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The Cost of Living: A New Myth

Toward a More Accurate Measure of the Cost of Living Commission to Study the Consumer Price Index

Final Report to the Senate Finance Committee from the Advisory
94 pp.

Bias in the Consumer Price Index: What is the Evidence?

by Brent R. Moulton. Journal of Economic Perspectives

American Standards of Living, 1918-1988

by Clair Brown
Blackwell, 489 pp., $39.95

Getting Prices Right: A Methodologically Consistent Consumer Price Index, 1953-94

by Dean Baker
Economic Policy Institute, plus appendices pp., $10.00

1.

When the Advisory Commission to Study the Consumer Price Index released its report in early December claiming that consumer inflation is being overstated by 1.1 percent a year, its findings were generally treated by the press as if they were technically irreproachable. The Boskin Commission, appointed by the Senate Finance Committee and named after its chairman, Michael Boskin, President Bush’s chairman of the Council of Economic Advisers, was repeatedly described as “blue-ribbon,” “distinguished,” and “bipartisan.” The report was said to have met the highest academic standards. Many people I spoke to, including economists, took it for granted that the Commission was at least approximately right, and recently Alan Greenspan, the Federal Reserve chairman, spoke approvingly of its conclusions.1 All agreed that the consequences were enormous. To take one example: because the payments for many federal programs, the largest of which is Social Security, are linked to the Consumer Price Index (CPI), it would cost the government an unnecessary $1 trillion in additional spending between now and 2008 if the CPI were indeed overstated by 1.1 percent.

But without working directly on the problem of consumer prices, even the most thoughtful economists, not to mention members of the financial press, may not be able to appreciate fully the labyrinthine complexity of the CPI. In fact, the Boskin Commission’s conclusions are based on a high degree of conjecture and speculation, as I believe most interested observers would conclude if they actually read the ninety-page report. The Commission conducted little original research and much of the evidence it cites is old or covers only limited periods of time. Even a strong supporter of the Commission’s work, William Nordhaus, professor of economics at Yale, warned at the recent convention of the American Economics Association in New Orleans that some of the most important of the Commission’s conclusions are “highly subjective.” The adjustments in the index for the price for food, according to Nordhaus, “have no quantitative support; housing is a guess; and medical care is based on a few preliminary studies comprising a tiny fraction of the expenditures.” A member of the commission, Harvard professor Zvi Griliches, was quoted in a New York Times article as conceding that the numbers are “squishy.”2

The CPI is the nation’s main measure of consumer inflation. The Bureau of Labor Statistics (BLS), which compiles the CPI, tracks the prices of about 80,000 goods and services each month in seven major groups, such as food, clothing, and medical care, and the rents of about 5,000 apartment units. It calculates the relative amounts consumers spend in each of these categories, and the overall average is turned into an index in which 100 is equivalent to the average of prices in the period 1982-1984. The change from year to year in this index is consumer inflation. In 1996, the CPI rose to 158.6, a rise of 3.3 percent from the previous year. If the Boskin Commission is right and the CPI is overstated by 1.1 percent, then consumer inflation in 1996 was only 2.2 percent.

The Boskin Commission believes the CPI overstates true inflation in several ways. First, it claims, the index is updated too slowly to reflect the consequences when consumers substitute one product or one brand for another as prices change. If the price of beef goes up, more consumers will buy chicken instead, but the CPI will not take into account that they are paying lower prices for chicken. The Boskin Commission concludes that the CPI is really .4 percent a year lower than reported as a result of the effect of substitution and related technical concerns. This is the best-documented of the Commission’s claims.

As for the rest of the Boskin Commission’s estimated overstatement of the CPI (within a range of .8 percent to 1.6 percent), it attributes another .1 percent to the failure of the CPI to allow for the proliferation of new discount retailers who charge significantly lower prices. The largest share of the adjustment—.6 percent—the Commission attributes both to improvements in the quality of existing and the introduction of new products that are not recorded by the CPI. An unspecified part of this it also attributes to the CPI’s failure to take account of the decline in the prices of new products—such as cellular phones—fairly soon after they are introduced. These proposed adjustments for quality improvements are the most subjective of the Commission’s claims.

