All Commentary
Sunday, May 1, 1977

“Indexing”: The Wrong Way Out

Inflation is caused by the issuance of too much paper money. Inflation is the issuance of too much paper money. Its most conspicuous consequence is to raise prices. But it never raises all prices, wages, and incomes simultaneously or to the same extent. The persons whose wages or incomes it raises least or latest suffer the most from inflation and raise the greatest opposition to it.

Therefore some politicians and economists propose that this be remedied by what they call “indexing” or “indexation.” This consists in prescribing that everybody’s price, wage, or income be raised as much as the average “level” of prices. This usually means: by the same percentage as the official “Consumer Price Index” of the country has gone up.

The mere statement of this proposed remedy suggests some of its difficulties. We must distinguish first of all (though it is surprising how seldom this is done) between mandatory and voluntary indexing. This country has already adopted a large measure of the latter. According to a calculation made in 1975, the incomes of more than 65 million Americans were indexed: 31.3 million Social Security recipients, 19 million food stamp users, 7 million union members, 4 million aged, blind, and disabled persons on Federal aid, and so on—including also members of Congress and thousands of other employees of federal, state, and local governments.1

This “voluntary” or quasi-voluntary indexation does some harm, as I shall later point out, but not nearly as much harm as mandatory indexation. Mandatory indexing is a form of government wage-and-price control. Like any form of price control it is bound to be disruptive. “Standard” price control prescribes maximum wages and prices; mandatory indexing would prescribe minimum wages and prices. Imposing price ceilings brings underproduction and overconsumption of many commodities, causes shortages and leads to rationing. Imposing wage and price floors would lead to massive unemployment and to surpluses of goods that could not be sold at the higher prices.

What Is Not Seen

It is amazing that among the champions of compulsory indexing there are some self-styled free-market economists. Inflation from its very nature does not raise all prices, wage-rates, and incomes simultaneously and uniformly but at different times and by different amounts. And during an inflation individual prices, wage-rates, and incomes also change in relation to each other, for the same variety of reasons that they do when there is no inflation. But the advocates of indexing see all these changing divergencies not as market fluctuations that accelerate and smooth out a necessary re-allocation of production to changes in demand, but as “inequities” that need to be eradicated.

What the advocates of indexing overlook is that in a market system, with division of labor, practically every man’s money income is some other man’s cost. Therefore, indexing not only creates more inequities than it cures, but it tends to disrupt and misdirect production. When wage-rates in industry X, that have not yet gone up as much as the average, are suddenly and mandatorily boosted to that level, profit margins in that industry are narrowed or wiped out. One result is bankruptcies of marginal producers and less output. Another result is not a higher income for all the previous workers in that industry, but more unemployment. Similar consequences follow when raw material prices or rents are boosted by mandatory indexing. And every upward adjustment to produce “equity” creates the need for other upward adjustments, a never-ending process.

Misallocation of Resources

One of the great evils of inflation, of course, is that it tends to redistribute wealth and incomes erratically and wantonly. Another consequence is that it leads to the misdirection of labor and investment. But indexing, by arbitrarily altering and falsifying the market signals still further, only tends to increase the misdirection and misallocation of labor and output.

The advocates of indexing appeal to a class interest. What they say in effect is: You haven’t got your “fair share”; you are being cheated, and only indexing will save you. Powerful pressure groups push for a kind of indexing calculated to benefit them at the expense of everybody else. But if they could succeed in their aim, the result in the long run would be damaging to them as well as everybody else. The strong unions, for example, want to keep abreast of increases in the Consumer Price Index as a minimum. On top of that they ask for so-called “productivity” increases, increased pensions, and other guarantees. The result can only be reduced returns to employers, leading at best to less capital formation and slower growth, if not to increased bankruptcies and unemployment. The typical newspaper reader is led to assume that the official Consumer Price Index, on which most indexation schemes are based, represents all prices of all consumer goods. It is in fact not even designed to do that. Its full official name is the “Consumer Price Index for Urban Wage Earners and Clerical Workers.” It covers only 400 items out of the thousands bought and sold by consumers. It is weighted to apply to a particular minority. Its calculation is arbitrary in a score of ways. As a measure of changes in “everybody’s” cost of living, it lacks precision. And it necessarily must, because each person’s particular “mix” of needs and purchases is individual. The average is never the actual. The average family has 3.1 members, but there is not a single family in the United States with 3.1 members.2

Unevenly Applied

But these statistical defects are a comparatively minor objection to indexing. Contrary to the naive assumption of its advocates, indexing simply cannot be applied evenly all around the circle. It can only fix prices; it cannot guarantee incomes. It can order that wage-rates be raised; but it cannot insure that employment will not thereby be reduced. It can order that the price of an item be increased, but it cannot guarantee that the sales of that item will not be diminished.

