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Thursday, March 23, 2006

Was There a Conspiracy to Alter the CPI and Reduce Entitlement Spending?

Did the government change the calculation of the CPI from an arithmetic mean to a geometric mean for valid economic and statistical reasons, or was it a conspiracy designed to save money on entitlement spending?:

macroblog: Is The CPI A Government Conspiracy?: It seems that a lot of people think so, and several readers have pointed me in the direction of Mr. John Williams, whose website appears to be devoted to the proposition that there liars, damned liars, statistics, and the lying damned liars who construct them. Williams' section on the conspiracy that is the consumer price index has several of the usual complaints -- the use of quality adjustments, the invoking of "core" inflation, and so on -- but what he seems most exercised about is the shift in methodology from "arithmetic mean" to "geometric mean" calculations that the Bureau of Labor Statistics implemented in 1999:

In the early 1990s, press reports began surfacing as to how the CPI really was significantly overstating inflation. If only the CPI inflation rate could be reduced, it was argued, then entitlements, such as social security, would not increase as much each year, and that would help to bring the budget deficit under control. Behind this movement were financial luminaries Michael Boskin, then chief economist to the first Bush administration, and Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System...

Shortly after Clinton took control of the White House ... attitudes changed. ... Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. ... Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by a total of 30%.

The material on Williams' website is a bit dated (appearing first in 2004), but his take on the price statistics appears to have a lot of fans, being cited as recently as yesterday in readers' comments to an article by David Wessel. So what is this arithmetic-mean/geometric-mean thing all about? The Bureau of Labor Statistics explains;

In contrast to the fixed quantity weights of the current CPI formula, the geometric mean estimator ... implies that consumers can alter the quantities of goods and services they buy, albeit within the narrow range of a CPI category, when the relative prices of those goods and services change. It is, in part, this property of the geometric mean estimator that led to the Boskin Commission recommendation of its use in the CPI.

In other words, the crime of a geometric weighting scheme is to assume that people change their behavior when prices change. If you are looking for a cover-up, you won't find it at the BLS... What this means is that the methodology employed by the BLS conspires to do nothing more than implement the common sense proposition that consumers substitute high-priced goods for similar lower-priced goods:

Substitution can take several forms corresponding to the types of item- and outlet-specific prices used to construct the basic indexes:

  • Substitution among brands of products, for example, between brands of ice cream;
  • Substitution among product sizes, for example, between pint and quart packages of ice cream;
  • Substitution among outlets, for example, between a brand of ice cream sold at two different stores;
  • Substitution across time, for example, between purchasing ice cream during the first or second week of the month;
  • Substitution among types of items within the category, for example, between ice cream and frozen yogurt;
  • Substitution among specific items in different index categories, for example, between ice cream and cupcakes.

Notably:

...overall substitution across categories, such as between ice cream products in general and apples in general, is not addressed by the geometric mean formula. ...

Product categories without close substitutes are, in fact, treated in the old-fashioned way that Williams and his fans seem to prefer.

The new formula, the geometric mean estimator, will be used in index categories that comprise approximately 61 percent of total consumer spending represented by the CPI-U. The remaining index categories ... will continue to be calculated as they are currently.

No doubt about it, measurement is hard, and there are a lot of judgment calls that have to be made. But when it comes to assessing the motivation for those calls, I'm with David Wessel...:

I know that is a popular view. I've personally found the technicians at agencies like the Bureau of Labor Statistics to be straight shooters who do their best to cope with the complex methodological issues inherent in measuring our large and dynamic economy.

And, for my money, they do it well.

Mine too.

    Posted by on Thursday, March 23, 2006 at 03:33 AM in Economics, Methodology, Social Security | Permalink  TrackBack (0)  Comments (19)

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