Innovation-Driven Dis-Inflation Distorts Perceptions of the Economy
 
On the central economic questions of inflation, productivity, and income growth, our perceptions are largely dependent on our ability to measure them.  Lots of smart people do great work collecting and analyzing data on prices and wages.  However, the world seems to be changing faster than our ability to accurately measure it.

The U.S. government frequently adjusts prices of goods to account for changes in quality.  However, these so-called “hedonic adjustments” are very difficult to estimate and are only done in a handful of areas.  So, while these adjustments to statistics have had a small aggregate impact on reported results, real-world experience suggests that there have been massive improvements in quality and value via innovation that isn’t reflected in the metrics

 Consider some new research by Austan Goolsbee and Peter Klenow, which bolsters the idea that the economic data don’t fully capture the benefits of the digital economy.  Based on new data from Adobe Analytics for millions of products, Goolsbee and Klenow show that e-commerce significantly lowers prices.
 
They estimate that online inflation was about 1 percentage point lower than in the CPI for the same categories from 2014-to-2017. In addition, the rising variety of products sold online implies roughly 2 percentage points lower inflation than in a matching CPI-style model index.

Writing in The Wall Street Journal, tech investor Andy Kessler is even more critical of our measuring abilities.  In fact, he thinks the government’s price and wage estimates are close to worthless.  Kessler acknowledges efforts to account for technological and quality improvements through “hedonic adjustments” but thinks they don’t come close to capturing true advances. He suggests the following thought experiment:

“Think about your car’s automatic emergency braking, sometimes known as pre-crash or collision avoidance.  It has been an increasingly popular option in recent years.  By 2022, it will be standard on most cars.  [It consists of] some silicon sensors and a few pieces of code - today it costs maybe $50 to produce. But what’s it worth?”

“Let’s do a little hedonic decomposing of our own. Before these sensors, you would have had to hire a person to ride shotgun and constantly watch for potential collisions and slam on the brakes for you. In 2016 the AAA Foundation for Traffic Safety estimated the average driver spends almost 300 hours a year in the car, logging more than 10,000 miles. Paying someone even $10 an hour to stare into traffic means that over five years, collision avoidance is worth nearly $15,000. Double if you want someone to look out the back window, too.”

“Does this show up anywhere in the consumer-price index? Of course not. One of the most lifesaving features has dropped in cost by three orders of magnitude in less than a decade.  But, to the BLS, it’s practically nonexistent.”

Similarly, consider that 20 years ago, many well-off U.S. citizens owned a camera, a video camera, a CD player, a stereo, a video game console, a cell phone, a watch, an alarm clock, a set of encyclopedias, a world atlas, a GPS navigation system in their car, a DVD player, and other “tools” that had a combined cost of more than $10,000.  All of that functionality is now either standard on smartphones or can be purchased at an app store for less than the cost of a cup of coffee.

Another fast-growing sector of the economy with serious measurement problems is healthcare.  Government statistics essentially do not adjust for quality improvements in healthcare despite the clear evidence that healthcare is more effective today than in the past.  For instance, average life expectancy has increased four years to 79 over the past 25 years. Many studies have shown that if quality improvements were factored into healthcare spending on conditions like heart attacks and colon cancer, inflation in those areas would be much lower than reported.

These examples of mismeasurement-or even “un-measurement”-suggest that, in many ways, consumers may be far better off than is commonly assumed.

However, many industries really are lagging in productivity and wage growth, precisely because they have yet to fully exploit the power of information technology.  That is, there’s a chasm between high-productivity and low-productivity firms and industries, based in large part on info-tech intensity.  This could be called the “information gap.”  And bridging this chasm is the driving force behind the growth in the Golden Age of the Fifth Techno-Economic Revolution, even if it isn’t yet showing up in the numbers.

That is, while a growing body of research suggests that the digital economy is delivering even bigger gains than the numbers convey, the majority of the economy is still operating below its innovation potential; that’s why we still have inflated prices and depressed wages in those industries.

And this implies an unprecedented opportunity.  Once health care, education, transportation, retail, construction, energy, and manufacturing begin operating more like the competitive, tech-focused industries, the low-price, high-wage benefits of technology will spread to millions more workers and consumers. Fortunately, there’s evidence that these industries are beginning to do so.

Given this trend, we offer the following forecasts for your consideration.

First, interest rates will stay low as the impact of innovation keeps inflation subdued.

Furthermore, sustained low inflation and interest rates should support higher equity valuations.

Second, over the coming decade, growth stocks will out-perform value stocks.

If innovation is creating solid value for consumers now and into the medium-term, it is positive for the creators and beneficiaries of this change. In periods of intense change, growth stocks should do particularly well.  Many stocks that appear cheap may simply be victims of change and innovation.

Third, businesses that help facilitate the transformation of traditional industries to digital industries will be some of the biggest winners.

Innovation not only impacts high-tech sectors but drives down the price of commodities; adjusted for mileage and the CPI, automobile fuel costs less in 2019 than in 1968.  And innovation also transforms business models.  From a sector perspective, technology companies are disrupting the way we buy things, pay for goods and services, consume media, and more.  Companies that facilitate e-commerce or benefit from the shift to online advertising could be big beneficiaries of these changes.

Fourth, companies in the so-called Consumer Discretionary sector will benefit from increased consumption due to lower quality-adjusted pricing.

It’s a classic case of price elasticity.  Mobile phones that serve as navigation-aides, encyclopedias, and cameras are just the most obvious example of products where intense feature improvement led to a better value for consumers; and that frees up money to be spent on other goods and services.  For example, more time spent on leisure and sports, as well as the greater share of spending devoted to those activities, has already enhanced those businesses.  And,

Fifth, the U.S. government will place greater emphasis on accurately measuring inflation and growth.

However, it’s unclear that this problem will ever be truly resolved because the adjustments are so subjective.  For investors, consumers and managers alike, it’s probably enough to know that we’ll continue getting more for our money as long as we strive to maximize innovation.

References
1. Alger Insights. May 2018.  Brad Neuman, CFA.  THE IMPACT OF INNOVATION DEFLATION. 

https://www.alger.com/AlgerDocuments/AlgerInnovationDeflationWhitePaper0616.pdf

2. June 15, 2018.  Bret Swanson.  The other ‘digital divide’ suggests a massive economic upside. 

https://www.aei.org/technology-and-innovation/innovation/the-other-digital-divide-suggests-massive-economic-upside/

 
3. May 2018.  Austan D. Goolsbee & Peter Klasnow.  INTERNET RISING, PRICES FALLING: MEASURING INFLATION IN A WORLD OF E-COMMERCE. 

https://www.nber.org/papers/w24649.pdf

 
4. The Wall Street Journal. June 3, 2018.  Andy Kessler.  The Canard About Falling Incomes: Don’t believe the government’s consumer-price index, which is obsolete.

https://www.wsj.com/articles/the-canard-about-falling-incomes-1528054223

 
5. Entropy Economics. March 2017.  Michael Mandel & Bret Swanson.  The Coming Productivity Boom. 

http://entropyeconomics.com/wp-content/uploads/2017/03/The-Coming-Productivity-Boom-Transforming-the-Physical-Economy-with-Information-March-2017.pdf