For another example, let us look at how indexing would affect savings and loan institutions. The government, as has been suggested, could offer notes and bonds on which the annual interest rate varied with consumer prices, and on which even repayment of principal was increased to correspond with consumer price rises. Perhaps some private borrowers would offer similar bonds. In that case there would probably be massive withdrawals from the savings banks to buy such securities. How could the savings banks then maintain their liquidity or solvency? Would they, in order to compete, have to offer their depositors a similarly indexed interest rate and indexed repayment of principal? Where would they get the money from? Would they, in lending mortgages, also demand an indexed interest rate and a similarly scaled-up repayment of principal? How many homeowners would dare to undertake such a risk or be able to meet the terms in the event of a major inflation?

Mandatory indexing is practically certain to favor the interests of the most powerful political groups. In a democracy it would favor primarily the big labor unions. It is naive to suppose, as some of the advocates of indexing do, that in the event of an actual fall in prices, the unions would tolerate a corresponding cut in money wages. Indexing would force wage-rates up, and keep them up, on a ratchet principle.

Among those whose incomes are already indexed—if not overindexed—are Social Security recipients. This is having a disturbing political effect. It must tend to remove many of our elder citizens as opponents of inflation, and make them complacent about it. If elderly persons and the members of labor unions ever come to assume that they are adequately protected against the ravages of inflation, and may even profit by it, the outlook for restoring balanced budgets and a sound currency will become all but hopeless.

Among those who are already overprotected by indexing are retired Federal employees. Lately Congressmen have been voting themselves all sorts of catch-up raises. This is the most ironic indexing, and the most ominous of all. If those who are responsible for permitting or producing the inflation are allowed to become also the profiteers from inflation, to whom can we look to end it?

Higher Tax Brackets

One of the most serious inequities wrought by inflation falls on all those subjected to progressive income taxes and to capital-gain taxes. Inflation keeps pushing them into higher tax brackets. They are called on to pay higher percentage rates even though their real income may not have gone up at all. Many are forced to pay taxes on so-called capital gains when in real terms they may actually have suffered capital losses. If the taxpayer were allowed to recalculate his money income or capital gain in “real” terms, it would remove this flagrant inequity, at the same time as it would take part of the profit out of inflation for the government that was producing it.

In this instance the argument for indexation makes a strong appeal to conservatives. In fact, it might perhaps with as much accuracy be called de-indexing taxes as indexing them. But politically speaking, it would be at best very difficult to get such tax indexing or de-indexing except as part of a sweeping indexation program. And such a program would only tend to prolong and increase inflation itself.

Prolonged and Accelerated

Indexation tends to prolong and accelerate inflation for two reasons. It does so first because it postpones, diminishes, or removes the worst effects of inflation on influential groups, and so greatly reduces the political opposition to inflation. And it does so also because of its purely mathematical effect. In Phase 1, say, indexing would bring all (or most) wages and incomes that were below the average up to the average. But as soon as Phase 1 had been completed, the average itself would be raised by that increase. This would necessitate a further upward adjustment in Phase 2; and so on. To make the new wage and income levels sustainable at each stage, there would be great political and economic pressure to increase the money supply still further.

The effect is even greater when indexation directly increases government expenditures themselves. It does this most notably, for example, when Social Security payments are indexed. When government expenditures are forced up automatically whenever the Consumer Price Index rises, we have come close to a formula for perpetual inflation.

It should be pointed out that the same sort of result would follow, though on a smaller scale, if tax rates were also indexed or de-indexed so as not to go up with increasing nominal money incomes. This indexation would make tax revenues lower than they would otherwise be, and so tend to increase the deficit—unless the government compensated, as it no doubt would, by openly increasing income-tax rates.

Even if indexing did not increase inflation or the political pressures for inflation, it should at least be obvious that it does nothing by itself to reduce or slow down inflation. Even Milton Friedman, one of the strongest advocates of indexing, concedes that “indexing per se will not, in my opinion, do anything to reduce inflation,”3 and even that “…widespread indexation would reduce the public pressure to end inflation.”4 How does it come about that, with all the objections to it, indexing is nonetheless being seriously proposed and discussed? The active discussion began in this country early in 1974, when Milton Friedman returned from a short visit to Brazil full of enthusiasm for the indexation program that he found there.

