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The federal government's annual consumer price index monitors about 90,000 goods and services.Photograph by Carl Tremblay

Is America in the 1990s a dreary landscape of struggling middle-class families, crippling government debt, and children who will be worse off than their parents? Or is it really a bright place of steadily rising standards of living, a manageable federal debt, and hope even for the poor?

Some may guess that only the discovery of vast new natural resources--oil fields, perhaps, or diamond mines--could spark such a dramatic swing in a nation's economic self-image. But Dale Jorgenson, Ph.D. '59, Abbe professor of economics, and Warburg professor of economics Zvi Griliches may have found a trillion dollars' worth of optimism by digging in the seemingly dry soil of mathematical formulas used to calculate inflation.

Chart by Stephen Anderson

The two economists served on a panel of five experts chaired by Michael Boskin (and including Robert J. Gordon '62 of Northwestern University) that recently told the Senate Finance Committee that they have identified a seemingly trivial error in the annual consumer price index (CPI). According to the economists, correcting this error--which exaggerates the rate of inflation by 1 percent--could dramatically shrink the national debt. No less an authority than Federal Reserve chairman Alan Greenspan recently endorsed their conclusions.

The economists argue that decades of overestimating consumer prices have led to a false belief that wages fell by 13 percent from 1973 to 1995, when adjusted for inflation. In fact, the panel found, real wages rose by 13 percent during this period. "Fundamentally, people are better off than they think they are," says Griliches. "One view of the last 20 years is that they were thin years. We believe that they were significantly fatter than they looked."

The consumer price index is a formula designed to measure the cost of consumer goods; it was developed during World War I so shipyard workers could receive pay increases that kept pace with wartime inflation. The government calculates it by taking a representative group of market goods--like beef, bread, and housing--and averaging how much their prices change from year to year. (Government statisticians weight each item according to what percentage it comprises of the average American family's budget.) If the "market basket" becomes more expensive, the government defines that as inflation, and, among other things, raises Social Security payments to compensate.

It's a simple system. But, the panel of economists concluded, it cannot accurately measure the complex and subtle ways that consumers respond to changes in the market. For one thing, the CPI updates its choices of popular goods only about once a decade, so the sample falls behind the times. For example, consumers today increasingly choose to stay home and rent videos for $3.50 each instead of paying $7.50 to go a theater. Calculating inflation by looking only at the rising price of movie tickets gives a false impression.

Also, new electronic goods like microwave ovens enter the market, drop dramatically in price, and become part of the daily lives of many Americans before the government adds their falling prices to the index. This delay also exaggerates inflation. Perhaps most significantly, the CPI overlooks the fact that many goods are improving in quality as their prices rise--or even remain stable. A personal computer that cost $1,500 in 1984 has only a fraction of the capacity of one that sells for $1,500 in 1997. (Many high-tech products, in fact, show a pattern of prices falling while quality improves.) Likewise, while a basic service like health care has become much more expensive, its effectiveness has also improved dramatically.

But, the economists warn, fixing the1 percent error in the CPI may prove a herculean task. Senior citizens' groups and taxpayers are likely to protest lowering the index because it will mean smaller annual cost-of-living increases in Social Security, which are keyed to the CPI. And because federal income-tax exemptions--and the tax brackets themselves--also follow increases in the index, lowering the CPI would boost people's taxes.

The payoff to the government, however, could be huge: $1 trillion less in national debt by the year 2008. Political observers say Republicans and Democrats may try to quietly fix the error in the CPI during budget negotiations this summer as a way to provide cover for the ticklish act of balancing the budget. "The political dances and minuets that will take place over this issue will be very interesting," says Jorgenson. "But I think, in the end, the correction will be adopted because people will see it as an issue of fundamental fairness. Given the relative affluence of many elderly Social Security recipients, it isn't fair that they receive unjustly high CPI adjustments at the same time the government is reducing payments for welfare recipients, who are generally poor and young."

Some economists have criticized the panel's conclusions because they add subjective guesswork--about what a "better" product or lifestyle means--to a normally empirical field. "Is it really a 'better' quality of life when everybody gets to use the Internet all the time?" asks Dean Baker, an economist with the liberal Economic Policy Institute. "What if that means nobody's out there talking to the neighbors?"

The recommended corrections to the CPI may end up being adopted only in part, says Katharine Abraham, Ph.D. '82, the U.S. Commissioner of Labor Statistics. Popular new products like cellular phones will be added to the calculations more quickly, she says, but also warns: "We really don't want government statisticians to be making subjective decisions about our lives."

~ Tom Pelton

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