Be Cautious Using Price Indices

I’d just like to say that I’ve thought about something I probably should have dealt with in my previous post.

Namely, the fact that the “real” value of expenditures during the years of World War II is complete bullshit. Why? Because the deflator is totally wrong in those years.

Understand: like any index used to measure inflation, the GDP deflator is essentially a measure of prices. And like all measures of prices, it can only really be said to reflect the real purchasing power of money if prices actually reflect the effects of supply and demand-that is, the market is allowed to find the price which will clear it. However, during World War II, prices were heavily regulated and controlled. As such, while there is an underlying inflation going on in the prices that would clear the markets for various goods, the actual prices are not allowed to go any higher, and inflation manifests as chronic shortages and rationing, rather than higher prices. As soon as the price controls are lifted, there will appear to be a sudden burst of inflation-appear-but in reality this is merely the inflation that had already occurred, finally materializing.

Incidentally, Milton Friedman has compared the policy of fighting inflation by controlling prices to fighting a fever by breaking the thermometer. I thinking this doesn’t quite go far enough. It’s akin to fighting a fever by breaking the thermometer and ingesting the contents.

At any rate, I’m making some effort to correct for this, by trying to create a “price control corrected” index. You can clearly see what I’m talking about in the Consumer Price Index published by the Bureau of Labor Statistics. In late April of 1942, the General Maximum Price Regulation restricted most prices from rising above their highest levels in March of that year. Prices continued to be controlled throughout the War, and for a bit afterwards Truman and the Republicans fought over whether or not to end them, with the Republicans eventually prevailing, thanks in no small part to the courageous and heroic efforts of Senator Robert Taft of Ohio. In October of 1946 Truman was forced to do away with meat price controls to end a shortage, because by September polls indicated the public had turned against the controls, and not long after the Democrats suffered a massive electoral defeat in the mid term elections-by which I mean four days-in November, Truman abolished all price controls except on rental housing, sugar, and rice-but even before that, the conflict over the issue resulted in a brief lifting of controls in June of 1946, as a result of Truman vetoing a bill which would have continued the controls for only 9 more months-the re-imposition of controls in July was much less extensive than it had been during the War. not surprisingly, this shows up in the Consumer Price Index.

pricecontrolledcpi

The period in red is from April of 1942 to June of 1946. You can see that as soon as price controls ended, the price index shot up. But there was no sudden burst of new money, no sudden shift in the supply or demand for money. Prices rose to clear markets that had previously be restricted from doing so by Government fiat. So correcting for the actual gradual, rather than sudden decrease in the purchasing power of consumer dollars, one needs to “back date” the inflation into the period of price controls. My first attempt at doing so looks like this:

correctedcpi

The “corrected” CPI has been adjusted to increase gradually over the period April 1942 to October 1946-which allows for an adjustment period for the prices and also for the gradual, or punctuated nature of the end of controls. I can then use this corrected price index to “correct” other indices, like the GDP deflator, by assuming the same ratio between a corrected index and the corrected CPI as the uncorrected index and uncorrected CPI. An important point here is that a sudden apparent increase in prices can cause estimated “real” income to fall, or rise less than it really did-conversely, an apparent stagnation of prices can cause estimate “real” income to rise, even if it is actually flat.

The effects can be significant. For example, between 1942 and 1945, I would have previously estimated that the “real value” of total private expenditures fell about 17%-back dating the inflation hidden by price controls, the actual drop is more like 24%. Additionally, the boom in the private economy after the war is more dramatic as well, which is a given since it recovered from deeper depths during the war than I thought-A rise of 66% from 1945 to 1948 as opposed to 51%.

Anyway, food for thought.

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2 Responses to “Be Cautious Using Price Indices”

  1. Estimating The State of Labor Markets (Unemployment Statistics vs. Economic Realities) | Time to Choose Again Says:

    […] Using my estimates of the private economy and it’s deviation from it’s long term trend, accounting for mismeasured inflation during WWII, based on the relationship between the two: I chose a quadratic curve to prevent the formula from […]

  2. aaron Says:

    An analogy I like to use with money is it’s often like the dye for an MRI or CAT scan. Boosting money supply will tell you the dynamics are, what takes it up fast, slow, or that it doesn’t event reach. It is very rare and unlikely that this injection also has a medicinal effect.

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