The True Rise in Cost of Living

For more than eight decades, some of the smartest people in the economics business have worked on index-number theory.  The basic issue is how to measure price inflation.  A few years ago the government (Bureau of Labor Statistics) started publishing measures (chain-weighted price indexes) that no longer fail to account for consumers constantly shifting the bundle of goods they buy toward those whose prices are rising less rapidly, as the standard CPI does.  Consumers do substitute when relative prices change, and the new measures recognize this.

This issue is technical, but it has become crucial in the “fiscal cliff” discussion.  Republicans wish to use the new measure to index (link to inflation) benefits of transfer programs, particularly Social Security (OASDI).  Liberals don’t like this — it will slow growth of incomes among Social Security recipients (me included).  I hate to say it, but the Republicans have it right on this one: using a chain-weighted price index better reflects the true rise in the cost of living.  If we are indexing benefits, as we have now for many years, it should be done properly.  And here’s a case where economic theory, coupled with careful applied research by a government agency, has produced the right answer.  It’s time to use it.

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COMMENTS: 31


  1. John Greenspan says:

    But I would argue that Food Inflation is not properly accounted for in either CPI- A large portion of a retired person’s expenses

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  2. Chad says:

    On the same note, we need to somehow link medicare benefits to the length of morbidity, that is, the period of ill health for old people. Obviously life-spans are increasing, but the period of healthy life is also increasing as well, further reducing the need to allow benefits at the currently unsustainable and unfunded age of 62 or 65 or… I don’t know I’m only 26.

    I think a huge part of the problem is ‘anchoring bias’ on the current ages and rules. The question is, if we were creating the plan today, would we use the current ages (which would lead to an incredibly unsustainable liability) and indices? Of course not. So we ought to seriously change these programs, and the sooner we do it, the less impact it will have on people and their financial planning.

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    • John Dorman says:

      Life expectancy has really only increased in the last 30 years for those in the upper half of the income distribution. They have pulled the average up. They live longer and get sick later yet begin receiving benefits at the same time as those in the bottom half who have not made such gains.

      The seniors that need health care and supplemental income the most are the group that would bear the brunt of any fall in weighting or increasing of eligibility ages. JG’s comment that food inflation is not properly accounted for in the context of retired people lands squarely here as well.

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    • Mike B says:

      The simple truth is something between 50 and 80% (I forget the exact number, I think its 80) of Medicare spending occurs in the last 6 months of life. Now of course that is a bit of a truism as people most frequently die after some sort of health episode, but on the other hand is disproves the notion that Medicare is being bled dry by longer lifespans and chronic illness. At the very least the system needs to emphasize end-of-life decision making to steer patients away from the binge of medical care inflicted on dying patients to squeeze a few more weeks of life out of them while racking up billable items in the ICU. Hell, I would even embrace death panels because when you are getting highly subsidized care and the alternative is none beggars shouldn’t have the right to be choosers. The government should help provide a minimum standard of care, not unlimited time hooked up to machines.

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      • OAO says:

        > The simple truth is something between 50 and 80% (I forget the exact number, I think its 80)

        Do you have any proof ? I heard the same story about French data, it had a big impact, and it was wrong.

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  3. Alan Z says:

    It seems to me that if we are measuring the increase in a given quality of life, then if I switch to chicken because steak’s price is rising faster, my quality of life has gone down (putting aside heart attack proclivity). If I am to have the same quality of life, then my benefits need to increase at the same rate as the basket of goods I was originally buying.

    Under your theory, if housing costs increase so fast that we all move to hovels, then the measure of cost of living would properly go down to reflect the cost of hovels. That may be a proper measure of what it costs to live the way people are actually living, but if the idea is to keep people at the original level of living, taking into account inflation, then benefits need to rise at that higher level.

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    • James says:

      I think you might have a problem with your starting assumptions about what constitutes quality of life. Why, for instance, do you assume that eating chicken instead of steak means a lower quality of life? I happen to prefer chicken myself, so it would seem that cheaper chicken means I have a higher QofL, no?

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      • Imad Qureshi says:

        Actually, quality of life is subjective as you said. However, Alan’s point is if people are switching to something cheaper then they might be compromising on their quality of life. and if this method is used then according to Alan, theoretically speaking, your quality of life will eventually go down.

