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It’s Goldi-Locks economic methodology by the left. Sometimes methodological individualism is evil (like when folks like myself assert that there is no “we”) but sometimes it is essential. Here is a summary of the controversy over the President’s Budget which is suggesting we index social security benefits to a chained CPI rather than the traditional measure. I’ll keep this post from being too wonkish and remind readers of what I am talking about.

Traditional ways of measuring just how much prices “overall” change over time in an economy actually ask the question, “how much worse off is the typical person (in eco-speak we say “representative agent”) because of the price change? It’s hard to actually know the answer to this question. Why? How would you answer the question, “how much satisfaction do you get from consuming the entire bunch of stuff that you will consume this year?” And then imagine a follow-up question a year later after prices change (increase?), “now that prices have gone up, how much more money would you need in order for you to be just as satisfied as you were last year?” Since we don’t really know how satisfied we are, much less the “representative American” we end up calculating something quite different that we KNOW will leave you with the same satisfaction and we KNOW will also overstate just how bad the price change is for you.

What is that?

Well, I know what you consume today.

And I know what that costs you to consume today.

And I know what that would cost you to consume tomorrow after prices have changed.

So, the measure that the CPI normally uses is to ask how much your bundle fixed of goods has increased in cost from year to year.

Why do I know this makes you satisfied? Well, you were 🙂 level of satisfaction this year when you purchased that bundle. So if you purchase the same bundle next year, you will still be at 🙂 amount of satisfaction. So, if we ask how much more money you have to spend on this same bundle of stuff next year as compared to this year, this is a measure of how much worse off the price changes made you.

Now we KNOW that this HAS to overstate how bad the price changes are. Why? Because if prices increase, you rarely consume the same things especially if all prices do not increase at the same rate (this is what is meant by “substitution” in the linked article). When some prices increase faster than others, when we can, we consume more of the relatively cheaper stuff. To push this to the extreme, how much poorer would you REALLY feel if the price of a rare cavier increased by 1000% this year? Would you argue with a straight face that you are 1000% worse off? Not at all, most of us do not even eat caviar. So, make this example a little less extreme and this is what we mean by substitution. If “caviar” gets more expensive more quickly than “soup” we will substitute away from caviar and toward soup. Indeed, if soup prices do not change at all, then the “real” impact of the overall price increase on our well being, especially if we like soup as much as caviar, is very small.

The proposed price measure that the Obama Budget wishes to use corrects for these substitutions as well as other factors (e.g. wonk alert! such as making hedonic quality adjustments to your bundle) and it may indeed be more accurate and get us closer to the “real” impact of price changes on our well being.

What makes the argument over which CPI to employ a Goldi-Locks argument is that the general criticism of any aggregate measure like the CPI is that at best it captures the average impact such changes have on a “representative” person in the economy. This is an argument typically made by folks who understand the importance of methodological individualism – that individuals are the ones that make choices, experience pain and pleasure, and are the proper unit of focus for our study. Thus, Krugman is arguing quite correctly, “not all people are the same! The CPI only measures how much better or worse off a “typical” person is, but older people are different than everyone else. Their experience with price changes will be different than mine and yours. If the price of lipitor doubles, a 10 year old is not likely to be impacted. If you are 70 with a cholesterol problem, that just ain’t so.”

And you know what comes next, because this is the case, then we cannot use this new fancy CPI which gets closer to the real experience of the “average” American (who is not YET on Social Security, though with the new labor market we live in, and the “generosity” of the DI program that may soon change) to adjust “benefits” which are made available to the elderly. In other words, the old are individuals, they are not the average American. There is no “we.” It’s a convenient position to hold if the purpose is to maintain a state program that otherwise might see some shrinking of the rate of increase in its growth rate (notice I did not say “cuts’).

