Inflation
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.
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