Indexation

Milton Friedman wrote in 1974 that indexation could be used to reduce inflation

But I know of no other that has been suggested that holds out as much promise of both reducing the harm done by inflation and facilitating the ending of inflation.

Indexation is the gradual increase of a payment based on some index, generally a price-based index such as the consumer price index (CPI). The objective, as Friedman noted, is to offset inflation. In theory, an indexed payment stream will maintain its real purchasing power.

Price indexes such as the CPI, or the non-farm GDP deflator, are of course statistical estimates. They are approximations of true inflation.

The CPI tends to overstate inflation for at least four reasons

  • substitution effect: when the price of a product in the consumer basket increases relative to other products, consumers tend to substitute to other products
  • quality bias: although the ABS to some extent uses hedonic pricing, it does not fully capture improvements in quality – the car one can buys today is much more reliable than the one bought 10 years ago (for example)
  • new product bias: new products are not introduced to the basket until they have been well established. The dramatic price falls associated with technology are not captured in the CPI
  • outlet bias: the shift to online purchasing and new ways of buying products has not been captured in the CPI.

The eminent economist Ted Sieper thought that these biases meant that the CPI tended to overstate inflation by 100 to 150 basis points.

If the objective of an indexed payment stream is to maintain real purchasing power, then, the index would be approximately CPI minus 1 percentage point. In practice the CPI index has been used, which actually means the recipient of the income stream is gradually becoming better off.

One would think this would be the end of the argument. Yet successive governments have used higher indexes for various payment streams. For the age pension and the disability support pension, it is the higher of several indexes, including the CPI, the pensioner and beneficiary index and the Male Total Average Weekly Earnings index. As I noted in an earlier post, the Reserve Bank unilaterally increased its indexation of the Reserve Bank Superannuation Scheme to MTAWE in 2002.

Latterly there has been a campaign from recipients of the Military Superannuation and Benefits Scheme to increase indexation. The previous government asked Trevor Matthews to conduct a review of the indexation of public service and military superannuation schemes. His 2008 review report recommended that the indexes for these schemes be maintained at CPI.

Importantly Matthews found that the majority of defined benefit schemes around the world are indexed to prices (ie: CPI equivalent) rather than wages (ie: MTAWE equivalent). The Australian State defined benefit schemes are similarly indexed to CPI.

I agree with Matthews’ assessment. The indexation for all defined benefit superannuation schemes: public service, military, political and judicial, should be the CPI. I agree with this even though I would personally benefit if the indexation was to be increased.

We have an ageing population, with an increasing number of people who will collect the age pension. We have a large cohort of people receiving the DSP.

All of these schemes should be indexed to the CPI.

There is no case, except jealousy, for pensions and defined benefit superannuation schemes to be indexed to a higher rate. We need to reduce pressures on the budget. Otherwise there is an increasing likelihood that tax rate will need to rise.

The Government should cut all indexation to the CPI, and legislate so that the Reserve Bank’s scheme reverts to its 2002 indexation of the CPI.

About Samuel J

Samuel J has an economics background and is a part-time consultant
This entry was posted in Budget. Bookmark the permalink.

12 Responses to Indexation

  1. Boambee John

    Like you Samuel, I would benefit personally if the indexation of public service pension schemes were to be increased; like you, I think that indexation should stay on CPI.

    While I recognise the weakness of the argument, at least in theory the wages increases should include an improvement in productivity; retirees can’t offer this improvement, therefore their pensions should not be indexed to wages.

  2. Ted Sieper thought that these biases meant that the CPI tended to overstate inflation by 100 to 150 basis points. is that all

    the computing power in your IPhone would have cost $3.5m in 1991. It is a camera and a TV and many of expensive products rolled into one. stick that in your CPI quality and new product bias.

    p.s. Ted Sieper was one of the best lecturers I have came across.

  3. Samuel J

    Jim – I enjoyed very much attending Ted’s lectures. He is orders of magnitude more intelligent than Garnaut, Henry and Fraser put together.

  4. Samuel J

    One retired military officer told me that he deserved higher indexation because he had sacrificed his life for his country. I replied ‘obviously not’.

  5. Ted gave his lectures without notes.

    afterwards, I could not work out how to condense them because every word was a gem.

  6. MemoryVault

    Of all the rubbery figures manufactured out of thin air by various governments since Whitlam’s time,
    surely the official CPI would have to win the “Silly-Putty of the Decade” award.

    Followed closely, of course, by that other great official fairy story,
    the “average weekly wage”.

    Basing anything on either is sheer folly.

  7. Squirrel

    I do appreciate (and share) the broader Budgetary concern underlying this piece, but the argument that the CPI tends to overstate “inflation” runs completely contrary to my experience and observation (including careful recording of living expenses, based on a quite stable lifestyle, over a number of years).

    My consistent experience is that expenses which involve limited, or no discretion, go up at several times the rate of CPI – utility tariffs, council rates, insurances (particularly health and household) – reflecting the fact that they are either monopolies, or involve limited genuine market competition, and usually have a high component of Australian labour costs and productivity improvement (or lack of it).

    Yes, we can now get electronic gadgets which didn’t exist in earlier years, or which do lots of new things, and the prices for those have generally come down – particularly with a stronger dollar – but the prospect of being able to buy a better cheaper tablet than a few years ago is not much help when the costs of things you need to pay for are galloping ahead, and chewing up a steadily increasing proportion of the discretionary dollars which you might otherwise spend on shiny new gadgets etc. (if you’re that way inclined).

    I am also a little sceptical on the suggestion of ever-improving product quality and reliability – planned obsolescence is not a new concept, and seems increasingly now to be an art form.

  8. I am the Walrus, koo koo k'choo

    The Reserve Bank move is really outrageous. Where do they think they are going to get the money for this? How would the budget for it? They are acting as if they have a magic ‘money tree’ somewhere in 1 Martin Place.

  9. Alex Davidson

    Over the last few decades broad money supply has increased roughly 10% per annum. That is a far more useful measure of inflation than any attempt to measure its effects through an arbitrary ‘basket’ of prices of non-homogeneous goods and services. The solution is not indexation, but a return to sound money and truly free markets. Then as productivity improves, prices will fall, raising living standards without indexation.

    Right now we have the perverse situation where much of the benefit we should be experiencing through lower prices is being vacuumed up by price increases in areas of the economy that are either government monopolies or under strict regulation.

  10. Squirrel

    “Alex Davidson

    #1225472, posted on March 15, 2014 at 9:13 am

    Over the last few decades broad money supply has increased roughly 10% per annum. That is a far more useful measure of inflation than any attempt to measure its effects through an arbitrary ‘basket’ of prices of non-homogeneous goods and services. The solution is not indexation, but a return to sound money and truly free markets. Then as productivity improves, prices will fall, raising living standards without indexation.

    Right now we have the perverse situation where much of the benefit we should be experiencing through lower prices is being vacuumed up by price increases in areas of the economy that are either government monopolies or under strict regulation.”

    Thanks – laconic and logical.

  11. Max

    The solution is not indexation, but a return to sound money and truly free markets. Then as productivity improves, prices will fall, raising living standards without indexation.

    Yes Yes Yes – give that man a cigar

  12. Fred B

    Anyone who has ever been subjected to the bureaucratic thuggery of the ABS’ Household Expenditure Survey - that is the source of the so-called basket of goods used for the CPI – will be forever suspicious of the CPI because they know the bullshit responses that they gave to the arrogant bastards’ intrusive questions and unremunerated, time consuming diaries which were only completed under the threat of huge fines.

Comments are closed.