We all know about inflation. One popular measure is the Consumer Price Index (CPI), which measures the change in price of a fixed basket of goods. The other popular measure used for inflation is the Personal Consumption Expenditures (PCE) price index. This index measures the price of what consumers actually purchase and captures the effects of consumers changing their consumption bundles over time. While the latter is a better measure for the prices at which consumers make purchases, it takes longer to calculate. In practice, the earlier CPI release gives a pretty accurate preview to the PCE price index.
While consumption is a substantial two-thirds of total expenditures in the US economy, other prices definitely matter. On average, a third of our income is spent on other things. Below is a stacked bar chart of quarterly GDP components – the classic Y=C+I+G+NX.* Investment spending composes a relatively stable 16.7% and Government spending composes about 16.5% of GDP. We almost never hear much about the price of these other things.
People complain a lot about the price of food. But that’s only about 8% of total consumption expenditures. In raw dollar terms, gross Investment and government expenditures compose three times more of our incomes than food. So, you’d think that people or even economists would care to discuss those prices. As it turns out, the Bureau of Economic Analysis (BEA) creates price indices for other GDP components too. Below is a graph that charts the percent change in prices since 2000 for consumption (red), Investment (Blue), Government (green), and overall GDP (black). Of course, the GDP price index is just a weighted average of the others.
From 2000Q1 – 2024Q1, consumer prices rose by 67%. Though the average economy-wide price rose comparably at 72%, how we get there has some wrinkles. Specifically, investment goods are only 45.5% more expensive. As I said recently, buying capital, and enjoying future consumption, is very affordable! Indeed, if the average price of consumption goods and investment goods are both lower than the average price of GDP goods, then that leaves only one culprit for the average rise in prices: The government(s). The average price faced by government spending on final goods and services has risen a whopping 100%.**
But what story can we tell that fits the data? Here are couple that are plausible:
- We use government spending to encourage greater production, ensuring that more is purchased than otherwise would be. This greater demand drives up the price as a natural consequence. Whether the resources are ultimately used well by government hands is a matter of opinion.
- A large part of government spending is on labor, and the price labor has grown faster than the price of goods.
Insofar as governments purchase anything, story 1 seems somewhat necessarily true. Interestingly, if you think that competitive markets are powerful and that the long-run price is determined apart from demand, then government spending doesn’t affect long-run real wages at all (this is worth its own blog post) and the government just faces prices consistent with purchasing a lot of labor.
Two pieces of evidence strongly support story #2. If the high prices that government faces are driven by the price of labor, then we should observe similar patterns concerning labor elsewhere in our economy. Specifically, the price of services consumed by households should rise at a comparable rate. After all, both consumers and governments are demanders of services. Additionally, median nominal wages wouldn’t be a bad indicator either. Indeed, the below graph illustrates that both reflect a very similar increase over the same period.
In conclusion, the average price that the government faces is higher than the average price that consumers face. However, this is largely due to the greater part of government purchases being for labor. In fact, there may be some government efficiencies to explore, but the prices that governments face have gone up only a little more than the price of services that consumers purchase. Consistently, median wages have also doubled in this twenty four-year period. Indeed, if we make the heroic and unrealistic leap of saying that government spends *only* on services, then our economy enjoys about 38% more service production than what households consume directly.
* Y=Expenditures, C=Consumption, I=Investment, G=Government Spending on final Goods & Services, NX=Net Exports
**It’s important to remember that G in the GDP equation doesn’t include transfers, subsidies, or interest payments. It includes only the spending direct on goods and services.
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