The Inflated Case Against the CPI


T
here is now the appearance of an expert consensus that the
government's most important measure of inflation, the consumer price index
(CPI), seriously overstates the true increase in the cost of living. This sudden
enlightenment is less the result of new research than political convenience. A
cut in the CPI would reduce government payouts and ease the path to deficit
reduction. Even better, it would do so via a technical adjustment that left few
political fingerprints.

Tax brackets and government benefit programs such as Social Security are indexed
to the CPI. If the CPI overstates inflation by 1 percent, as the Senate Finance
Committee's Boskin panel has proposed, and the index is adjusted accordingly,
this would reduce benefits and the deficit by a cumulative total of $634 billion
over 10 years. Not bad for a technical fix.

Doubtless, the way we measure inflation requires continuous refinement. The
Bureau of Labor Statistics (BLS) takes this task seriously, and has made myriad
small adjustments over the past three decades. For years, there was a nuanced
and relatively obscure debate about how to fine-tune the CPI. Lately, there has
been a politically driven frenzy, as a small group of economists has labored to
uncover--and exaggerate--all the ways in which the CPI might overstate
inflation. Many claims have been advanced based on very little real evidence.
There has also been virtually no effort to examine the ways in which the CPI
might understate inflation.

The immediate protagonists are the five-member panel appointed by the Senate
Finance Committee, chaired by former Bush economic advisor Michael Boskin, to
make recommendations on revisions in the CPI. Though the group includes some
eminent economists, all had previously testified on the CPI's supposed bias. All
were chosen as known quantities who could be reliably counted upon to recommend
a downward revision. Other eminent economists such as former BLS Commissioner
Janet Norwood, who took the opposite view, were ignored. The panel was appointed
in June 1995 and announced its 1 percent solution in mid-September. It conducted
no original research. Instead, it used rough rules of thumb to reach its
conclusions.




THE CASE FOR SHRINKING THE CPI

Five factors are usually cited by those claiming an upward bias in the CPI.
Each provides some basis for claiming the index overstates inflation. However,
the size of any resulting overstatement is far smaller than what is being
claimed, and may well be offset by the sources of understatement in the CPI.

Substitution Effects. This is the most frequently cited source of bias,
perhaps because so many reporters learned about it in their introductory
economics classes. Most goods have close substitutes. If oranges are $1.99 a
pound, consumers switch to apples. The CPI measures the prices of a fixed basket
of goods and services. When the price of some goods in this basket rises
temporarily, thrifty consumers shift to substitutes. By holding the basket
fixed, the CPI then overstates the true increase in the cost of living for most
consumers. This is a fair criticism.

However, most studies that have tried to measure the size of this bias find it
to be very small, between 0.1 percent and 0.2 percent annually. (The Boskin
panel scored it as 0.3 percent.) Moreover, one might fairly argue that even a
close substitution "choice" dictated by a price rise entails an
offsetting loss to quality. Presuming the substitute to be identical is like
comparing, well, apples and oranges.

The Wal-Mart Effect. Over the last several decades discount stores have
displaced many traditional retailers. As a result, consumers purchase many goods
at far lower prices. The CPI does base its local samples on where consumers
actually shop, but the CPI does not record the switch from a traditional
department store to a discount store as a price decline. Rather, the price
differential is treated as offsetting the lower quality of service in the
discount store. Clearly this treatment misses a cost saving. Since discount
stores have grown rapidly at the expense of traditional retailers, many
consumers must consider the cheaper price well worth the lower quality service.

However, the importance of this difference for the CPI has been vastly
overstated. Only about 15 percent of the index consists of goods that could
potentially be sold in discount stores (primarily apparel, appliances, and
household furniture). The share of consumers who patronize discounters versus
full-price retailers simply does not change much from year to year. Moreover,
even if the true price difference is as much as 10 percent (after adjusting for
differences in service quality), this would lead to a bias of just 0.015 percent
a year. This compares to a figure of 0.2 percent to 0.4 percent often cited by
those claiming a substantial CPI overstatement of inflation. The Boskin panel
used a figure of 0.2 percent.



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Quality Bias. One of the largest sources of alleged overstatement of
inflation is the failure of the consumer price index to fully account for the
improvements in product quality. Clearly, a $2,000 computer today is a far
superior machine to a $2,000 computer bought as recently as 1994. Most products
are continuously improving in quality. But in fact, the consumer price index
already includes extensive adjustments for product quality. It may even
overstate the improvement in quality in some cases.