Of course, it is widely held by the left that there actually is a “we” who signed the social contract, who occupies the macroeconomic models that drive business cycle research, monetary policy research, fiscal policy research and so on. You like the idea of “Aggregate Demand and Aggregate Supply”? Then you are saying that we can easily abstract from the demand and supply of all of the different entities in the economy and lump ’em together like GDP eaters and GDP makers. When folks like me say this is problematic, and that claiming things like “animal spirits” and demand shortfalls and the like, even if true, does not help us much if we cannot easily identify WHO and WHY.  And the same goes for the idea of the fiscal multiplier that is used to support stimulus. When folks of “my persuasion” argue that not all spending is the same, and that not all workers and consumers are the same, we are accused of invoking the ideas of some long-dead white guys who conjured up such stupid theories merely to entrench the elite status of the aristocratic whites at the expense of the rest of us (I always liked having that accusation levied at me, given that my family is half from Sicily, and probably with a Moorish heritage (for sure we know 1/16th of us is, which makes me more authentic than, say, Senator Warren, right?).

So, Krugman and the left are indeed right that the “CPI” that seniors face is different than the one that the “representative agents” face. But it seems to only matter to them when we are talking about preserving a government program. If the CPI seniors faced turned out to be less burdensome than the traditional measures, would we be seeing the same opposition to the proposed change to a chained (more accurate) price index? I doubt it.

4 Responses to “On the Chained CPI Dustup”

  1. jb says:

    Apparently BLS has taken a shot at devising a CPI for the elderly, I’m not sure what might have become of it.
    http://www.bls.gov/opub/mlr/2008/04/art2full.pdf .

    However, I know that is not the thrust of your argument Wintercow. Your point is well taken. It seems to me that the CPI might be a reasonable gauge to try to assess say, monetary policy, e.g. the impact of Fed policy decisions on “general price levels” but using an aggregate measure of prices to adjust social welfare payments…oye.

  2. Harry says:

    The Fed’s zero/negative interest rate policies, designed to stimulate employment in the favored housing and construction industries, has robbed seniors of income and eventually principal — far more than a Rube Goldberg system to index social security benefits. As they well know, unemployment. Is a lagging indicator, as is any CPI.

  3. Tim says:

    The current CPI has the same problem as the chained CPI with regard to the elderly. Apparently, it only matters to Krugman when it might reduce Government. The elderly CPI was considered not different enough to continue doing with the methodology that was used. A true elderly CPI would require a separate Consumer Expenditure Survey for the elderly plus a separate Point of Purchase Survey since the elderly might shop in different outlets as well as have different spending patterns. This would virtually double the expense of the CPI.
    In any case, the true problem is which is the better index in the real world?

    The chained CPI approximates a superlative index which is a 2nd order approximation to the true Cost of Living Index. This has been shown theoretically. That is better than the current formula which is a combination of Laspeyres and Geomeans. The superlative index requires current quantities as well as prices. Chained CPI only updates the quantities every 6 months, I believe, which is why I say it “approximates” a superlative index.

    There is therefore real reason to switch to the chained CPI, simply because it is more accurate.

    • Harry says:

      Tim, JB, and WC. thank you for the valued explanations and analyses.

      Being an employer and one who has participated in salary discussions of other organizations, the CPI has often been invoked as a starting point to decide what to offer employees the coming year. I think it was in 1983, when the Greenspan Commission tried to fix the problem that future beneficiaries would suffer from the ravages of inflation by indexing benefits, and they picked the CPI, which always lags real inflation. All other things being equal, if the government were to be inflationist in the long term, beneficiaries would get screwed, the same ways you kill a frog by slowly boiling it.

      A more aggressive and realistic way to index social security benefits would have to index the benefits to gold or some commodity index, but then this would have required more discipline from the Treasury, Congress, and our central bank.

      When I started working, the best advice I ever got was to plan for retirement as if Social Security was going to go bankrupt or be a pittance, and with every passing year this has been good advice. My daughter and all her friends believe this is the future, and they are wise.

      Chain weighting versus some other method, however sophisticated, is a small-ball side issue. Printing eighty five billion dollars a month and encouraging Kim Jong Un to feel good about his urges worries me more.

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