But in addition to the speculative nature of the Commission’s conclusions about quality, what has also been missed in most press accounts is the degree to which the BLS already makes a large adjustment in the CPI for such quality improvements—in fact, a considerably larger one than the .6 percent recommended by the Commission. Prices are reduced for quality because as products improve, the consumer is able to buy more well-being for every dollar spent. For example, if automobiles are much better than they once were—more efficient in their use of fuel or more durable—an increase in the price of those cars should justifiably be reduced by some amount when computing the cost of living. Consumers, it can be said, are buying “much more car” than they once did. Similar adjustments should ideally be made for improvements in the quality of food, clothing, consumer electronics, health care, and so on.

The BLS, however, has its own procedures to take account of such changes in quality, and these have been largely ignored both by the Boskin Commission’s report and the comments on it. Several of the most important of these procedures were significantly revised and improved in the 1980s, and last year, the BLS conducted a study to determine the size of adjustments made to the CPI as a result of improved quality. The study, completed only this November, included about two thirds of all the goods and services in the CPI during 1995. When we extrapolate for the entire basket of goods and services, the adjustments for improved quality total about 2.2 percent of the index. 3 The size of this adjustment surprised every economist I spoke to before writing this article. In other words, had the BLS made no adjustments for quality and merely recorded price increases, the CPI would have risen by about 4.7 percent in 1995 rather than the reported 2.5 percent.

Though the Boskin Commission had access to this study, if only a few weeks before publication of its report, it made no mention of it. The Commission says that the improvements in quality it is discussing are for the most part above and beyond what the BLS takes into account. But this is not necessarily the case, and it is one of many questions that require further investigation. The BLS is reviewing its study and may, I am told, reduce somewhat the estimate of its adjustments for quality.4 But even so, the adjustment is so large that some economists believe the BLS may actually overestimate improvements in quality by as much as, or more than, the amount that the Boskin Commission thinks quality has been underestimated.

None of this is to say that the Boskin Commission hasn’t summarized much useful information about how information on prices is gathered today. Its stated objective, which is to turn the CPI into a measure of the true cost of living rather than merely of price changes, is commendable. But after reading the Boskin Commission report and several other analyses of the CPI—one of the most important of which, “Bias in the Consumer Price Index: What is the Evidence?” is by a BLS staff member, Brent Moulton—it seems to me that any immediate acceptance of the Commission’s main conclusions is decidedly premature. After more research is completed, the Commission could well turn out to be wrong.5

Careful appraisal of its conclusions is all the more important when we consider how serious the consequences of either overstating or understating the CPI can be. As the Commission points out, fully one third of the federal budget is indexed to the CPI. The annual cost-of-living adjustments to Social Security benefits are determined by the annual change in the CPI, as are those in other federal pension programs. Income tax brackets are also adjusted according to the CPI. If the CPI is overstated by 1.1 percent, according to the Boskin Commission, the federal government will have a net additional expenditure of $148 billion more than it should in the year 2006 alone. The cumulative outlay would come close to $700 billion over the next ten years and, as noted, reach more than $1 trillion in 2008. It is not hard to understand why the Senate Finance Committee is interested in the subject, or how politically convenient it might be for Washington’s budget balancers if there were a broad technical consensus among economists that the CPI overstates inflation.