For example, the price index for new cars has increased approximately 150
percent from 1970 to the present, although the average price of an actual new
car has increased about fourfold. Based on the CPI's price adjustment, it should
be possible to purchase a car today for approximately 2.5 times what a
comparable car cost in 1970. In 1970, a new Volkswagen Beetle cost about $2,000.
But no new car is on the market today for anything close to $5,000, as would be
implied by the new car index. The bottom-of-the-line new car available today for
$9,000 is doubtless a significantly better car than a Volkswagen Beetle, but
there are probably many consumers who would prefer to purchase a new Beetle at
$5,000 rather than pay more for a better car.

This is the general problem with the quality adjustments in the index. Price
increases attributed to quality adjustments are not counted as price increases
in the index, even though many consumers might not pay for them if they had the
choice.

There are also many areas where quality has plainly deteriorated. For example,
many consumers have to spend more time fighting with health insurance companies
over the processing of claims than 20 years ago, but this deterioration is not
picked up in the index. Airline service has declined--less legroom, more changes
of planes and missed connections, fewer meals, more convoluted fares. Other
examples include longer waits in traffic and time spent waiting on hold or
navigating voicemail instructions. None of these quality deteriorations are
recorded in the CPI. Given the very limited research on quality adjustments in
the CPI (the most frequently cited work is now twelve years out of date), it is
impossible to reach any conclusive judgment about the size, or direction, of
quality bias in the present index.

New Products. New goods are typically not included in the index until
several years after they first appear on the market. During this time, they
often undergo large price reductions--which are not picked up in the index. The
inclusion of these price declines would lead to a lower measure of inflation.
The classic example of this problem is the hand calculator. When it first
appeared on the market it cost over $1,000. Within a couple of years its price
had fallen to under $100. This huge decline in price was not picked up in the
CPI.

But wait. Most people don't buy very expensive new products. Such products only
find mass markets after their price has come down dramatically. (How many people
bought thousand-dollar hand calculators?)

The CPI is an "expenditure- weighted index," meaning that each dollar
of consumer expenditure is weighted equally. This means that if Donald Trump
spends 1,000 times what the average consumer spends, his expenditures count
1,000 times as much as those of the average consumer. Of course, it is the
Donald Trumps who buy the expensive new products.

However, it is possible to construct the index in a different way, which would
count each consumer's expenditures equally. Under this system 1 percent of my
budget would count the same as 1 percent of Donald Trump's budget in determining
the weighting of a particular item. Such an approach is clearly more appropriate
for the purposes the CPI is intended for. There is no reason that Social
Security recipients should get a smaller cost of living adjustment because a few
wealthy people experience huge savings on hand calculators. Nor does it make
sense that such a bonanza for the wealthy should affect wage contracts that use
the CPI as a point of reference.

A "person-weighted" index that counted each individual's expenditures
equally would provide a much better gauge of the increase in the cost of living
experienced by most of the population--and it would virtually eliminate the
problem of new goods as a source of bias in the index. Here is a case crying out
for a genuine technical adjustment, but one that cuts in the opposite direction
from the Boskin panel.

Formula Bias. This is the most technical issue (sorry). Suppose the
price of a good rises from $1.00 to $1.10. This is a 10 percent increase in
price. Suppose it then falls back from $1.10 to $1.00; this is a 9 percent
decrease in price. If these changes were just added together it would imply a 1
percent increase in price even though the price had not changed at all. BLS was
never so foolish as to construct the CPI in such a way that it would be
generally subject to this bias. But there are other such technical problems. BLS
has researched this issue extensively, and uncovered and corrected several such
areas. It is possible that problems of this sort may still exist in places, but
the impact is likely to be extremely small, almost certainly less than 0.1
percent annually.

Let's give the critics the benefit of the doubt. Adding all of these possible
biases together, a plausible estimate of inflation overstatement in the CPI
would be 0.4 percent--not the one full percentage point estimated by the Boskin
panel. But this is a gross adjustment, not a net one: It revises only those
elements of the CPI that apparently overstate inflation. To be accurate, one
needs to offset this adjustment with factors that suggest the CPI may be too
low.




A DOWNWARD BIAS?

The possibility that the CPI understates inflation has received little
attention, since it won't help cut the deficit. Indeed, if the CPI errs on the
low side, then Social Security pensioners should be getting bigger checks.
Consider three distinct sources of downward bias:

Health Insurance Costs. The CPI does not include most increases in
insurance premiums for individual health insurance, or increases in copayments
or deductibles on employer-purchased insurance. This has been a major drain on
household budgets in recent years, as employers have shifted more of the cost of
health insurance back to their employees. Nor does the CPI include increases in
required payments by beneficiaries of government programs such as the proposed
increases in the Medicare Part B premium. This exclusion would lead to an
enormous understatement in the cost of living of an elderly household. Even
under the Clinton Medicare proposal, the premium is scheduled to rise by
approximately $500 per beneficiary over the next seven years. This increase will
consume nearly 5 percent of the annual income of a couple with an income of
$20,000, the midpoint of the income distribution for families over 65. Under the
Gingrich proposal, the total increased costs to consumers would be substantially
higher.

