Wednesday, June 22, 2005

Inflation and Social Security Finances

A comment on the previous post asks:

What is the source of the (small) beneficial effect that higher inflation has on the SS balance? Why does higher inflation help the SS balance?
Good question. There are actually two inflation series that are relevant, the CPI and the GDP price deflator. Quoting from Section V.B of the Trustees Report:

Future changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers (hereafter denoted as CPI) will directly affect the OASDI program through the automatic cost-of-living benefit increases. Future changes in the GDP chain-type price index (hereafter, the GDP deflator) affect the nominal levels of the GDP, wages, self-employment income, average earnings, and the taxable payroll.
As to why there is a slight positive effect of inflation on the program's finances, Section VI.D5 of the Trustees Report later states:

The patterns described above result primarily from the time lag between the effects of the CPI changes on taxable payroll and on benefit payments. When assuming a greater rate of increase in the CPI (in combination with a constant real-wage differential), the effect on taxable payroll due to a greater rate of increase in average wages is experienced immediately, while the effect on benefits due to a larger COLA is experienced with a lag of about 1 year. Thus, the higher taxable payrolls have a stronger effect than the higher benefits, thereby resulting in lower cost rates. The effect of each 1.0-percentage-point increase in the rate of change assumed for the CPI is an increase in the long-range actuarial balance of about 0.21 percent of taxable payroll.
That seems like a pretty tenuous justification, and, not surprisingly, the effect is not large. More importantly, there is typically a "wedge" between the inflation in the CPI and the GDP price deflator (assumed to be 0.3 percentage point per year, see Table V.B1). Very roughly, the CPI is what we consume, and the GDP deflator is what we produce. The most important item that is weighted more in the former than the latter is oil, since we import so much of it. If we get unexpectedly higher inflation due to oil prices, that will likely worsen, not improve, Social Security's finances.

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IRawk said...

I think you entirely missed the point here.

Inflation that is not captured by CPI has a HUGE positive effect on the SS expenses.

Inflation is defined as increase in money (and/or credit) supply relative to the demand for money. In simpler terms, it means the government is counterfeiting money. In the very old days this used to be called coin clipping. Now it’s called “monetary policy”. We live and learn.

Lets say the (not-so-hypothetical) erosion of purchasing power (theft?) due to government counterfeiting is 6% a year, but the fraudulently calculated CPI only reflects a 3% a year erosion.

The government is effectively defaulting on (i.e. stealing) the 3% real erosion that is not captured by their politically-motivated CPI number. This means they just shaved 3% off their expenses, and screwed over the SS recipients. They are paying them back what they promised, all right (in dollar terms) its just that the money is now worth a whole lot less.

On an epistemolgical level (changing subjects here), the use of an aggregate statistic such as CPI is pure rubbish. Second, even if one WERE to believe in such a statistic, the fraud involved in the CPI is mind-boggling. Do web searches on chain-weighting, hedonic indexing, the Boskin commission, etc etc. etc. My personal favorite is the hedonic indexing of textbooks. Hardcover? More pagesin the new edtion? Even though it costs $30 more than last year you are really paying less. Close enough for government work, anyway.

Andrew said...

I'm sure I've missed something here. You say, "Inflation that is not captured by the CPI." That, and the rest of your post, suggests that the growth in the CPI understates the increase in the cost of living. However, I haven't seen any reports that this is true in general. In fact, the typical conclusion is that the growth in the CPI overstates the increase in the cost of living. (This may not be true of the cost of living for the typical elderly household's consumption bundle, but that's a different issue.)

IRawk said...

Exactly right. I have three contentions.

First, CPI does not measure inflation. You (and everyone else) are confusing cause and effect.
Second, CPI is not valid methodologically.
Third, CPI understates consumer price increases, and deliberately so.

1) CPI does not measure inflation

CPI is not an economic variable. It is a statistic that at best gives an inaccurate picture of an economic phenomenon: inflation. Inflation does not occur in a vacuum. It is a direct consequence of central bank and banking system actions.

Inflation is a rise in the money stock. CPI rises occur when the value of money declines relative to the goods and services it can purchase. In other words, inflation is a monetary phenomenon, not a price phenomenon. General prices go up because inflation (monetary/credit expansion) is happening, not the other way around. Government counterfeiting (increasing the money stock) and bank-system fraud (fractional reserve banking) are the root causes of inflation. Note that I am not saying that an increase in money causes an increase in CPI. I’m saying an increase in money IS inflation.

Inflation may or may NOT result in price increases (or an increase in CPI). They likely will be revealed in price increases as measured by CPI, but this need not be the case. Prices are determined by both real and monetary factors. If real factors pull things in opposite direction to monetary factors no visible change in CPI may take place—or it may even drop when inflation is rising. If you want to examine aggregate statistics, it would therefore be much more useful to examine money supply figures, fractional reserve ratios, credit extended, etc. when trying to get a true picture of inflation rather than the CPI.

The use of an aggregate price index such as CPI ignores other key elements.
a) First, the opportunity cost. If the government HADN’T been printing money and the banking cartel HADN’T been extending credit, would prices be even lower (i.e. the purchasing power of money even higher?)? You can thus have inflation AND falling CPI prices.
b) asset price inflation (stocks, bonds, houses, commodities) is not captured in consumer price inflation. If all of the money/credit ends up in stock/bond/commodity/real estate bubbles, you’ve still got serious problems even if the CPI is flat or negative. Particularly on the housing side
c) Most importantly, the CPI ignores the malign economic effects that are caused by inflationary policies regardless of whether this accompanied by increases in consumer prices. Money/credit expansion distorts the structure of production, leading to malinvests that must be liquidated.

