My Mom Thinks Hedonics are Crap

I am sorry to interrupt my originally planned post, but felt that I simply had to comment to Andy’s post at Tight Fisted Miser who thinks inflation may not be as bad as perceived.  Personally, I tend to disagree so I would like to expand upon my comment that I made.  Andy does make a good point when raising the issue of hedonic regression, but I think the analysis needs to be taken further.

What is Hedonic Regression?

Of course, we should all be on the same page so that means we should understand hedonic regression prior to beginning further discussion.  Hedonic regression is an economic theory that attempts to ascribe increased value to something of higher quality by breaking out component parts.

In Andy’s post, he cites the example that the average home size in 2009 was 2,700 square feet vs 1,400 square feet in 1970, and that is true.  The larger sized home should cost more without the impact of inflation.  That should be expected and is entirely justifiable.

Both Sides of the Equation

However, if you want to apply these mathematic adjustments to one side of the equation, you need to do it to both sides to avoid changing the equation (algebra 101).  So, let’s look at salary hedonics.

Using Little House’s data from the inflation post that inspired this discussion,  the average income in 1971 was $10,622 per year.  In order to apply hedonics, I will use productivity data from the United States Bureau of Labor and Statistics (the increase is annualized).

  • 1973-1979:  1.1%
  • 1979-1990:  1.4%
  • 1990-2000:  2.5%
  • 2000-2007:  2.4%

So, I will take that average salary and starting in 1972 multiply by 1.1% for seven years, then 1.4% for eleven years and so on.  The result?  In 2007, I would expect the average salary to be $20,193 based upon the same rationale that a the worker in 2007 is more valuable due to improvements in productivity the same as the house is more value due to improvements in size and amenities.

Comparing Both Sides of the Equation

So we see that salaries have almost doubled due to hedonics as has the size and quality of homes.  Thus the excess above a doubling could be ascribed to inflation.  Is there any fault in this logic?

So you might expect the new house in 1971 which cost $25,200 to cost about $50,000 in 2011.  And yet the data shows that the actual cost is $169,000 or just over 3 times expected.

Doing the same thing for salaries means that the salary of $40,000 in 2011 is only twice that which might be expected.  This means that the average worker is in fact losing ground to inflation!

Granted the standard of living for homes have improved.  I don’t think anyone would debate that fact.  However, inflation is still ugly.  Saying it is not as bad means the difference between being stabbed 30 times vs 20 times.  Doesn’t mean much to me.

Items that Need No Hedonics

Of course, Super Saver brings up a good point in the commentary which is exactly why my mom thinks hedonics are crap.  She uses the same gallon of gasoline in 2011 that she used in 1971.  Granted the car is nicer, but she still needs to get from point A to point B.

She also drinks the same gallon of milk and the same diet Pepsi.  The same head of lettuce is used to make her 7 layer salad.  The stamp that she puts on the letter still gets to its destination in 2 or 3 days after putting it in the box and raising the little red flag.

Finally, she doesn’t really care if the latest iPod is better than the original version since my parents still have 8-tracks (but that’s another story).

The Good, Bad, and Ugly

It wouldn’t have been so bad for my parents if their salaries had kept pace with the cost of gasoline, food, and postage stamps but that wasn’t the case.  Their salaries increased about 2.5 times from 1971-2005.  The majority should have been explained by hedonics so they actually lost ground to inflation.

It is probably expected since once you hit a certain level, most people stop advancing.  My mom taught in the same school for 30 years.  She got her master’s degree in education, but didn’t go beyond that.  So I can understand that she simply got some cost of living increases.  Unfortunately, they didn’t keep pace with inflation.  Ugly!

So inflation is ugly and salary growth has been bad, but what is good in all this?

My parents bought a house in 1973.  They paid $5,000 for the lot and $25,000 to have the house built.  It sold in 2005 for over $150,000.  And it wasn’t even hedonized!

It had the same square footage when it sold in 2005 as it did in 1973.  The size of the lot was the same.  Nobody built a beach or ocean by the property.  No mountain view was added.  At least they did get rid of the green shag carpeting that was in my room before selling.

Even though no major improvements were made to that property, it still sold for more than 5 times what it cost in 1973.  That is awesome!  So at least they managed to be on the right side of the inflation equation by owning real estate.

The Moral of the Post

Inflation sucks!  Don’t let anyone tell you otherwise.  It is bad and is probably worse than you think.  The only way to beat it is to own stuff.  Own real estate, own gasoline, own food or farmland or stock in companies that own food or farmland or gasoline if you can’t own them outright.

You want to be able to maintain your purchasing power.  Salaries won’t do it.  Pensions and social security won’t do it.  You have to do it yourself with investments designed to keep pace with inflation.

Not to pick on Andy, since he does make a great point.  Standards of living have increased dramatically in the last 40 years.  My flat screen HDTV is much better than the 19″ black and white I remember as a kid with the antenna with an aluminum foil hair-do to maximize reception.

But I would rather prepare for the worst and be pleasantly surprised if in 40 years, inflation isn’t so bad.  And we haven’t even begun to talk about substitution bias in the CPI.

OK, readers.  What are your thoughts?  Inflation, hedonics, CPI, wealth gap, gold, fiat currency.

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