May 02, 2020
There has been some discussion of whether we should anticipate deflation or inflation as a result of the impact of the pandemic. I have been in the camp arguing the latter, based on the idea that precautionary measures will raise costs in major areas of the economy while reducing supply. (This is not an argument against stimulatory policies that are needed to restore employment. The inflation is a one-time price rise that will be reversed when we get effective treatments and/or a vaccine. It is not an inflationary spiral story.)
However, it did occur to me that there is an important measurement issue that could affect how we view higher prices. To see the issue, let’s imagine we had Donald Trump’s bar and grill. As Trump has advocated, we have people tightly packed together, eating their burgers and fries. There are also long lines at the door, with no one practicing social distancing.
Now, imagine that Dr. Fauci takes over the restaurant after it goes bankrupt (this is a Trump business) because so many of the customers were getting sick. Under Dr. Fauci, the restaurant adopts safe practices. This means operating at only one quarter capacity, having sufficient time between parties to ensure that the tables, chairs, and surrounding areas are fully sanitized, and having checkers at the door taking people’s temperatures and asking about their health and contacts. To cover his higher costs, Dr. Fauci raises prices by 50 percent.
So, the question for inflation hawks everywhere is whether this 50 percent price increase should be treated as inflation? The counterargument is that Dr. Fauci’s restaurant is providing a better product than Donald Trump’s restaurant. Customers can eat their dinner with a much lower risk of catching the coronavirus. This should be worth a premium, just like people are willing to pay more money for a car with automatic braking or other safety features. In effect, this is a quality improvement, not an increase in price.
My guess is that the folks at the Bureau of Labor Statistics will not see it that way and treat safety-related price increases as inflation. I’m not knocking them, they would have to develop the methodologies to make the adjustments. That takes time and we’re seeing the price increases now. I’m just trying to call attention to a conceptual problem here.
While the problem is extraordinarily stark in this case, it is not a new one. I used to point out that AIDS led to a reduction in the measured rate of inflation. The reason is that when expensive new treatments came into use, their price was not picked up as an increase in the CPI or other price indices. (We only measure the change in price of existing drugs, not the cost of new drugs.) When these drugs came off patent, and their prices plunge, their price decline would be included in the CPI, lowering the overall rate of inflation.
There is no real solution to this sort of problem. The CPI is inherently individualistic. It measures the change in quality-adjusted prices as though the world around us is unchanging. However, we know it does change constantly and the value assigned to goods and services changes enormously as a result. (Hey, does anyone want a lava lamp or a bean bag chair?) And it’s not just fashions. Our need for major items like cars, cell phones, and Internet access depends hugely on the social environment.
For this reason, we can’t really say that the CPI is measuring changes in the cost of living. It is a price index. Oddities, like the treatment of safety-related price increases that are a result of the pandemic, may bring this point home, but the problem is always there even if we choose to ignore it.