What's the Best Measure of Inflation; M. Skousen

by Mark Skousen "The Consumer Price Index overstates increases in the cost of living by about 1.1 percentage point a year." -Michael Boskin, Stanford Universityl A ccording to recent surveys, most profes sional economists believe that the Con sumer Price Index (CPI) consistently over states the cost of livingin the United States by one percentage point or more. Even pro market economists such as Michael Boskin and Milton Friedman assert that the CPI, which is prepared monthly by the Bureau of Labor Statistics, exaggerates changes in the living expenses. As a result of these studies, the government hopes to establish a more accurate CPI and thus save Washington billions of dollars. The CPI is used to index federal taxes and Social Security payments. A lower CPI could in crease tax revenues by $70 billion and reduce Social Security checks by $75 billion over a fiveyear period. It could substantially reduce the federal deficit.

The CPI is determined each month by a survey of prices of 364 items that compose a typical bundle purchased by urban consumers during the base period, 1982-84.Items include food, consumer goods and services, rent, and property taxes. Each month several hundred Dr. Skousen is an economist at Rollins College, Department of Economics, Winter Park, Florida 32789, and editor of Forecasts & Strategies, one of the largestinvestment newsletters in the country. The third edition ofhis book Economics of a Pure Gold Standard has recently been published by FEE. survey workers visit approximately 21,000 stores in urban areas and collect prices on these items. The CPI is a market basket index of these items, valued according to a weighted average. What's Missing in the CPI? Unfortunately, the price-index methodol ogy is defective in two ways. First, the current CPI fails to take into account quality improve ments, new products, substitutes, and sale prices. As a result of these omissions, many economists argue that the CPI tends to over estimate the cost of livingin the United States.

Second, the CPI does not include all items determining an individual's cost of living, and this fact may cause the CPI to consistently underestimate the cost of living. How many people buy a fixed market basket of goods and services that match in any way the gov ernment's survey for "an urban family of four"? For example, I have two children in college. According to government surveys, college tuition and related expenses have risen at double-digit rates over the past decade or two. But the CPI doesn't cover college expenses. My family and I also travel frequently outside the United States. Overseas the dollar has lost much of its purchasing power over the past 20 years. How does the CPI reflect the dollar's decline? It doesn't. Crime has been a problem in our commu nity, so we bought an expensive security protection plan for our home. The CPI 314 doesn't include such an expenditure in its fixed basket of services.

What if interest rates rise? The CPI does not directly account for the costs of borrowed money or mortgage payments. The Biggest Omission But probably the most serious defect of the CPI is that it does not register the largest item in everyone's household budget-taxes. The CPI covers property taxes, but not sales taxes or income taxes. Today, government expen ditures (the most accurate measure of total taxation) represent 32.2 percent of the econ omy (GDP). If the CPI is supposed to repre sent the cost of living, doesn't it make sense that it should include taxation, the cost of government? Taxes and government spending have been rising rapidly throughout the twentieth cen tury, as the following graph shows: The Growth of Government Expenditures, 1929-1995 (as a percent of GOP) 35 30 25 20 15 10 5 o Source: Economic Report of the President Since 1982-84, the base period for the current CPI, total government expenditures have increased from $1.1 trillion to $2.5 trillion, a 127 percent increase. During this same period, the CPI has risen only 60 percent. Clearly, if taxes were included in the CPI, it would be rising at a much higher rate.

315 In short, you have two major deficiencies in the CPI, one that overestimates inflation and another that underestimates inflation. Which force is stronger? I don't know, but it would be national folly to include the former and ignore the latter. Mises to the Rescue In determining the best measure of infla tion' we should remember the words of Lud wig von Mises. Mises refers to the "level" of prices as "inappropriate" and "untenable" because" changes in the purchasing power of money must necessarily affect the prices of different commodities and services at differ ent times and to different extents." He goes on to say, "The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best crude and inaccurate illustrations of changes which have oc curred.,,2 According to Mises, inflation (deflation) is defined as increases (decreases) in the supply of fiat paper money by government, not changes in the prices of individual goods and services. According to this definition, the cost of living and declining purchasing power of the dollar have been extraordinarily and un necessarily high in modern times. If we use the monetary base (funds on deposit by the Federal Reserve) as a measure of fiat money, the money supply has increased 141 percent since the 1982-84 base period. If we use a broader definition, M2 (coins, currency, checking accounts, and money market funds), the money supply has increased 75 percent.

Either way, monetary inflation has been sig nificantly higher than the CPI's 60 percent. Perhaps increases in the money supply should be used as a better gauge of inflation. But it wouldn't make Washington happy-it would mean less tax revenue and higher Social Security checks. D 1. Wall Street Journal, February 25, 1997, p. A24. Professor Boskin headed a government panel investigating the CPI. 2. Ludwigvon Mises, Human Action, 3rd ed. (Regnery, 1966), p.222.