May 28, 2020

Are General Price Level Indices Theoretically Coherent?

Hello dear readers. I ended up being very slammed the last couple days preparing for a talk that I gave today so I haven’t finished Part 7 of my Federal Reserve Coronavirus series. Hopefully I’ll have it finished tomorrow night. My written remarks from the talk I gave today will be published as a premium post on Saturday. To tide readers over, I’m going to republish an old post from my old blog which I think is still relevant today, and which I’ll be building on in future pieces on business pricing.

Are General Price Level Indices Theoretically Coherent?

It is notable that the whole conception of a general change in price level has been gradually falling into disfavor in recent years. In considerable part this has been due is the recognition of the fact that prices do not tend to move up and down together. Rather, when a general index of prices moves down, it is likely that the sensitive prices will fall very much more than the administered prices, with the reverse behavior in the case of a price rise. The whole conception of a general change in price level does not apply to such price behavior. Yet the impediment to general price changes would seem to be the presence of insensitive prices and of price administration. If all prices were “made in the market,” and therefore as sensitive as most agricultural prices, the concepts of a price level and of general price changes would be appropriate so long as the constant flux of individual price relationships to conceive of wage rates that are as sensitive as goods prices and of general changes in the price-wage level, though of course the latter conception is appropriate only to a sensitive-price economy. - Gardiner Means  (Means 1947, pages 33-34).

What is inflation? The Oxford dictionary defines inflation as “A general increase in prices and fall in the purchasing value of money”. What does a “general” increase in prices mean? For that matter, what is “the value of money?”. We are so accustomed to the concept of inflation and “the value of money” that we rarely fundamentally question them. From the perspective of economic theory however, there is no prima facie compelling reason to think these are coherent theoretical concepts. This does not mean we can’t construct an index of prices, but not every index has a coherent analytical vision behind it (for a famous example, look at the misery index). The late great economist Fred Lee liked to say “all economic theory is product specific and price specific”. This means that a theory can only coherently explain the behavior of individual products and prices and one can’t presume it also applies to the behavior of an index. Indices can change because of all sorts of reasons that have nothing to do with the underlying dynamics explained by theories.

In traditional neoclassical economic theory, the theoretical edifice behind a price index is that there is one generalized “value of money” and an index of current consumer goods and services prices successfully measures it. The fundamental forces of supply and demand are supposed to determine relative prices and the quantity of money straightforwardly determines the overall price level through determining “overall” demand. These theorists presumed that you can aggregate individual products, individual firm  demand and supply curves into “market” demand and supply curves. You can then put all the product demand and supply curves into a general equilibrium system where the same forces determine relative prices and thus money has no role besides as a numeraire (the famous “Hahn problem”). Thus they had a product specific and price specific theory which they assumed was aggregatable to the macroeconomic level. However, none of these steps have proven to be true ( Andrews 1964, Jo 2016, Lee et al 2004 and Moudud 2012). Thus there is no neoclassical theoretical foundations for a monolithic “general” price level.

Since there is no unitary force moving "general prices" in contradistinction to relative prices, there is no unitary value of money. There is only a range of things you can buy at different prices. Why then do we persist in treating Consumer Price indices as fundamental? Why is the same index used to adjust everything from wage contracts to social security? In other words, if effective demand doesn't determine the price level but only impacts specific prices, and only weakly at that, what theoretical meaning does a price index have? So the consumer price index grew 3 per cent faster, so what? Does that say something about the value of money in general or did 6 industries increase their target profit margins? Did product quality change significantly across a number of products important to consumers? Neoclassicals try to get around the product quality issue by “quality adjusting” price level indices. However, once you don’t have some homogeneous substance which is the “essence” of all output (whether that substance is labor time, or utility) there is no theoretical basis for such adjustments.

Using developments in Post-Keynesian theory originating with the economist Gardiner Means I would argue that an index of consumer prices which are based on organized exchange market prices and an index of administered goods and service prices could be constructed separately in a coherent way. I would further make the case for constructing an index of tradable administered price goods and services and non-tradable ones since they behave differently (whether because of baumol disease productivity factors or because non-tradable goods face localized and more geographically concrete competition). However, the reason to construct these indices isn’t to claim all the prices in the index will change for the same reason but simply to say that they are more similar to each other than the prices in other indexes. Nor would we any longer be driven to claim that faster growth in one or more of these indexes necessarily says anything about the state of effective demand and thus necessarily implies that x or y macroeconomic policy is worthwhile.

It is interesting to note that John Maynard Keynes in the general theory comes to a similar conclusion. He says in the greatly underrated chapter 4 that, “...the well-known, but unavoidable, element of vagueness which admittedly attends the concept of the general price-level makes this term very unsatisfactory for the purposes of a causal analysis, which ought to be exact”.This leads to one of the greatest statements on quantitative analysis ever made:

To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth — a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of a quantitative analysis

This is a well known set of issues; yet strangely heterodox economists have not really taken it up. You can still find plenty of heterodox economists uncritically speaking of “inflation”. A fruitful avenue of future research would be reorganizing data to be coherent from a heterodox economics point of view. From here we can ask what different policy implications would heterodox economists derive from multiple price indices, including multiple indices of asset prices?

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Andrews, P.W.S. 1964, On Competition in Economic Theory, Macmillan & Co Ltd, London, and St. Martin’s Press, New York.

Jo, Tae-Hee. "What if there are no conventional price mechanisms?." Journal of Economic Issues 50.2 (2016): 327-344.

Lee, Frederic S., and Steve Keen. "The incoherent emperor: a heterodox critique of neoclassical microeconomic theory." Review of Social Economy 62.2 (2004): 169-199.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan.

Means, Gardiner Coit, Warren J. Samuels, and Frederic S. Lee. A monetary theory of employment. ME Sharpe, 1994.

Moudud, Jamee K. "The hidden history of competition and its implications." Alternative Theories of Competition: Challenges to the Orthodoxy 14 (2012): 27.