The Cost of Living Index

April 5, 2010

THE COST OF LIVING INDEX
The concept of the value of a dollar is difficult to grasp because we habitually measure the value of all other things in terms of dollars. We use the dollar as a unit of measure, like the inch or the ounce. Initially the U.S. dollar was a fairly useful unit of measure, when it was defined as a twentieth of an ounce of gold. Gold has been valued rather consistently for thousands of years. With the abandonment of gold, the dollar is now a rubber yardstick which keeps shrinking without end.

There is, however, no good way to measure the value of gold or of the dollar. At any moment in time, the market determines the terms of exchange of any money for any other goods, with all of the exchange rates (prices) for other goods varying constantly and independently of each other.

Each exchange rate depends on the supply and demand for each of the goods being traded, including the money good. A change in the supply of money affects the rate of exchange just as a change in the supply of the other good affects the rate of exchange. Economists understood this long ago but bankers didn’t want to hear about it.

Governments, too, don’t want to hear about it. Governments want cheap credit (Loans at low interest rates) to fund their pet projects (wars, pyramids, moon landings), which the taxpayers will not willingly finance. A reckless banker is the Government’s best friend.

A cost of living index is supposed to indicate the value of a dollar (and thus the rate of price inflation) by taking the total cost of a “basket” of goods. The result, however, depends on the choice of goods in the basket, and the “weighting” given to each good.

Goods change. Apples are pretty much the same product they were 100 years ago, but today’s cars are totally different than the cars of 100 years ago, and buggy whips, in common use 100 years ago, are now antiques. Things like computers change so rapidly that there’s no comparison between the current products and those of 10 years ago, much less 100 years ago.

All goods are not given equal importance in the cost of living. If you average the prices of 1 house, 1 car, one hamburger, 1 aspirin, and so on, the cost of living index will depend almost entirely on the cost of the house. So the statisticians apply weighting to each good according to the percentage of income that the “average” family spends on each such item per year.

Obviously, this requires lots of questions for the statisticians to answer: How big a house, in what location? What make and model of car? Which size hamburger? With cheese? This also gives the statisticians plenty of leeway to please the politicians by picking and weighting the goods in the basket to make the resulting inflation look low.

Thus, for many years while the price of housing was going up like a skyrocket, housing prices were omitted altogether from the basket. This gave the impression that the government was nicely in control of inflation.

Nevertheless, our government employs statisticians to give us a cost of living index. They use this index to adjust Social Security Pensions. Employers use the index to adjust pay scales. The government has every incentive to keep the index low to keep down Pension increases. The statisticians oblige by choosing the goods and the weighting in the basket.

We can sense that the value of the dollar is falling, as prices, in general, rise, but we can’t put a meaningful number on it. The cost of living index is, instead of an educated guess, a creative work of fiction to suit political purposes.

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