Inflation's COLA Cure

The price-battered U.S. gropes toward more indexation

The nation's 35.2 million Social Security recipients are receiving a pleasant surprise this month. Their July checks have been increased by a helpful 14.3%. Like about one-quarter of all Americans, they are receiving a cost of living adjustment (COLA) designed to ease the pain of inflation. As double-digit price rises continue to erode their incomes, many weary consumers see a COLA as the pause that refreshes. But critics charge that automatic income adjustments may push the U.S. economy into a permanent inflation high.

Indexation, the system of pegging payments such as salaries or Government Social Security benefits to the rate of inflation, is a siren that has attracted supporters on both the political right and left. Milton Friedman, a sometime adviser to Ronald Reagan, has advocated COLAs as a stopgap to mitigate the social disruptions caused by soaring prices while action is taken to bring inflation under control. And Rudy Oswald, chief economist of the AFL-CIO, says, "Indexation allows workers to make up for some of the inflation that has taken place."

The Federal Government is already heavily hooked on COLA. In the 1981 budget, 42% of all Government outlays will go to programs whose benefits are indexed. These include civil service pensions, food stamps and disability payments. The largest chunk, $140 billion, will go for Social Security benefits, and the latest 14.3% boost has added $20 billion to the budget.

Indexation is also widespread in the private sector of the economy. The United Auto Workers in 1948 negotiated the first labor contract that included a COLA clause. The percentage of employees covered by cost of living escalators has risen from 26% in 1965 to 58% at the beginning of 1980. The current auto agreement, which is typical of those for many major unions, pays workers an extra penny an hour for each three-tenths-point rise in the Consumer Price Index. That has increased the average hourly wage so far this year by 71-c-, to $9.84. Such escalator provisions usually match only 50% to 70% of consumer price increases.

Inflation adjustments are now creeping into other areas of American society. Atlanta landlords, for example, insert COLA clauses in office leases. Divorce settlements often contain a clause that increases child support and alimony payments according to rises in the CPI. California and a few other states have indexed their income taxes. This automatically raises the amount of earnings covered by each tax bracket, thus keeping tax rates the same even though inflation-bloated incomes are increasing.

Republican Senator William Armstrong of Colorado has proposed indexing federal income taxes. He and others maintain that inflation is pushing people into tax categories originally intended for only the superrich. Americans will pay $14 billion more in federal taxes this year solely because of inflation-induced salary increases. Says Armstrong: "The problem now is that the recipients of federal money are all indexed, while the people paying the taxes are not. If there's no possibility to deindex recipients, then it's only fair that we protect taxpayers through an indexation of taxes."

But a backlash against indexation is beginning to develop. Says Jo Anna Gray, a Federal Reserve economist: "Indexation only aggravates the type of inflation we now suffer." As salaries increase to meet prices, firms raise their prices again to pay for the higher wages. The end result is that cost of living adjustments create a perpetual inflation machine.

Some corporations are now challenging COLA payments. Steel companies last spring got the United Steelworkers to forgo a 320-an-hour COLA increase in order to pay for higher pensions for retired union members. The copper industry was willing to accept a strike this month when the union would not agree to divert a 29-c--an-hour COLA increase to help pay for its benefit funds.

Budget-strained state and local authorities are also becoming disenchanted with the salary escalator ride. In November, the Chicago Transit Authority sought to alter a contract provision that guaranteed its bus drivers virtually complete wage protection against inflation. The drivers struck for four days, but went back to work under a court order. They were finally forced to accept a new COLA agreement that raised salaries by only 55% of the inflation rate.

Opponents say that cost of living adjustments often cause higher inflation rather than just help people keep up with past price hikes. This is because the increases are usually based on the CPI, which exaggerates the level of price rises. The market basket of goods used to calculate the CPI is heavily weighted toward items like mortgage rates and energy costs, which have recently had outsized increases. But since many Social Security recipients already own their houses and have mortgages at low fixed rates, they have suffered less inflation than that registered by the CPI.

Most economists suggest that another inflation indicator could be used to calculate cost of living adjustments. One possible alternative is the index used to adjust the gross national product for inflation. It is called the G.N.P. deflator and measures price increases in the whole economy and not just for consumer products. In the past year, for example, the CPI has increased 14%, while the more broadly based G.N.P. deflator has risen by only 9%.

In Western Europe and Latin America, where indexation has been much more widely practiced than in the U.S., governments and the public are increasingly disenchanted with COLAs. Israel maintains the world's most comprehensive network of cost of living adjustments, and that nation has soared into triple-digit inflation (see box). Brazil, which has been heavily indexed since 1964, is now backing away from the system in the face of 100% inflation. Last January the governments of both Denmark and The Netherlands refused to grant workers and welfare recipients the expected automatic increases in salaries and benefits. Says one top European Community economist: "Indexing is the fool's gold of modern economics. Nothing breeds inflation as much as cost of living benefits."

Indexation is ultimately an inflation medicine that has dangerous side effects. Because they somewhat dull the pain of higher prices, COLAs weaken the desire to fight inflation. But, despite the dangerous illusion that price rises no longer hurt, the inflation malady lingers on. qed

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