The Brazilian Model

To have Brazil upheld as an economic or monetary model for the United States to emulate seems a strange irony. Brazil, one must admit, does not have the very worst inflation record in the world in recent years. Chile and the Argentine have been competing too vigorously for that honor. But Brazil does have one of the worst records—especially one of the worst long-term records. It was inflating at a double-digit rate as early as 1941. The accompanying table shows its annual record for the last 26 years:

Annual Percentage Change,

1952 . . . 20.8%       1964 . . . 91.9%

1953 . . . 16.8          1965 . . . 34.5

1954 . . . 26.2          1966 . . . 38.3

1955 . . . 19.1          1967 . . . 25.0

1956 . . . 21.7          1968 . . . 25.5

1957 . . . 13.4          1969 . . . 20.1

1958 . . . 17.3          1970 . . . 19.3

1959 . . . 52.0          1971 . . . 19.5

1960 . . . 23.8          1972 . . . 15.7

1961 . . . 43.2          1973 . . . 15.5

1962 . . . 55.2          1974 . . . 34.5

1963 . . . 80.6          1975 . . . 29.4

1976 . . . 46.3

Source: Getulio Vargas Foundation.

It will be noticed that in the single year 1964 consumer prices in Brazil soared 91.9 per cent. In fact, in the first quarter of 1964 the annual rate of inflation was running at 150 per cent, but at that point the Brazilian authorities took hold and applied the old-fashioned “classical medicine.” They imposed a heroic contraction in the growth of “aggregate demand” by severe fiscal and monetary restraint. It was this, and not “indexing,” that slowed down the cost-of-living rise to 25 per cent in 1967.

The indexing that was applied in Brazil in this three-year period was not the kind that its present American advocates are recommending. Brazil’s authoritarian government was careful not to allow full indexing of labor incomes to rising consumer prices. In this way it was not only able to prevent heavy unemployment, but by diverting a larger proportion of industry’s income to profits, it encouraged capital accumulation, plant expansion, and “economic growth.” Once fuller indexing came into play after 1967, labor’s opposition to inflation diminished, and inflationary policies were resumed.5

Automatic But Voluntary

When an inflation once develops and continues beyond a certain point, indexing arises almost spontaneously and spreads by mutual acceptance as the only way of mitigating an otherwise intolerable situation. This was exemplified in the hyper-inflation in Germany in 1922 and 1923. But such indexing should always be voluntary, and flexible enough to adapt itself to special situations. When it is mandatory and Procrustean, it can only increase economic disruption and create at least as many inequities as it cures.

We come back to the point that one man’s price, wage, or income is another man’s cost. Inflation is a disguised, haphazard, and iniquitous form of taxation. It is a government-imposed swindle or robbery, and most of us must be swindled or robbed by it. As Dr. Hans F. Sennholz has put it:

“If a government resorts to inflation, that is, creates money in order to cover its budget deficits or expands credit in order to stimulate business, then no power on earth, no gimmick, device, trick or even indexation can prevent its economic consequences. If by way of inflation government spends $10 billion in real goods, capital or labor, someone somewhere must forego $10 billion in real resources. It is a fundamental principle of inflation that there must be victims. Indexation may shift the victimization; it cannot prevent it.”6

The Only Real Cure

One last argument against indexing remains. It is the most important of all, and in itself sufficient. The advocates of indexing tacitly take it for granted that, inflation is some mysterious and incurable disease, like cancer; and as it cannot be cured, the best we can do is to live with it and try to mitigate the pain as much as possible. This is a preposterous assumption. Every economist worth the name knows precisely what causes inflation and how to stop it. It is caused by a government that insists on spending more than it can or is willing to raise by taxes; a government that recklessly runs chronic deficits and issues more paper money to pay for them. If the politicians responsible for government policy had the will, they could stop inflation overnight. The proponents of indexing blandly suggest that the same government that is creating and prolonging the disease continue to do so but graciously provide us with indexation as a partial pain-killer or rather, that it shift the pain from some of us to someone else. They propose a complicated and spurious cure and overlook the simple, real, and only one: Stop the inflation.


1U.S. News and World Report, Aug. 18, 1975, p. 44.

2The reader interested in a fuller analysis of the defects of the CPI may consult the pamphlet “The Case Against Indexation,” by John W. Robbins (Committee for Monetary Research and Education, P.O. Box 1630, Greenwich, Conn. 06830).

3lndexing and Inflation, American Enterprise Institute, 1974, p. 2.

4Ibid., p. 18.

5For a more detailed description, see Ronald A. Krieger, “Inflation and the ‘Brazilian Solution,’ in Challenge, Sept.-Oct. 1974, pp. 43-52. And for a fascinating history of the incredible monetary mismanagement and chronic inflation in Brazil from the seventeenth century to the present, see Norman A. Bailey’s pamphlet: “Brazil as a Monetary Model” (Committee for Monetary Research and Education, Greenwich, Conn., June 1975.)

6lnflation Survival Letter (Washington: Human Events, July 1, 1974.)

  • Henry Hazlitt (1894-1993) was the great economic journalist of the 20th century. He is the author of Economics in One Lesson among 20 other books. See his complete bibliography. He was chief editorial writer for the New York Times, and wrote weekly for Newsweek. He served in an editorial capacity at The Freeman and was a board member of the Foundation for Economic Education.