The Economy's Dirty Little SecretRudi Dornbusch
Inflation in the U.S. has been low for more than a decade--3.6% since 1985--which is half the rate of the previous 10 years. And it may soon fall even further. Yet this additional decline in inflation won't result from superior Federal Reserve policy, highly competitive markets, or a soft economy. It will come from an adjustment of the way the consumer price index (CPI) is measured. With new and better measurements, inflation would fall somewhere between 0.7% and 2%.
Unfortunately, the shift to more accuracy is highly controversial. The overstated official inflation rate has helped some groups benefit at the expense of others, including the Treasury Dept. Everyone from senior citizens to labor unions would initially decry it, but improving the exactness of data is good policy because it allows the economy to collect a bonus.
The overstatement of inflation in the official CPI measure stems from some obvious causes. Over time, people's consumption patterns change as they substitute relatively cheaper goods for expensive ones. But computation of the CPI "consumption basket" tends to lag behind the change. Too much weight is given to high-priced goods over relatively cheap ones. It takes periodic rebasing of the basket to eliminate the bias.
SMARTER SHOPPERS. In addition, the quality of most goods improves over time. This quality improvement must be reflected in the downward adjustment of inflation, and, indeed, allowance is given. But it's far too little, since quality improvement is so dramatic, what with new materials, better cars, and far better computers. Also, people are serious discount shoppers these days. On Fifth Avenue, it is called an "accommodation," elsewhere simply a sale. Ideally, the CPI would capture this by collecting the discount prices--but often the list price, not the transactions price, gets into the sample. This, too, overstates inflation.
The opposition to cutting the CPI is strictly political. The official inflation measure is used in three key places. In the Social Security cost-of-living adjustment, it has led to continued overpayment. Because true inflation is less than official inflation, real payments to the recipients are steadily rising. Seniors have been overpaid by billions of dollars over the past decade.
Also, taxpayers have been getting a break by being asked to fork over too little. Tax brackets are indexed, and official inflation pushes the thresholds of those brackets up too much, allowing the middle class to escape a more serious tax bite. And finally, the cost-of-living adjustment in labor contracts is also too high. That reduces corporate profits.
It is clear that the President and Congress are not eager to bite the CPI bullet: Taking more money from the middle class and paying less to the elderly is a prescription for riot. Telling workers they are overpaid when in fact they feel squeezed seems politically suicidal. Yet the right thing is to use true inflation. Congress and the President could then turn around and allocate the harvest by introducing middle-class tax cuts, reducing capital-gains taxes, or whatever is the fashion of the day. They might even ease up on the more extreme budget cuts now on the table. There is simply no reason to keep using the wrong numbers.
GIFT HORSE. The bonus for doing things right is the potential for a period of far easier money. The Fed is constrained by headline inflation that focuses on the official CPI rate, not the facts. Everybody knows there is virtually no inflation in America, yet the Fed must go by what the official numbers show. Lower inflation on the front page means lower interest rates in no time. In Germany, this just happened when a revision of the CPI pushed inflation down half a percentage point and the Bundesbank responded with a half-percentage-point cut in rates--with possibly more to come. By cutting the current CPI in half, the Fed would be able to push down rates to 4%. There would be an economic boom unlike anywhere else in the world.
Of course, the adjustment is simply a bonus and not a license for perpetual unbounded growth. But who minds a bonus? The extra economic growth will improve the budget--thereby also lowering interest rates.
Using a better CPI is not the panacea that will turn America into a monetary and fiscal paradise. But it would unleash enough favorable effects to make it well worth the effort. When President Clinton introduced a strong budget package at the outset of his term, low interest rates and vigorous growth followed in no time. The President should muster the courage for another round rather than yield to the shortsighted tantrums of the overpaid and undertaxed.
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