WHEN PEOPLE talk about the inflation rate, they generally have in mind the government statistic known as the Consumer Price Index. That's the number that, notoriously, rose at an annual rate of 18 percent in January. A great many Americans think it only fair that their incomes should rise at an equal rate to keep them even with inflation. Many government benefits, like Social Security and the other pensions, are now increased by law in proportion to the CPI. Labor contracts similarly use the CPI for their cost-of-living adjustments. What if the CPI is wrong?
In fact, the CPI is currently overstating the inflation rate by a wide margin -- apparently three or four percentage points. For one thing, it overcompensates for rising costs of mortgage interest. But some of the anomalies go much deeper.
Let's take, as an illustration, the price that you pay for electricity. There was a time when your electric bill represented nothing but the cost of producing electricity -- and the public utility regulators told the companies to produce it as cheaply as possible. That usually meant burning coal. Then people discovered that the coal smoke was not only smelly but toxic. Congress told the utilities to clean up their act. The utilities are complying, usually by installing enormously expensive stack-scrubbing equipment. Part of the current increases in the price of a kilowatt-hour of power is the cost of pollution control.
You are no longer buying just electricity from the utility. You are now buying electricity plus cleaner air and a new kind of health protection. But the CPI doesn't know that, and has no way to take it into account. It treats the cost of pollution control as though it were pure inflation.
Pollution control, incidentally, is not a small item in this country's financial accounts. Currently the government and industry together are investing around $12 billion a year in it. The conventional statistics pick up the cost, but they do not pick up the benefit. As a result, it appears there as inflation.
This statistical defect has two serious consequences. First, it means that none of the cost of pollution control is being shared by the people whose incomes are indexed to the CPI, although they certainly share in the cleaner air and water. All of the cost is being carried by people whose incomes are not indexed. Second, and worse, it means that the statistical system itself is contributing to inflation. When it reports a number that is too high, and then adjusts millions of Americans' pensions and wages to it, the process of measurement is actively speeding up the rise.
There are many statistical distortions that made little difference when the inflation rate was 2 or 3 percent a year. But the 15 percent, they become enormously important. Indexing government benefits to the CPI is especially dangerous, for it transmits all those statistical distortions back into the real economy in which everyone works and lives.