        That being said, the basket of goods we are talking about will not be used based on what retirees are buying from social security income. It is what normal people are buying with their income. So those people will not simply reduce their quality of life by always buying cheap stuff. In fact they’ll be making smarter choices with their money. So at the end I disagree with Alan that quality of life will go down.

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      • James says:

        This could be extended, chainwise, into an exercise in the law of unintended consequence. As for instance lower COLA increases, intended to save money, force SS recipients to switch from a diet of steak & potatos to a lower cost but arguably more healthful one of brown rice with a little chicken, and to walk/bike short distances rather than driving. So obesity rates plummet, and the recipients live a longer, healthier life, which is an objective quality of life increase. But because they live longer, they collect far more in lifetime benefits than under the old system.

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    • Matt says:

      It cuts the other way, too. If steak becomes cheaper and people switch to it from chicken, that improvement in COL will not be reflected using the current method.

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    • Mike B says:

      The purpose of Social Security is to keep seniors out of abject poverty. If they wanted to keep eating steak they should have put money into a 401k. When it comes to government benefits we should remember that beggars can’t be choosers. I have no problem providing benefits to the less fortunate and I won’t label them as moochers, but I’ll be dammed if I am going to feel bad if someone’s quality of life drops a notch or two in the process. This isn’t Communism…your life choices have consequences that extend down to some sort of government supported floor.

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      • Reubwn says:

        Don’t you think a civilized society should aim higher than merely keeping its seniors out of abject poverty? I don’t think that’s necessarily anything to be proud of.

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      • TexasTexasTexas says:

        I agree with this reasoning. Govt provides chicken, even spam, but not steak.

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      • Mike P says:

        Standard of living should be priced into the inflation adjustments. Using the chained CPI we lose track of the negative externality of reduced quality of life.

        The CPI discussion has nothing to do with communism. It has to do with inflation. The government supported floor standard of living should never go down as time moves forward.

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  4. Tim Miller says:

    I have not looked into chained-weighted indexes (C-CPI), so existing papers on it may answer my major issue with C-CPI. C-CPI is less than the standard CPI by virtue of accounting for people buying cheaper stuff when prices rise. That is logical, as if prices rise I may stop shopping at Macys and head over to Penneys, and then after further price increases I may shift to Walmart. But at some point, there is no store cheaper to go to (not saying Walmart is the cheapest, I just stopped at that 3rd step for brevity’s sake…. which I just shot to heck with this explanation).

    How does C-CPI account for this “bottoming out” of cheap retailers?

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  5. Bodger says:

    I would have to question the whole chain CPI process. In theory the explanation is “if beef becomes more expensive, those who cannot afford it will substitute something else, like chicken”. Yes, but what happens when chicken becomes too expensive. And the chicken substitute? And the chicken substitute substitute? By the chain logic, as long as the elderly poor can find tree bark and mud to eat everything is fine, no harm done.

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  6. John Greenspan says:

    The whole reason this is happening is because the Fed is monetizing the US debt. The consequence of this is inflation. So to hide this fact, they are changing the rules of the game, ie CPI to chained CPI. That will buy some more time but eventually its all going to come crashing down when the Fed has to unwind the Trillions in purchases made. We will see 20% bond yields again and ironically this will show up in the cost of housing which is a major portion of the old CPI.

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  7. Donnie says:

    “Republicans wish to use the new measure to index (link to inflation) benefits of transfer programs, particularly Social Security (OASDI). Liberals don’t like this — it will slow growth of incomes among Social Security recipients (me included).”

    Is this really what Republicans want? I don’t think so. They want cuts, and if it is also technically better, good. If it ended up increasing benefits, but was technically correct, they would not want it.

    Also, it isn’t Republicans who are even proposing this. It is the Administration proposing it, and trying to get it accepted by Congressional Dems, so that they can offer it to Republicans as a spending cut.

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  8. sfer says:

    This doesn’t work for those at the bottom.

    If you are already surviving on macaroni and velveeta, what are you going to use as a substitute?

    It works for those who are relatively well off, but applies the cuts to everyone.

    But then, who worries about those at the bottom?