Today's basket of health services is in many respects superior to that of, say,
two decades ago--thanks to new technologies, drugs, and lifesaving procedures.
It's also true that under managed care, many doctors are more harried and
patients are often rushed out of hospitals. Some of the higher cost of today's
health care reflects not better service, but deadweight losses--the cost of
claims processing, risk selection, mergers, and acquisitions. Spending on health
care has quintupled in three decades, but it's not at all clear that the quality
has. It would take a great deal more research to determine how to net out the
improvements and degradations to quality, and then weigh them against the
unambiguously higher cost.

Personal Business Expenditures. This category of expenditures, which
includes items such as lawyers' and brokerage fees, has been rising at the rate
of 0.2 percent a year for the past 20 years as a share of disposable income.
This is a category of spending that may not provide direct benefits to consumers
but rather is often a cost of maintaining a standard of living threatened by
deteriorating external circumstances. Suppose, for example, that I have to hire
a lawyer in order to resolve a dispute with my health insurance company, because
health insurers are becoming more aggressive. Compared to a situation where the
insurance company deals with me honorably, this is a needless expense. I am
worse off in direct proportion to the amount of money that I have to spend on my
lawyer, regardless of the quantity or quality of legal services provided.

Similarly, if I have to rely on a private financial counselor to ensure a secure
retirement, instead of receiving a company pension, I am worse off in direct
proportion to the amount of money I must pay the counselor, not the fee per
financial transaction. Likewise the cost of divorce lawyers and security
consultants. Since the CPI only measures the change in the price of these
services, rather than the change in the overall need for the services or genuine
benefit derived, it is understating the true increase in the cost of living.

Quality of Life Factors. Many factors that affect the quality of life
are not picked up in the CPI. An obvious example is crime. If people have to
spend more money in order to live in a safe neighborhood--say on security
alarms--it is not captured by the CPI. Nor is a deterioration in the quality of
public schools and therefore an increased need for spending on private schools
or personal tutors. Nor is the cost of joining a private exercise club because
the local public facility has closed or become unsafe. Many of these issues are
quite complex and cannot be easily quantified in any meaningful way, but this
doesn't make them any less real. Anyone attempting to make conclusive statements
about changes in the "true" cost of living must be prepared to address
such issues.

Given the very limited amount of research on the biases in the CPI, it is
impossible at this point to reach any conclusive judgment about the magnitude or
direction of the overall bias in the index. While the claim that "the CPI
overstates inflation" has become a virtual mantra of the Washington
punditry, honest proponents of this view acknowledge that it is based on very
little evidence. The best solution would be to provide the professional
statisticians at BLS with the resources they need to improve the CPI. This is
clearly preferable to bending economic statistics in whatever direction is
politically expedient.




Unexpected Twists

One striking thing about this whole debate is that conservatives try to have
the argument both ways. Supposedly, a lower CPI would cut the deficit; and
cutting the deficit would stop us from "robbing our grandchildren."
But if the Boskin panel is right and the CPI is overstated by 1 percent per
year, then real median wages are rising at 2 percent per year. This means that
they will double in approximately 35 years, so that the average real wage will
be approximately $50,000 a year (in 1995 dollars) in the year 2030. If so, our
grandchildren will do just fine and there's no need to slash the Social Security
of their grandparents.

An overstated CPI also means that people had been much poorer in the recent past
than we realized. If the CPI was overstated by 1.5 percent in the past, as
suggested by the Boskin Commission, then the average annual wage in 1960 was
just $11,215 measured in 1995 dollars. In 1960, today's 70-year-olds were 35. It
is hard to justify taking Social Security benefits from these people in order to
make the 35-year-olds of 2030 better off.

In addition, the critics have ignored the implications of a significant CPI
revision for monetary policy and growth. Alan Greenspan, chairman of the Federal
Reserve, has testified that the CPI overstates inflation by as much as 1.5
percent. But if the official inflation rate is lowered, it undermines the entire
rationale of Greenspan's tight money policy. So politicizing the CPI leads to
some unexpected implications. It would be far better to return the question of
CPI revision to intellectually honest technicians, where it belongs, and to
argue deficit reduction on its merits.



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