April 15, 2005
What Is a Price Index, Anyway?
The joke about economists is that we talk about money, but we don’t have any. And when it comes to having power and wealth, the status of those who compile the economic statistics we all consume is usually several notches below even that of the lowly economist. Most are employed by government agencies, after all. And the last time I checked, I didn’t see anyone from the Forbes 100 list on a public payroll.
But the statistics these anonymous statisticians work hard to polish and perfect can reverberate throughout the economy. And fewer statistics are more powerful than the data reported for prices and inflation.
The Consumer Price Index, produced by the Bureau of Labor Statistics, is probably the single most important piece of economic data for businesses and households in the country. Its growth, which we call inflation, is factored into thousands, if not millions, of escalation clauses in labor agreements, purchase contracts, and government programs.
But what exactly is a price index? Few of us are probably inclined to even “pop the hood” on such a complex animal, much less form an opinion on what is good and what is bad about it. Yet with billions, if not trillions of dollars at stake, we should probably have a better idea of what the challenges and issues are in putting them together.
The questions may be technical, but their ramifications are profound. Just look at the issue of Social Security financing that is before us today. At least part of the deficit looming in the program’s future can be blamed on what was, essentially, a botched inflation indexing scheme.
For almost a decade, Congress let stand a faulty benefit calculation process in Social Security that essentially added an inflation correction twice. First, the wage base used to calculate benefits was boosted, then the benefits themselves were indexed. Since it was politically impossible to reduce benefits when the error was finally corrected, it pushed the benefit growth path permanently upward, benefiting current recipients but pushing the insolvency date closer.
Now another indexing question has emerged as central in the Social Security debate. Should benefits be indexed to wage growth, as is currently done, or should an index based on prices be used instead? This simple question is of enormous consequence to the long-term viability of the program, since switching from a wage to a price index would slow benefit growth. And it is hard to understand, beyond the desire of current retirees to simply have more money, why taxpayers should be expected to do any more than protect the purchasing power of the benefits of previous generations.
But what are these “prices” these indexes are supposed to be measuring? The question seems simple, but the answer is not. There are a few things, like gasoline, food, and toothpaste that most of us buy regularly and are easily defined. Those are easy. Then there are things like housing and life insurance that we don’t buy everyday. Those are harder. But hardest of all is the exploding category of goods and services – including everything from automobiles to health care – whose qualities have changed so drastically that a simple comparison of prices to the past cannot be made.
When quality and price both go up, which part is inflation and which is not? That’s a problem economic statisticians have grappled with for years. In fact, for items like computers and digital cameras, quality and price have usually moved in opposite directions. These kinds of phenomena help explain why, despite the highly visible escalation in prices for energy and health care, growth in the overall CPI remains at a fairly tame rate of less than 4 percent.
Even that overstates the impact of price increases on households, to hear some tell it. We don’t need to be fully compensated for, say, a rise in the price of coffee, because we can switch to drinking tea. And then we can resume arguing over price indices.
About the Author
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