But if the CPI is incorrectly reduced by as much as 1.1 percent a year, it would harshly penalize many Americans. The AFL-CIO figures that an average retired couple would lose $2,360 over the next five years if the cost-of-living adjustment for Social Security were reduced by 1.1 percent a year. The average widow or widower would lose $1,470. Many private corporate pensions are tied to the CPI as well, as are private wage contracts and rents. Nor is it apparent that the CPI, which measures average inflation for all consumers, is applicable to the elderly. In a recent study, the BLS found that actual price increases for the elderly may exceed the current CPI by .2 percent or .3 percent a year.6 A reduced CPI would also lower the poverty threshold, removing many poor Americans from benefit programs. In fact the cost-of-living increases for the poor may be significantly underestimated by the CPI. A study by the economist Trudi J. Renwick finds that the increase in the cost of living of single-family households at or below the poverty line has been understated by the CPI by 50 to 100 percent since 1983.7

The CPI is also essential for measuring the performance of the economy. It is used to determine how much total expenditures on consumption should be discounted for inflation in the Gross Domestic Product, and it therefore affects the federal government’s computations of economic growth and productivity. It is also used by the government to discount workers’ wages to determine “real wages.” A reduction in the CPI would imply that the economy and real wages have grown faster than we thought. On the other hand, because the overstatement of CPI would apply approximately as much to the years before the early 1970s as after, the widely reported slowdown since the early 1970s in the growth of Gross Domestic Product, productivity, and real wages would still have taken place even if the Boskin Commission proves right.8 A lower CPI between 1945 and 1973 would simply imply that real economic growth was significantly higher in those years than reported.

  1. 1

    The Commission members include Michael J. Boskin, professor of economics at Stanford University; Ellen R. Dulberger, director of marketing strategy for IBM Personal Computer Company; Robert J. Gordon, professor of economics at Northwestern University; Zvi Griliches, professor of economics at Harvard University; and Dale Jorgensen, professor of economics at Harvard University.

  2. 2

    Louis Uchitelle, “Balancing Quantity, Quality and Inflation,” The New York Times, December 18, 1996. This article and another by John M. Berry, “CPI Report Coming Under Fire,” The Washington Post, December 19, 1996, are noteworthy exceptions to the press’s uncritical reception.

  3. 3

    Brent R. Moulton and Karen E. Smedley, “Addressing the Quality Change Issue in the Consumer Price Index,” Bureau of Labor Statistics, Washington, D.C., draft of research in progress, January 1997. The BLS studied nearly 70 percent of the goods and services in the CPI and found that it made quality adjustments amounting to 2.56 percent in 1995. Assuming that some but not as much quality adjustment was made for the remaining 30 percent, a private economist, Charles Hulten, estimates that the entire CPI was adjusted by the equivalent of about 2.2 percent.

  4. 4

    The BLS is currently combing the data for possible distortions in its sample. But it doubts any adjustments will total more than .5 percent and thinks it is probably less.

  5. 5

    Brent Moulton lists a number of other estimates of the overstatement of the CPI, but all are less detailed or comprehensive than the Boskin Commission report, and some are admittedly merely educated guesses. All were published before the degree of quality adjustment made by the BLS was known. The Congressional Budget Office, for example, estimated the overstatement between .2 percent and .8 percent a year. Jim Klumpner of the Senate Budget Committee estimated the overstatement between .3 percent and .5 percent a year. Though not mentioned by Moulton, the highest estimate I have seen was nearly 3 percent by Leonard I. Nakamura of the Federal Reserve Bank of Philadelphia, whose methods were the least orthodox of those cited. Moulton notes that the literature in general is biased by examination of goods and services where there is a high likelihood that quality improvements will be significant.

  6. 6

    Kenneth J. Stewart and Joseph Pavalone, “Experimental Consumer Price Index, Americans 62 years of Age and Older,” Bureau of Labor Statistics, 1996. The main reason for a higher cost of living for the elderly is their out-of-pocket health costs, which have risen rapidly in recent years. The Boskin Commission makes note of this but claims there may be offsets such as elderly price discounts. It did not actually do research on the subject, however.

  7. 7

    Trudi J. Renwick, “Basic Needs Budget: 1996,” Public Utility Law Project of New York, Inc., 1996.

  8. 8

    Boskin himself made this point at the annual meeting of the American Economics Association in New Orleans in early January.

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