since not everyone's personal experiences are the same, it is not safe to make generalisations from them.

Cost of Living

The previous notions of “inflation” (anecdotes about rising prices, looking at the purchasing power of average wages) come up, but in my view, easily seen as being distractions. However, there is an alternative way of viewing inflation – as the cost of living – which cannot be easily dismissed.

I will first note that economists have a technical definition of a “cost of living index” that I am deferring to a technical appendix. I am interested in a looser definition that is probably closer to how non-economists might think about this. The two versions overlap, but the looser definition results in something that is harder to measure.

I would attempt to describe a notion of the cost of living as follows: how much does it cost to achieve a certain lifestyle (standard of living)? We can then see how much that cost changes over time. We might even make the definition fuzzier and look at the basket of goods and services that could be purchased by a worker of a certain type. (Note that my proposed definition has problems, but I am trying to best capture views that I see other people make.)

If the world were simple, this definition might be adequate. If we assumed that all goods and services feature price changes that are all the same, we could then look at a basket of purchases, and see how much the cost of that basket changes.

Unfortunately, the world is not simple.
  • Not all prices change by the same amount.
  • The goods and services that are available for sale change over time. New products appear, and some disappear. (Good luck finding whale bone corsets for sale.)
  • If we try to define the standard of living relative to worker’s salaries, any number of things can change. Different classes of workers see different rates of income growth. Also, tax rates can change, implying changes to after-tax purchasing power.
We will now look at the problems posed by the ambiguity of this definition.

Consumption Basket Changes Over Time

Most complaints about a falling standard of living use a reference period that is decades in the past. (This is particularly true for young people who wish to blame “boomers” for high shelter costs.) The problem is that the consumption basket changes over time, as does what constitutes “middle class” (or whatever the target demographic is).

The most obvious case is telecommunications services. Growing up in Winnipeg in the 1970s, the typical “middle class” expenditure would have been only on a primary land line (cable television was a bit of a luxury until the 1980s, but other areas of North America may have had cable rollouts earlier). In 2021, cable has reverted to a luxury (and possibly land lines), while cellular phones, data plans, internet, and streaming services are all viewed as middle class necessities.

As someone who is concerned about resource depletion (“Peak Oil”), I would argue that developed country lifestyles will change due to those constraints, and so we cannot pick some desired consumption patterns and expect them to be around forever.

Relative Price Changes

Even if we look at shorter time scales, we still run into the problem that not all prices change by the same amount.

For example, the COVID-19 pandemic that hit the world in 2020 disrupted the meat processing industry. When I go shopping, chicken and beef are considerably more expensive than they were before the pandemic, while the rise in pork prices was more moderate. The obvious reaction is to have more vegetarian meals and eat more pork. This then raises the question: how much did my “standard of living rise”? 
  • How much would it have cost if I kept my buying habits unchanged by the price rise?
  • How much my spending actually rose, keeping in mind that I switched away from chicken and beef?
The people who want to complain about inflation will chose the first option – which implies the highest rate of inflation. But that is ignoring the story how capitalism is supposed to work: price changes can signal a shortage of goods, pushing consumers towards other products. (For those of my readers who are fans of economic arguments, I just want to note that the previous statement might generate controversy – a controversy I am not interested in discussing here.)

Pretending that purchasing habits never change contradicts the reality that “middle class” consumption patterns indeed do change, as discussed earlier.

It should be noted that how to account for relative price shifts is the major problem faced by statisticians trying to construct price indices. There is no obviously “correct” answer.

Structural Changes

The last problem faced by vague “standard of living” concepts is that the structure of the economy changes, and these changes affect lifestyles.

Comparing Canada and the United States since the 1930s offers a good example. Until the 1930s, the two countries had somewhat similar situations, particularly in the west, which were opened by settlers forcing the indigenous population out of the way at roughly the same time. (The eastern parts of North America had a slower settlement process.)

Although both countries created welfare states in response to the Great Depression of the 1930s, the Canadian model was more expansive. Canada effectively socialised non-elective health case, and heavily subsidised university education.

This then raises difficulties in comparing the “standard of living” between the two countries. Canadian tax rates are generally higher, but people are not driven into bankruptcy by emergency health care costs. Although Canadians can be stuck with student debt, the debt loads are effectively smaller than the United States.

As such, we see that government policies can restructure spending habits. How would we measure the change of the “standard of living” if the United States restructured its health care system to follow the Canadian model?

Concluding Remarks

Individuals can track their own expenses and have a feeling for how their “cost of living” has changed. The problem is that this cost of living concept is vague, and different people have different experiences.
When economists and market participants discuss the economy, they need a firmer definition of inflation that they have at least a chance of measuring. Those inflation numbers might not be perfect, but they offer something concrete to point to. However, it must be understood that the changes to the CPI may not reflect an individual’s personal experience – and nobody who understands the CPI construct would insist that this is the case.

Technical Appendix: Cost of Living Indices

(Not done yet.)


(c) Brian Romanchuk 2021

2 comments:

  1. "However, many people view inflation as rising cost of living"

    Unlike many, I mostly view inflation as an erosion of my savings. I seem to always have a bigger project in view; it takes savings to accomplish bigger projects.

    Inflation makes future projects less reachable by the delay of acquiring adequate savings. Borrowing as a substitute for savings is an option but carries dangers. In this context, borrowing is simply using someone else's savings to speed up your own goals.

    So you can see that for some folks, inflation is more than a cost-of-living change.

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