Who's Afraid of Chained CPI?

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The fiscal cliff debate hangs on an arcane fix for measuring inflation. Both sides should know way we measure inflation is arbitrary and flawed, by nature.

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Reuters

As the fiscal cliff talks evolve and devolve, the latest spat has been whether the arc of federal spending should be curtailed by changing the way that we assess costs. The proposal from the White House is to switch the way cost-of-living adjustments are made for Social Security benefits. Rather than pegging those to the Consumer Price Index as currently calculated, these would be pegged to a "chain-weighted" Consumer Price Index, which would save as much as $125 billion in additional benefits over the next decade.

Sounds wonky, and it is. But so is much of how the federal government accounts for spending, and these metrics intimately shape what we spend, how we spend, and how we think about the present and the future. The primary measure of inflation, the Consumer Price Index (CPI) uses a fixed basket of goods that resets periodically. Chained CPI uses a basket of goods that adjust more fluidly to account for what statisticians and economists call "the substitution effect." A fixed basket of goods is easier to calculate: just define the basket and then measure the price changes. But in the real world, people don't passively accept changing prices. They change their behavior. The price of gas goes up? People drive less; they carpool more; they buy more fuel-efficient cars and consume less gas. The price of a domestic flat screen television goes up? They buy a less expensive import. In short, people don't necessarily bear rising costs passively; they react and shift to maintain their standard of living. The traditional CPI index doesn't capture that.

For all its wonkiness, the proposal to change the benchmark used to determine Social Security and various other benefits has engendered attacks from all points on the political spectrum: the left assails it as a backdoor technicality that will increase burdens on the elderly and the less well-off; the right scoffs that Obama's proposals don't constitute true deficit or spending reduction but are simply accounting tricks, and the media treats it as politics as usual with the cynical corollary that because almost no one understands what these rules are, it makes it easier to enact them.

Despite ample media scrutiny over the past week, it's safe to say that this debate is about as arcane as it gets. Almost no one knows the difference between CPI and chained CPI, even if for years the Bureau of Labor Statistics has been compiling multiple varieties of the index, which serves as a proxy for the rate of inflation. One variant is the chained index. There are others, including a special index for cost-of-living for the elderly and for CPI minus the volatile effects of energy and food (known as Core CPI). All of these use quarterly surveys of 7,000 families about prices paid for 211 different consumer goods in 38 different regions, for a total of 8,018 data points. That is how we assess inflation: whether those data points are going up or down, month-to-month. Every two years, that basket of goods and their weight in the index is adjusted.

Long before the current imbroglio, there have been questions about how inflation is calculated. Statisticians have understood the issues about "substitution effect" for years. In fact, they understood that when these indices were created. In the 1920s, Irving Fisher of Yale argued that the "ideal index" of prices would be a blend of fixed baskets of goods and something that captured how behavior changes in real time. The problem is that the fixed basket is easier to calculate and less costly. That is what the BLS adopted in the 1940s and what has been the standard ever since. In turn, Social Security benefits were pegged to the index, with cost-of-living adjustments based on what the official CPI reported.

Now comes the White House saying: 'Hey, let's base those increases not on CPI as it emerged in the 1940s but on "chained CPI."' Overall, the chained CPI or any chained index that accounts for how people react to higher prices tends to report less "inflation," hence the $125 billion in savings.

The proposal has plenty of precedents. The BLS in 2002 began calculating an alternate CPI (called the C-CPI-U), a chained CPI, which is precisely the metric that the president now suggests. It did so after decades of criticism that its methodology was too brittle and did not capture prices as they are actually experienced and then offset by consumer behavior. In fact, in the 1990s, the Federal Reserve under then Chairman Alan Greenspan decided to base its interest rate decision more on what is known as the Personal Consumption Expenditure Deflator reported by the Bureau of Economic Analysis in the belief that it better captured actual inflation than the CPI.

So if your head is spinning with all of the acronyms, let alone the inside-baseball methodology, the larger point is that this thing we call "inflation" has never been a simple number. Few people over the past decades believe that inflation has been truly tamed. The headline numbers say that inflation has been increasing at a modest 2 to 3 percent for the past two decades, but most people believe that the cost of living has been much greater. They experience daily the gap between their needs, wants and income. Inflation as a statistic, however, is not concerned with those challenges. It is an attempt to measure prices systemically, and not whether Mr. Smith in Tulsa is managing to balance his expenses and income.

Ever since the Great Inflation of the 1970s, however, inflation has been a metaphor for whether the country is thriving. Clearly - whether this is acknowledged or not - there has been a gap between the expenses many people must bear and the organic ability of the country to grow and meet those needs. Whether that is any greater than it was in the 1950s - the supposed high point of the American century when as much as a quarter of the population lived in poverty - well, that is another question.

What the proposals this week do reveal, however, is how often our understanding of the world is based on official statistics that are themselves limited. Numbers like CPI were never seen by their inventors or by their compilers as absolutes that perfectly answer pressing social questions such as what is a living wage and what is the basic cost of living for an average family. Their flaws were understood from the get-go, and government statisticians have been tinkering with them for decades, fully aware that they are arbitrary and limited.

In essence, these statistics have always been subject to revision. They have always been arbitrary markers attempting to answer thorny issues of whether our economic system is stable and providing people with the means to meet or exceed basic needs and then some. There is nothing sacrosanct about the current measures, and no sacred cows are at risk with the president's proposal to adjust the CPI to reflect a more fluid measure. It may be inside baseball; it may strike many as yet another cynical way to make future costs evaporate and leave the consequences to those least able to bear them. But in truth, these proposals open up a wealth of possibilities to alter our current spending trajectory with the full knowledge that much of what we take for granted is based on numbers that we invented only a few decades ago and which have always been limited, provisional and subject to improvement. Chained CPI? Bring it on.

"The Edgy Optimist" column is initially published at Reuters.com, an Atlantic partner site

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Zachary Karabell is Head of Global Strategy at Envestnet, a financial services firm, and author of The Leading Indicators: A Short History of the Numbers that Rule Our World. More

At River Twice Research, Karabell analyzes economic and political trends. He is also a senior advisor for Business for Social Responsibility. Previously, he was executive vice president, head of marketing and chief economist at Fred Alger Management, a New York-based investment firm, and president of Fred Alger and Company, as well as portfolio manager of the China-U.S. Growth Fund, which won a five-star designation from Morningstar. He was also executive vice president of Alger's Spectra Funds, which launched the $30 million Spectra Green Fund based on the idea that profit and sustainability are linked. Educated at Columbia, Oxford, and Harvard, where he received his Ph.D., he is the author of several books, including Superfusion: How China and America Became One Economy and Why the World's Prosperity Depends on It (2009), The Last Campaign: How Harry Truman Won the 1948 Election, which won the Chicago Tribune Heartland Award, and Peace Be Upon You: The Story of Muslim, Christian, and Jewish Coexistence (2007), which examined the forgotten legacy of peace among the three faiths. In 2003, the World Economic Forum designated Karabell a "Global Leader for Tomorrow." He sits on the board of the World Policy Institute and the New America Foundation and is a member of the Council on Foreign Relations. He is a regular commentator on national news programs, such as CNBC and CNN, and has written for The Wall Street Journal, Newsweek, Time, The Washington Post, The New Republic, The Los Angeles Times, The New York Times, and Foreign Affairs.

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