Jeff Madrick on the CPI

[michael perelman <michael@xxxxxxxxxxxxxxxxx>]

http://www.nytimes.com/2001/12/27/business/27SCEN.html

December 27, 2001

How Much Does Anyone Really Know About the Real Rate of
Inflation

By JEFF MADRICK

  n 1997, a commission appointed by the Senate Finance Committee
concluded that the annual
  Consumer Price Index computed by the Bureau of Labor Statistics was
probably 1.1 percent too
high, and perhaps even more.

The Boskin commission's findings, named after its chairman, Michael
Boskin, a Stanford economist
who served as President George Bush's chief economic adviser, made
headlines in the financial news
media, and many took its conclusions as gospel.

But perhaps they shouldn't have. At the time, many members of the Senate
Finance Committee were
cheered by the findings. To them, it meant the federal government could
justify reducing Social
Security benefits, because payments are tied to increases in the price
index. So are countless wage
contracts, as are the federal income-tax brackets.

If it was right, it also meant that both the economy and productivity
were growing faster than
reported, a boon to arguments on Wall Street and in Washington that the
nation was embarked on a
new economic revolution.

But a new, comprehensive study sponsored by the National Academy of
Sciences, and partly
commissioned by the Bureau of Labor Statistics itself, raises serious
questions about just how much
the Boskin commission or anyone else knows about the true rate of
inflation.

The study, undertaken by a panel of 13 economists from a wide variety of
institutions and led by
Charles Schultze of the Brookings Institution, restores one's faith in
cool-headed economic analysis
and measured use of economic theory.

"It is the report that the Boskin commission should have done," says
Joel Popkin, a Washington
economic consultant.

The main contention of the Boskin report was that the Labor Department's
statistical experts did not
fully take into account the improved quality of many products. You may
pay $1 for a razor, but if you
get twice as many shaves as before, you are really getting more for your
money. In effect, you are
paying 50 cents for that razor.

The same is true with automobiles. If they are more durable or have
automatic window locks, say,
buyers are getting a little more for their money. The labor bureau
basically agrees with the theory and
makes many such adjustments. But Mr. Boskin's group and many other
economists contend that the
adjustments are not adequate and that reported inflation has been much
too high.

The problem with that argument, says the Schultze panel, is that such
estimates are difficult to make
and easy to exaggerate. It points out many holes in the Boskin analysis.
For one thing, in some cases,
it is likely the Bureau of Labor Statistics over-adjusts for quality,
meaning inflation is too low, not
too high. For another, the Schultze panel cites evidence that the Boskin
commission may have
overstated quality in important areas.

For example, Jack Triplett, a former bureau economist now with
Brookings, says the Boskin
commission's analysis of quality increases for cars was simply
misinformed. Two government
economists, Brent Moulton and Karen Moses, seriously criticize the work
on housing and medical
care.

One of the striking oversights of the Boskin report, I believe, was that
it paid almost no attention to
areas in which product quality deteriorated, like airline service and
education. And in the years since,
consumer surveys consistently have found declining satisfaction for both
goods and services.

This Christmas season brought the point home for me. My new printer
broke down within a year, my
laptop within 18 months. My new answering machine garbles messages.

One assumption of the Boskin commission was rejected outright by the
Schultze panel. How do you
take account of the benefits to consumer well-being of new products?

Some ingenious economists believe you can assume the product already
exists but is sold at a price so
high that no one will buy it. They argue that the difference between the
imagined price and the actual
price of the new product, once introduced, should be included as a
reduction in the price index. But
such an estimate is difficult to make credibly, and including benefits
from new goods as a reduction
of inflation, the panel concluded, is itself theoretically questionable.

The most important contribution of the panel, however, was to clarify
the central assumptions about
the uses of the C.P.I. and other price indexes.

The simplest way to measure prices is to compute the changes for a fixed
basket of goods and
services. This is what probably most Americans think the consumer price
index does. But in the early
1960's, a government commission urged the Bureau of Labor Statistics to
adopt a broader concept:
the index should reflect the cost of maintaining a given "standard of
living." Thus, if products
improve, the standard of living improves, or it costs less to maintain
the old standard of living.

Certainly quality improvements have to be taken into account. But so
must many other factors that
affect the standard of living, including the quality of public goods,
like transportation and the
environment.

The Schultze panel concludes that such an index is inherently too
ambiguous to develop in an
objective way. How does one account for traffic congestion, for example?
A car is worth less if
traffic deteriorates. If the crime rate rises, people may have to buy
more security devices. Should that
be translated into a fall in living standards?

The panel also cites evidence that consumers need constant improvements
just to remain as satisfied
as they were. How does one incorporate rising expectations into an index
that measures the standard
of living?

The Schultze panel therefore recommends a conditional cost of living
index that is relatively
unambiguous, including quality adjustments but deliberately leaving out
issues like congestion,
environmental degradation and consumer expectations.

The panel makes no precise estimate of whether the C.P.I. overstates or
understands the true rate of
inflation. But given the questions the panel raises about the
commission's central assumptions and its
analysis of specific product areas, the claim that the C.P.I. has been
and may remain seriously
overstated is not nearly as clear-cut as many economists have assumed.
And reported inflation has
already been markedly reduced through recent changes introduced by
government statisticians
themselves.

I hope this report is put between hard covers soon. It is my business
book of the year.

--

Michael Perelman
Economics Department
California State University
Chico, CA 95929

Tel. 530-898-5321
E-Mail michael@xxxxxxxxxxxxxxxxx