Price versus Wage Indexing

Amity Shlaes at Bloomberg is trotting out the old let's save Social Security by using price rather than wage indexing:

Social Security Peg Is a Fix Boomers Can Embrace, by Amity Shlaes, Bloomberg: ...On Oct. 15 the first baby boomer demonstrated she's ready for more beach-time by applying for a Social Security pension. ... As the boomers head for the beach, the revenue flowing to the government will begin to recede.

Many Americans believe ... there's nothing they can do but watch. This is wrong. Fixing Social Security is doable. ... Though you might have missed it, the best method for such a fix was offered by Fred Thompson..., ''one of the things that could be done would be to index benefits to inflation. Index benefits to inflation for future retirees.''...

Under the current system, seniors' base pension ... is calculated to reflect not only inflation but also real increases in the average wage over their careers. Real wages in the U.S. tend to rise over time... Growing productivity gives workers this reward. ...

Thompson was suggesting that we base the formula upon inflation alone. Then every pensioner gets what his big brother or sister did, adjusted for inflation. But not more.

Some call such an adjustment ''a cut.'' But the change is only a cut against what is on the theoretical Social Security books. ...[T]he change could better be described as ''a reduction in growth.''...

So why do plans like Thompson's get so little traction?

As Thompson demonstrated, the Keynesian lexicon over indexing is a problem. These days we don't really know what we are saying when we talk about inflation. ''Wage inflation'' in this context happens to include a real increase in wages. ...

How about a $100 million ad campaign to demystify Thompson's peg proposal? ... If a clear explanation of this problem actually penetrated the boomer consciousness, they might be willing to trim growth in benefits. ...

As we know, the crisis in Social Security is way overblown, so I don't mean to buy into the hysteria by responding, but let's take a look at the proposal anyway because we are sure to hear it again.

First, the comment about Keynesian lexicon getting in the way is pretty uninformed (to put it mildly). It does appear that someone doesn't "really know what we are saying when we talk about inflation."

The basics are very simple. Remember the basic equation for profit maximization from your principles of microeconomics class? It said that the money wage equals the price level times marginal productivity (you may have called the right-hand side the value of marginal product of labor). It's nothing more than MC = MR on the input side, the standard profit maximization condition:

W = P*MP

Or, in terms of the real wage

W/P = MP

Now put the first equation in percentage change terms:

%ΔW = %ΔP + %ΔMP

or, in words,

wage inflation = price inflation + growth in productivity.

All she is saying is that the change in real wages, (Δ%W - %ΔP) equals the change in productivity. There's nothing Keynesian about that, it's just a basic neoclassical result, and her attempt to take a swipe at Keynesians reveals the political rather than economic nature of her argument. 

Now, as to indexing, here's what happens if you don't adjust for rising living standards. Nominal wage indexing (as is done now) accounts for both changes in inflation and changes productivity over time (see the %Δ equation above), whereas price indexing only adjusts for price changes, it makes no allowance at all for changes in living standards (i.e. for changes in productivity).

The first regular social security payment was to Ida May Fuller on January 31, 1940. The payment was for $22.54 (a month) according to Wikipedia. Let's adjust that figure to its value today using only a CPI adjustment, i.e. we won't make any adjustment at all for rising living standards, just for changing prices. Using these index numbers for the CPI to adjust the $22.54 payment and convert it to today's dollars gives a payment of $335.67.

[For more detail and a fuller picture, the minimum and maximum payments by year are listed here. For 1940 the benefit was a minimum of $10 and a maximum of $41.20. In today's dollars, that range is $149.92 to $613.56 (for comparison, the actual maximum payment for 2007 is $2,116).]

Maybe Ida May's $335.67 was enough to live on in 1940 given the living standards at the time, no computers, no internet, no TVs, no advances in health care, etc., but good luck living on that now. If we go to pure inflation indexing, fifty years from now we'll have the same problem and the payments will have to be adjusted upward to reflect changes in living standards. This "solution" doesn't solve anything long-term, it simply pushes the problem forward by delaying the living standard adjustment.