The strange case of inflation in modern complex evolutionary economies

There is now a lot of attention to inflation. After a period of low inflation in both the USA and Europe (below 2%) inflation has now reached record-high levels. Households are worried and Governments are planning actions to curb inflation.

Unfortunately, inflation is an old concept poorly suited to represent the reality of modern advanced economies which are complex evolutionary systems. The basic concepts of inflation is the price increase of goods and services. If quantities remain constant and all prices move by the same percentage inflation is a well defined concepts. But in reality nothing stands still. If prices move in different directions and quantities change, we have to compute an index of price changes. But since the beginning of last century it is well known that there is no way to define uniquely an index of price change. It was demonstrated that it is even impossible to establish simple criteria that all indexes must satisfy. The concept of inflation becomes blurred.

But the actual situation is worse. Modern economies are characterized by an unprecedented level of innovation and qualitative changes. If products and services change qualitatively and old products are replaced by new products at a fast pace inflation looses its meaning and becomes an abstract theoretical term. In fact, it would be necessary to define theoretically the “true” price of innovation. Stated differently, to compute inflation we would need to define theoretically what is the correct price increase due to innovation and qualitative changes.

But this is a difficult and abstract task. It is not what is done. Today, in order to measure inflation, a basket of relatively stable products and services is selected and a price index is computed for that basket with methods such as the old Laspeyres, Paasche, or Fisher indexes. Hedonic adjustment that try to capture qualitative changes but have a limited applicability. Inflation computed on the selected basket of goods is then extended to the entire economy.

As a result, for large sets of products and services, price changes due to innovation and qualitative changes are computed as inflation. This has negative consequences in terms of decision making. In fact, to fight inflation governments and central banks apply measures, such as raising interest rates, as if modern economies were homogeneous systems. But modern economies are not homogeneous systems, they are complex systems that evolve innovating products and services.

Innovation and qualitative changes, risk to be punished instead of being supported. Far-sighted firms that are trying to innovate by improving quality and increasing complexity in order to reduce the “material footprint” of products and services are penalized by generalized measures to cool down the economy. Paradoxically, a healthy innovative economy working towards the objective of "decoupling" growth from the use of natural resources will be perceived to be in recession.

Governments should learn to value quality improvement as true growth. In recent papers we proposed a simple solution based on dividing products and services in two categories, high-innovation and low-innovation products. We stipulate that high-innovation products, selected with the aid of the Product Complexity indexes developed by Hidalgo and Hausmann, have zero inflation. (See Position Papers in my site: https://www.sergiofocardi.net/qualitative-growth-en)

Those who are now forecasting that recession is inevitable should really re-evaluate the role of quality and complexity in modern economies. Firms, and asset managers, on the other hand, should understand that innovation will be a profit-conservation strategy.