Saturday, January 22, 2011

Sounds like a weak argument

You do not need to inflation adjust real goods or services -- a chair is always a chair, a haircut is always a haircut. - Winterspeak

What is typically called "nominal" output is more correctly called "actual" output. What is typically called "real" output is more correctly called "inflation-adjusted" output.

In mine of 15 January I used or misused the words of Winterspeak to say we cannot measure real output. But the more I read over my post, the more I thought it sounded like a weak argument.

Next day I quoted Keynes to strengthen my argument. But I think it still sounds like a weak argument. So I want to kick it around some more.

I like Winter's distinction between "real" and "nominal." Real is atoms and sweat, he says. Nominal is numbers in a spreadsheet.

But you know what? There's more to the story. Economists refer to "real output" and "nominal output" and the words imply things that are simply not true. The words should not be used that way. It builds falsehood into economic theory.

Real output is stuff. As Winterspeak said.

"Nominal" output is the total value of all we produce in a year, valued at the prices we actually paid to buy it. Nominal output is as close as you can get to real output, if you are trying to put output into a spreadsheet. If you take this nominal output, this total value based on actual prices, and then you change that number to take inflation out of it... Well, then you are farther from reality, not closer to it. But they call that "real."

Winter says:

An inflation adjusted nominal term is not "real", because it is still a number in a spreadsheet. It is worth inflation adjust[ing] nominal values so you can account for inflation and compare nominal values meaningfully across time. Nevertheless, inflation adjusting a nominal value does not give you a real value, it just gives you an inflation adjusted nominal value.

Agreed. And I really like Winter's idea to call such values "inflation-adjusted" rather than "real." But why is it important? Because of the way such numbers are used.

Again, Winterspeak:

At an economy wide level, if nominal incomes increase faster than real production, there is a risk of inflation

That statement translates into an equation that looks like this:

inflation is proportional to income over real output

In order to make use of this equation, one would have to translate chairs and haircuts and real output in general into "inflation-adjusted" output numbers. So let's introduce that translation into the equation:

inflation is proportional to income over inflation-adjusted output

We now have the word "inflation" twice in the equation, once on the left and once on the right. What is the significance of this?

If there is a stable or slowly-changing relation between income and output -- and there certainly is -- then introducing an inflation adjustment on the right side of the equation makes the right side proportional to the left. It makes the right side numbers look like the left side numbers when you graph the two sets of numbers.

In other words, you can use the calculation to simulate evidence of similarity between inflation and the ratio of your choice. For the record, this is just what Milton Friedman did in his Money Mischief graphs, except his equation was

inflation is proportional to money over inflation-adjusted output

The trick is that when you call it "output" or "real output" it sounds okay. But as soon as you call it "inflation-adjusted output" the bad arithmetic starts to stand out.

Friedman used that equation to create graphs that show inflation is proportional to "the quantity of money relative to output." But really, all the graphs show is that inflation is proportional to inflation.


Greg said...

"Friedman used that equation to create graphs that show inflation is proportional to "the quantity of money relative to output." But really, all the graphs show is that inflation is proportional to inflation."

Which of course is true....... and meaningless. But Friedmans acolytes are so impressed by the truth they miss the meaninglessness.

Friedman may have been a smart man but I 've yet to find evidence that he had any profound insights into our world.

The Arthurian said...

He definitely had profound insights into human nature. I bet he wrote back to everybody who ever wrote to him. And I can tell you, it feels pretty great, when it's Milton Friedman who tells you that you are "barking up the wrong tree."

Greg said...

What were his profound insights into human nature?

When did Friedman tell you you were barking up the wrong tree? Did you mention this in a previous post somewhere? I'm getting the feeling you did and I'm not recalling.

The Arthurian said...

Oh, that was years ago... early '80s maybe. I probably didn't mention it before. I have run across two or three blogs where the blogger was bragging about his feedback from Friedman. I understand the feeling, for sure. But from those blogs and my own experience I got the impression that Friedman tried to answer all his mail. (So in that case, it's not something to brag about. It's just standard procedure.) And maybe this is circular reasoning on my part -- because part of why I think he was a great man is because he answered my letters -- But it does feel like something to brag about when a great man like that pays attention to ya, even if he's saying that you're wrong!!

And that's sort of the "insight into human nature" that I was referring to. Not much economics in it? I don't even care :)

But I still don't like his graphs.