    Hot debate. What do you think? Thumb up 9 Thumb down 11
    • John D-H says:

      I have found that practically all people have concerns for people on the bottom. Where we differ is how to prevent so many from ending up there and what to do about those who are already there.

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    • Dave says:

      Unfortunately, there will always be those at the “bottom”. The goal should be to make sure those at the bottom have the basic necessities to be able to contribute more to society as a whole. The goal should not be to eliminate, a bottom…this is a tail chasing exercise that won’t end well.

      It should be noted, that our “bottom”, in comparison to the rest of the world does pretty darn well. That is fact.

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  9. D says:

    How about we actually study the cost of living changes on the people we are looking to apply it to?
    http://www.cepr.net/index.php/blogs/cepr-blog/thoughts-on-the-chained-cpi-social-security-and-the-budget

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  10. Tom says:

    Why do you “hate to say it”?

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  11. mike5790 says:

    Most of these comments about “baskets” and equivalent living make no sense. Those that paid into the entitlement programs did that when the cost of living was X and thus, those receiving benefits could receive X. Regardless of what shell game you play with account titles, essentially the entitlements are a pay-as-you-go program with money coming in and going out. If the people funding the programs then, because of inflation or other cost of living reason are all living in hovels you danged well better not expect them to pay payroll et al. taxes to keep you in your suburban craftsman. If in fact, for example, population densities cause the net size of a home to decrease, land-size, etc., you DO NOT get to live in your static world. That is neither fair nor pragmatic. Economically unsustainable draws on the economy (by definition you are no longer productively contributing to the economy because the money you spend isn’t novel, it’s taken FROM the GDP) Eat your doggone chicken. Besides, shouldn’t we all be eating Kangaroo?

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  12. Allen says:

    The only true measure of inflation is the number of hours the minimum (or lowest paid workers) have to work to buy their necessities compared to how many hours they had to work in the baseline period. As a kid, my dad taught me to look at the cost of housing (rents and selling prices) against wages when we visited new towns. If the jobs are low wage and housing prices high you had a contracting or sick local economy and if the jobs were high wage and housing low you had an expanding or health local economy. After over 50 years of following those number I have found them as a reliable guide to economic health.

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    • James says:

      “If the jobs are low wage and housing prices high you had a contracting or sick local economy…”

      Aspen, Jackson Hole, Taos, Tahoe…

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  13. Mark Anthony says:

    Wouldn’t the “chained” index actually mask the true cost of living increase? The substitution of cheaper goods for more expensive goods is obvious as the cost of living rises, but is that not part of what needs to be measured in the cost of living? Substituting hamburger for steak is one example, but as the cost of living rises, that rise is lost as one then substitutes chicken for hamburger, then rice and beans for the chicken, and then finally cat food for the rice and beans. All the while “chain indexed” to show an artificially low rate of inflation and negligible increases in what it actually costs to live.

    To have a useful method of measuring cost of living and inflation I believe we need a fixed basket of goods, without chaining or “ex” gasoline or “ex” food or “ex” anything else. That volatility needs to be included if you’re going to be accurate.

    In the end all “chaining” is just an academics method of massaging the data to get the numbers politicians want to see.

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    • James says:

      “…and then finally cat food for the rice and beans.”

      Suggest you visit your local grocery store, and check the cost of (canned) cat food vs rice & beans, hamburger, etc. Or to check on-line, the first hit on “canned cat food” works out to $6.22/lb (24 3-oz cans). If older folks are eating cat food, I suspect it’s because of deteriorating taste buds rather than to save money.

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  14. Voice of Reason says:

    Despite Social Security starting as a Ponzi Scheme, it was managable because it was a safety net for those who were too old to work and needed money for survival. It’s going broke now because middle aged people see it as a way to retire early, and spend their golden years playing golf and sitting on the beach. If they wanted that life, they should have saved for it. This system will only work for its benefits are given out to those who are too old to work or save. Then it can work as insurance for “living too long.”

    I’d say take the average life expectancy, subtract 3-4 years, and use that number for when benefits start.

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  15. Donovan Moore says:

    WRONG! Food, which makes up a very large portion of the average American’s budget is WAY Under reported. How? Food companies have resorted to giving you less and using smaller sizes yet charging you the same price. THIS IS INFLATION THAT IS NOT REPORTED. We know this, too bad you can’t figure this out Dan.

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