In other words, true inflation (not the CPI) is the cause of the business cycle: booms, busts, recessions, and depressions. By lowering market rates below the natural one, credit expansion severs them from that which is compatible with the availability of real capital and with the willingness to save while more "roundabout"—but potentially more productive—methods are employed.

Thus, the builders of plants and the makers of equipment base their return calculations on low rates, but are blinded to the fact that these do not signal the necessary limitation of end-consumer competition for the factors of production which they, or those downstream from them, will need to secure the required return on their efforts.

At some point these factors will be bid away to other, more urgent uses, more compatible with consumers' time preferences—which may in fact have been increased (their demand for goods enhanced)—by the same lower rates which entrepreneurs have implicitly taken as meaning that such an appetite has diminished.

These distortions will lead to bottlenecks in skills, staff, resources, equipment. They will mean a consistent price path from high-order to consumer goods will not be possible. It will mean losses and the revelation of widespread "malinvestment"—not necessarily “over-investment,” but misdirected and sub-marginal investment, e.g. Global Crossing, Nortel, AT&T and many others in this past cycle! Just wait until housing gets hit.

Credit expansion will therefore sow the seeds of its own destruction as soon as any initial slack in the system is taken up and as soon as the rate of inflation (excess monetary addition) ceases even to accelerate (a process needed to keep the producer borrowers surfing ever ahead of the breaking wave of the faulty price/preference matrix in the economy).

d) Once inflation is defined as a general rise in prices, then anything which contributes to price rises is called inflationary and therefore must be guarded against. In short it is no longer the central bank and fractional-reserve banking that are the sources of inflation, but rather various other causes. In this framework, not only has the central bank nothing to do with inflation, but on the contrary: the bank is regarded as an inflation fighter. Thus a fall in unemployment or a rise in economic activity are all seen as potential inflationary triggers and therefore must be restrained by central-bank policies. Some other triggers like rises in commodity prices or workers wages are also regarded as potential threats and therefore must be always under the watchful eye of the central bank. This masks and confuses the true issue.

2) Invalid Methodology

Because inflation is not a general increase in prices but rather increases in the money supply, it is an exercise in futility to devise a more accurate Consumer Price Index. Moreover, despite its popularity, the whole idea of a CPI is flawed. It is based on a view that it is possible to establish an average of prices of goods and services. There is no definite "inflation rate" waiting to be unveiled. Even when the government is jamming the money supply, inflation affects different goods and sectors at different times and to varying degrees.

Every attempt to discover an inflation rate is necessarily flawed. We can't measure inflation the way we measure the height of a tree. Prices reflect too many variables. We can't be sure what accounts for changes. It makes no sense to lump together price changes for incomparable goods.

Nor is there a "price level" in the sense that there's a sea level, and the desire to make it stable (monetarism was the most elaborate) is a futile exercise. Let's say: liver transplants are going up in price, computers are going down in price, and milk remains the same. What can we conclude about movements in the overall price level? Honestly speaking, nothing.

There is no "average" price for goods and services because there are no "average" buyers of goods and services. All individuals are different. We’re not talking about apples falling out of trees. We’re talking about individuals conscious humans. Unlike in the physical sciences, you can’t average human behavior. There are only specific consumers who purchase specific products and services.

3) Technical Matters
All good economists say the current CPI understates the real inflation rate. But if economists could know the real inflation rate, there would be no need for a CPI. We'd only need to consult the financial fortune tellers.

The whole point of inflation is to create monetary illusion. It’s the same reason counterfeiters counterfeit money. They benefit at everyone else’s expense.

This said, we do need some way to gauge the effects of monetary policy on prices. Figures targeting the root cause of inflation (money supply etc) are the most preferably. But CPI and PPI can be useful as well.

To retain some modicum of honesty, we must adhere to two rules. The formula must be inclusive of many goods, sectors, regions, etc. (preferably weighted by their proportion of household expenditures), and it must be consistent. The best and practically only way to render an index number utterly useless is to change its definition in mid-course.

That, of course, is precisely what the politicians have done. And not because the old CPI was wildly inaccurate. The problem, if anything, is that it is revealing the wrong thing: that prices keep going up. What the government wants is a measure that shows less inflation. This directly helps their bottom line: it lowers expenditures, it lowers their borrowing costs, etc. (social security payments, etc. etc. etc.)

The Federal Reserve always promises that it's working to bring down inflation, but it never has. Since the Fed came into being, the dollar's value has plummeted at least 95%. Go look it up on the BLS inflation calculator. Now we can tell why the Fed supports the CPI change. It wants to cover its actions by appearing more successful at "battling inflation." What the Fed doesn't want to talk about is the real cause of inflation: not greedy consumers, avaricious workers, or price-gouging corporations, but the central bank itself, and its power and practice of creating money out of thin air.

If the government and the Fed really want to lower inflation, there's an easy way to do it. Stop the printing presses with a gold standard. With no artificial increases in the money supply and a growing economy, prices would tend to fall over the long run under sound money

A truly inflation-free economy would spur savings and growth, be free of business cycles, restrict government power, and restore living standards. To reduce inflation by defining it away, on the other hand, is like eliminating debased coinage by readjusting the scales.