Posted on | August 16, 2012 | No Comments
(This article by Philip Green and George Gabor first appeared as a special to the Financial Post on August 16 2012).
The Obama administration is considering adopting the “chained consumer price index,” as the principal measure of inflation upon which increases in payments to such things as Social Security would be tied. The Chained-CPI is lower than the CPI. Adjustments to payouts will fall behind price inflation, reducing the deficit. The administration and some members of Congress tout improved accuracy as a reason for the change. That claim is misleading. The prime reason is a self-serving desire to save money by stealth.
In 2003 the U.S. Bureau of Labor Statistics devised the Chained-CPI because it wanted an additional index that was closer to a cost-of-living index than a price index. In a pure price index, the basket of goods remains fixed and the index tracks the increase of prices in the basket. Consumers, though, have limited budgets, so they substitute products whose prices go up with products whose prices are stable or go down. By doing so, they incur a decrease–or at least a change–in their quality of life. Their consumption behaviour means that a pure price index does not track what they spend as they adapt to prices. The Chained-CPI attempts to track their spending on the items in the basket, rather than the prices of specific things in the basket.
Politicians and the financial press are understandably and justifiably celebrating the prospects of lower spending based on an “improved” CPI. The apparently lower inflation figure however will increase tax bracket creep, and thus taxes. It will also overstate GPD growth.
The proponents of the Chained-CPI justify the change by saying it is more “accurate.” Bloomberg says the “more accurate gauge of U.S. inflation … would yield immediate savings,” to the U.S. government: up to $300-billion within a decade. Payments for Social Security benefits that are tied to the CPI would decrease by $112- billion from 2012 to 2021. Social Security is the largest single expenditure in the U.S. budget.
“I don’t see how anybody can argue against having accurate formulas,” said Senator Mike Crapo (R). The co-chairs of President Obama’s National Commission on Fiscal Responsibility and Reform, said in the “co-Chair’s Proposal” that “current measures of inflation overestimate increases in cost of living” and that “adopting a more accurate measure of inflation would achieve savings government-wide.” The editors of Bloomberg say the Chained-CPI is “a more exact measure that accounts for the substitutions consumers make when a product’s price goes up.”
The justification of “accuracy” does not make sense when talking about inflation. It makes sense to talk about the accuracy of measurement instruments, such as a thermometer, because temperature is a real physical thing. The definition of “temperature” is clear, universally accepted, and firmly rooted in reality. You can check the accuracy of a thermometer by sticking it in ice water to get 0C and boiling water to get 100C.
Inflation is another story. You cannot do such an indisputable check on the accuracy of an inflation index. With any inflation index, the definition is the measurement “instrument” so it can’t possibly be inaccurate. It can, however, clash with a whole slew of other possible definitions according to which it will be deemed inaccurate. You cannot compare it to physical reality. You might be able to argue it is more practical because it is a better representation of reality. But be prepared for someone to disagree because they will see reality differently.
There is nothing wrong with having both a cost-of-living index and a consumer price index. The difference between the two is an indicator of the loss of standard of living caused by consumer price inflation.
But pretending that cost-of-living index can replace a price index would be like government meteorologists changing the way they report the temperature to adjust for consumers substituting autumn coats for winter ones.
Bloomberg explains the chained-CPI with an example of the kind of consumer behaviour it captures: shoppers stop buying Granny Smith apples because their price goes up and switch to cheaper red delicious apples, or switch to oranges if both become too dear. A consumer price index would track the increase in the price of Granny Smith apples; a cost-of-living index tracks what they spend on fruit within the constraints of their limited budgets. One tracks the price of apples, the other the cost of buying whatever fruit consumers can afford. Politicians with backbones could make the case that in austere times increases in Social Security payments should track the chained-CPI rather than the CPI, because in austere times you cannot expect to maintain your quality-of-life.
Economist John Williams, who runs a website called Shadowstats.com, says that base political motives are at work. He told us “the reasons for the CPI changes have been stated clearly by political Washington: to reduce the deficit by cutting cost of living adjustments to Social Security.”
When survival strategies in the face of price inflation are part of the way the government measures inflation, then distortion rather than accuracy seems to be the more apt description.
Philip Green and George Gabor are co-authors of misLeading Indicators: How to Reliably Measure Your Business, published by Praeger. www.misleadingindicators.com.
© 2012 Greenbridge Management Inc.