Eye on the Pie and Opinion

MARCUS: Consumer Price Index proposal costs little, saves a lot

July 30, 2011

The struggle to reduce government spending involves many small cuts. One small change will produce many loud screams. A change in the calculation of the Consumer Price Index would reduce Social Security and supplemental income payments.

Congress and the administration want to compensate for inflation with a cost of living adjustment.

However, for all of our philosophical pondering combined with our statistical cleverness, we cannot figure out what is “living” nor determine its “cost.” At best, we can measure changes in the quantities we consume and the prices we pay. That is the CPI.

Today, we measure price changes in a simple fashion. Let’s consider Sam the Steadfast. He consumes the same amount of beer and pizza regardless of how prices change. Year after year, as beer and pizza prices rise, Sam drinks his 40 bottles of beer and eats 30 pizzas. It’s what he does on most Tuesdays. Back in 2007, Sam spent $160 a year on beer and pizza. In 2011, he is spending $414.

If nothing else is included, the CPI has gone up 159 percent. But Sam is not a typical consumer. Charles the Changer does what most of us do when prices rise: He consumes less. Where in 2007 he matched Sam spending $160, beer for beer and pizza for pizza, he now buys just 21 beers and 12 pizzas with a total outlay of $191, an increase of just 19 percent.

In this world, Charles has suffered a decline in his standard of living because he now consumes less. Sam’s standard of living has remained the same, but he is paying much more for it. To adjust for inflation and changes in consumption, we want a measure that combines price changes with changes in the quantities bought.

The current CPI answers the question, “What does it cost today to buy the same combination of goods we bought at some time in the past?” It does this by keeping the basket of goods constant and letting prices change. But how do we adjust for the fact that people do change the quantities they buy?

Fortunately, there is Herbie the Hybrid. Herbie buys quantities this year that Charles bought last year. Herbie’s behavior allows us to look at the cost of maintaining the same level of consumption as in the previous year. The difference is, we now average the results over a number of years. Thus, the consumption level changes annually along with prices.

In 2011, Herbie spends $226 on beer and pizza, or 41 percent more than the $160 he spent in 2007. What’s the rate of inflation? For Herbie the Hybrid, it’s 41 percent. For Sam the Steadfast, it’s 159 percent. For Charles the Changer, it’s 19 percent.

In the past, increases in Social Security checks were calculated holding the market basket constant following Sam’s example. The new calculation has been proposed since 1996. It employs Herbie’s hybrid approach, measuring average year-to-year changes in prices for Charles’ changing basket of goods, lagged by a year.

Believe it or not, this example is terribly oversimplified. But the practical issues hidden behind the curtains do come forth. Linking annual changes is standard for many of our economic statistics, but it is not used to adjust Social Security payments. That lets recipients receive a little extra cash each month, adding millions to the deficit each month.

What would it mean if the Herbie solution were adopted? Some analysts suggest the average Social Security check might fall about $3 per month. There are 60 million persons drawing Social Security or supplementary income payments.

In sum, the new calculation method amounts to $2.2 billion of savings in the first year of deficit reduction.•

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Marcus taught economics for more than 30 years at Indiana University and is the former director of IU’s Business Research Center. He can be reached at mmarcus@ibj.com.

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