published in The Independent, 20 October 1995, p.11
Shortchanging the Beneficiary with a New Measure of Inflation
Keith Rankin, Dept. of Economics, University of Auckland
Moves are afoot to change the way inflation is measured in the USA. This is seen by anti-welfare Republican politicians as being an easier way of cutting benefits than through direct legislation.
Alleged problems with inflation measurement have been raised in recent months by US Federal Reserve Governor Alan Greenspan. Our Reserve Bank Governor, Don Brash made similar comments in his June 1994 monetary statement, and, more explicitly, in the Australian Financial Review (Supplement, February 1995). The issue is making its way onto the New Zealand agenda.
The main fault alleged with the CPI (including the NZ Reserve Bank's modified CPI) is that it takes no account of quality. Brash says "the CPI doesn't take into account, we believe, all quality changes ... we don't exactly know how large the bias is in New Zealand ... other countries' studies suggest the bias is between 0.5% and 1.5% ... 1% measured inflation is equivalent to genuine price stability."
The quality problem may be overstated by the CPI's critics. There are two key aspects to quality; features and durability/reliability. Statistics New Zealand should be measuring the prices of goods with identical features from year to year, even though an average product may have more features from one year to the next. Each review of the CPI basket, conducted every five years, allows for the quality adjustment, making it possible for the index to keep abreast of new features. The question of durability is more difficult to assess, but many people would be sceptical about claims that products are becoming more durable or more reliable. Sceptics would point to "in-built obsolescence".
There are reasons to believe that the CPI understates inflation, at least some of the time. When tariffs on new cars were slashed, the cost of motoring only fell for first time car buyers. For existing car owners, the cost of trading up actually increased as used-car values were slashed. In 1989, the CPI registered a price fall in the private transport sector at a time the cost of upgrading one's wheels was rising, and when public transport prices were rising by 6%.
The same measurement problem occurs with all consumer durables; increases in quality lead to higher depreciation rates. As with Windows 95, it is the upgrade price that matters. In a modern economy, we purchase features much as we purchase services.
We should not buy into the argument that the official measure of inflation has a net upward bias without a considerable amount of disinterested reflection.
The issue here is much more than an arcane discussion about index numbers. The issue that is driving the debate in the USA is that of welfare benefits. Even if we are to accept the Greenspan/Brash view, we must accept that most of the goods that might affect the accuracy of the CPI are not consumed by people who are dependent on benefits.
Consumption for legitimate beneficiaries means, in essence, just three things: rent, food, electricity. A fourth component is interest rates charged by loan sharks, which probably rise and fall in line with interest rates generally. A fifth component, public transport, is distorted in the CPI by the weighting given to international air fares. Has the quality of rental housing been consistently improving in recent years? Has bread and butter become one percent more nutritious or tasty each year? Has the reliability of electricity supply increased? Possibly, possibly not.
The issue is further confused in the social welfare debate, because inflation is not an appropriate indicator by which to adjust social dividends. Benefits should be adjusted in line with gross national product per capita, as indeed they have been over the long run.
The accompanying table shows how the old-age pension of £18 per annum (introduced by Dick Seddon's government in November 1898) would have fared had it been adjusted according to the CPI, or to the mooted US formula. This is contrasted with today's actual after-tax pension.
If the official CPI had been used, national superannuation for a single person (share twin) today would only be $2,156 per annum ($41.46 per week). If the Greenspan/Brash formula had been adopted throughout the life of the New Zealand old-age pension, national super would now be worth just $855 per annum ($16.44 per week)!
In 1899, New Zealand's social reforms - including the old-age pension - were seen around the world as a great advance. New Zealand almost certainly had the highest median standard of living in the world; a world which had already experienced a century of dramatic economic growth. I would hate to imagine what standards of living elderly people faced 100 years ago if it was at considerably less than what $855 would buy today.
If Don Brash is right about the bias in inflation measurement, then an elderly brother and sister should be able to share rented accommodation today on an annual combined income of $1,710, living to the same standard as their great aunts and great uncles 96 years ago. Such a pair (who would get a combined pension of $19,000 today) could not even live on $4,300 in the same degree of comfort as they could have in 1899 on £36. That suggests that the CPI systematically understates inflation; at least it does understate inflation as experienced by people on the poverty line.
Any members of the community who think that benefits are too generous should express their views openly, by presenting compelling reasons to the effect that we pay ourselves too high a social wage or that the level of transfer payments has become unjust or unsustainable. They should not follow the American example and use the issue of inflation measurement as a covert means of procuring welfare cuts.