The Price Index Divergence

David Leonhardt is running a great series on the sources of American income stagnation and I wanted to throw into the mix a technical point that tends to get overlooked in this discussion. When we talk about incomes stagnating, we’re talking (reasonably enough) about inflation-adjusted incomes. And typically we do that adjustment with reference to the consumer price index. But that’s not the only price index in the land. There’s also the GDP deflator which is used to distinguish between “real” and “nominal” GDP. And for the past thirty years, the GDP deflator has tended to rise more slowly than the CPI.

Why would that happen? Well in the short-term it’s easy to get divergence because only some production (GDP) is consumed. Some of it is capital goods. But in the long-term, you might think these indexes would line up. After all, the capital goods are ultimately used to produce consumer goods so it should all wash out. Systematic trade patterns tend to undue this. The American economy exports a lot of capital goods—747s and Windows and so forth—but consumers are spending a larger and larger share of their income on personal services (especially health care) that can’t be imported.

So there’s systematic divergence. And it’s a big deal. According to Lawrence Mishel of the Economic Policy Institute, this gap alone accounts for one third of the divergence between productivity and median compensation in the 1973-2011 period.

What does that mean in the real world? I think it’s mostly a longwinded way of emphasizing that incomes and prices are two sides of the same coin. The political discussion normally talks about income and wages in one box, and then college affordability or health care or housing in some other boxes. But the point of income is to buy things. If it were as cheap to find a place to live in San Francisco or New York as it is in Duluth, that right there would constitute higher incomes. If health care were cheaper, real incomes would be higher.