Now It’s Time to Play by the Right Numbers

The recently issued report of the Boskin commission, appointed by the Senate to evaluate the consumer price index, misses a key point.

The commission and practically all other economists agree that the CPI overestimates inflation; from this, the consensus draws the policy conclusion that major progress can be made in reducing the federal deficit by reducing cost-of-living adjustments.

This has, of course, raised substantial opposition from those who benefit from the adjustments, and the controversy will heat up when inflation-adjusted Social Security payments and income taxes come under consideration in early 1997.

Neither side, however, has mentioned a more fundamental issue: National economic policy for the last two decades has been targeted primarily on controlling an inflationary danger that has been less than what we had thought. We are now in a position to rethink macroeconomic--monetary and fiscal (federal budget)--policy.

Ever since the oil shocks of the 1970s sent prices spiraling upward, inflation control has been the primary objective of monetary policy, managed by the Federal Reserve Board. Such control has also been a frequent, if less consistent, objective of federal policy, and when the budget deficit has seemed over-expansionary, the Fed has stepped in with corrective measures.

Interest rates were raised to unprecedented heights, for example, when the Reagan tax cuts of 1981-82 exploded the size of the deficit. In recent years, Fed Chairman Alan Greenspan has taken almost every occasion to warn of the dangers of impending inflation.

Greenspan is one of the enthusiastic backers of reduced inflation estimates--both because inflation has, in fact, been overestimated and it is not good to base economic policy on quantitative mythology, and because of the effects on both the spending and revenue sides of the budget.

Reducing CPI-based cost-of-living increases in Social Security payments would cut federal expenditures; moderating inflation-based adjustments in tax brackets would increase tax revenues, thus attacking both sides of the deficit without annual tough political decisions.

A decision to change the CPI would be a tough one politically, but unlike periodic adjustments to Social Security and taxes, it would have to be made only once.

But Greenspan has not drawn the implication that if inflation is lower than we had thought, then his constant battle to reduce it further has been draconian. Keeping interest rates high enough to keep inflation at bay raises unemployment and slows growth.

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In recent years, economists have created the concept of the “non-accelerating inflation rate of unemployment” (NAIRU), arguing that if the unemployment rate drops below NAIRU, inflation will take off. Estimates of NAIRU in the last several years have ranged up toward 7%; current guesses are that it may have fallen toward current unemployment rates, between 5% and 5.5%.

In fact, unemployment has dropped this low with no sign of accelerating inflation. And in any case, it should be understood what “acceleration” means.

The mind’s-eye picture is of an ever-increasing spiral, rapidly approaching that of Germany in the 1920s, Brazil in the 1980s or Russia in the 1990s. But that is just not going to happen in an economy as fundamentally strong as ours.

Rather, as economist Robert Gordon, a member of the Boskin commission, has estimated, 10 years of steady over-pressure on the economy might raise inflation from its recent 2% a year to 6%--not desirable, but reversible when necessary, and perhaps worthwhile up to a point in order to restore employment and increase growth.

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In any case, the Fed has been dubious about unemployment falling as far as it has, let alone going lower; this in spite of the fact that the Fed, like the rest of the government, is supposed to be guided by the Humphrey-Hawkins Act of 1978, which mandates “full employment” (forgotten term!) as a central goal of national economic policy. But Greenspan has ignored the mandate, grumbled about it and tried to make inflation control the only objective of monetary policy, but Humphrey-Hawkins and full employment continue to be the law.

Now we learn that the inflation numbers themselves have been exaggerated. America has already lost much--in jobs and in production, and also in social stability and social justice--because of the overestimates.

The central lesson from the Boskin commission’s analysis should not be “Look how much better off we are now than we had thought” or “Now we can cut back even faster than we had planned.” Rather, it should be “Look how much better we can do now that the bad numbers that had scared us turn out to have been wrong.”