Note:  This post is adapted from a comment I made on David’s latest blog.

One of the most fundamental principles of economics is that people respond to incentives.  This is a basic axiom that almost no one would dispute.  From this, we can also conclude that groups of people, whether private (corporations) or public (government bureaucracies) also respond to incentives.

With this in mind, let us consider the Consumer Price Index (CPI).  The CPI is the government’s primary means of measuring inflation.  Whenever you hear a politician or a journalist claim that inflation is at such and such a percent, they are almost certainly referencing the CPI.  A detailed discussion of how the CPI is calculated is beyond the scope of this post.  Needless to say, many are quite critical of its methods and question its accuracy.  While I don’t have any sort of evidence that there is an active conspiracy to design the CPI in such a way as to under-report inflation, I would like to briefly review the incentives that government agencies might have to do so.

As the CPI is the primary measurement of “cost of living,” countless government programs, contracts, etc. are indexed to it.  Social security is indexed to the CPI.  Military pay and entitlements are indexed to the CPI, as are retirement and veterans benefits.  Many welfare programs are indexed to the CPI.  The government sells “treasury inflation-protected securities” (TIPS) that increase in value to compensate holders for inflation, as measured by the CPI.  This indexing means that these programs are designed to pay out more money to recipients in direct proportion to the rise in the CPI, in order to “keep up with the cost of living.”

How about an example?  Let’s say you are receiving social security benefits of $1000 a month.  At the end of the year, according to the CPI, the cost of living has increased by 2% (this would also be reported as inflation of 2%).  Because of this increase, your benefits will now also increase by 2%, to a total of $1020, an increase of $20.  This increase in cost of living requires the government to pay you more in benefits.  Considering how many millions of individuals receive government benefits that are indexed to the CPI, this will end up resulting in massive increases in benefits that the government must pay out.

Now, let’s consider what happens if they fudge the numbers a bit.  Not that they would of course, just a completely hypothetical what-if.  Let’s say that according to the CPI, the cost of living has increased by 2%, but in reality, the cost of living has actually increased by 10%.  In order to truly compensate you for the rise in cost of living, the government would have to pay you $1100, an increase of $100.  But because the CPI only claims a 2% rise in the cost of living, they only have to pay you the $1020, an increase of $20.  By manipulating the CPI, beneficiaries have lost out on $80 real dollars per month.  Extrapolate this out to the millions who receive benefits, and we are talking about massive potential savings.  (Please note:  I have no idea if this is the exact method that social security uses to calculate benefits.  As in, the indexing may not be as direct as in my example.  However, I am quite confident that the core logic of the concept applies, that a higher CPI equates to higher costs for the government in any program tied to “cost of living.”)

Given the vast multitude of government programs whose expenditures are tied to the CPI, it would seem that they have a rather large and significant incentive to cheat, and to under-report inflation.  Meanwhile, I can think of no possible motivation they might have to over-report inflation (if you can, please let me know in the comments or on Facebook).  While this doesn’t necessarily mean they are fudging the numbers, it certainly gives you a strong understanding as to why they might give it some serious consideration.