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August 21, 2022

Limiting Future Inflation

Inflation came to a standstill last month. The primary causes of that welcomed outcome were tightened monetary policy and an increase in the supply of petroleum. Nevertheless, Congress passed, and the president signed the Inflation Reduction Act. While this legislation may do many things, one thing it will not do is reduce inflation. Indeed, the most we can hope for is that the new law won’t make inflation worse.

Republicans showered the legislation with criticism, noting that it won’t reduce, and may even contribute to inflation. They are right. However, a little over a week ago, Indiana’s legislature passed, and the governor signed a stimulus bill they claimed would help reduce the effects of inflation. Like the Inflation Reduction Act, it will not. The best we can hope for is that this new stimulus will only worsen inflation modestly.

Democrats showered the legislation with criticism, noting that it won’t reduce, and may even contribute to inflation. They are right. This episode offers the spectacle of two political parties offering similarly effective bills, telling the same untruths about inflation and making the same complaints about their opponents. An observer must conclude one of two things. The elected leaders who make these claims are either ignorant or think that you, the voter, are ignorant. Though, in fairness, for some, both statements are surely true.

This sort of frivolous hypocrisy rightfully angers and frustrates many citizens. It corrodes trust in our Republic and weakens our ability to respond to actual challenges. I suppose we have a few more months of performative anti-inflation politics. The only useful lesson in all this is in reminding us why Profiles in Courage was such a slender volume. It also raises the question of what could we do better to prevent inflation and future price-level shocks.

Inflation is always, everywhere a monetary phenomenon. It is the occurrence of too much money chasing too few goods, leading to higher prices in general. Another way to think about it is that it represents the loss of value of currency. It isn’t a higher price for one thing, but higher prices across the board because money is worth less than before. Other things can look like inflation, such as a supply shock or a petroleum embargo. But at its essence, inflation is about too much money.

The worst of this bout of inflation is likely behind us, but inflation will come again. One way we could better keep inflation in check is to be better at predicting it. In another 100 years, economists will have about as much data on inflation as weather forecasters in 1950 had about hurricanes. Some economists, notably Larry Summers, got this one right, as did many in the Federal Reserve.

So, one lesson might be to listen to more than just the consensus forecasts, perhaps weighting them by risk. More dire predictions might be given more weight. One problem with this is that as bad as inflation might be, overreacting to inflation can be worse to the economy than underreacting. There’s no low-cost, low-risk solution in the policy response to inflation, and there never will be.

A better goal would be to boost worker productivity, which would lessen inflationary pressures. The low growth of the U.S. economy from 2009 to 2020 helped set the stage for today’s inflation. These includes the Tax Cut and Jobs Act from the Trump Administration, which I supported in this column.

Increasing productivity means that an economy can produce goods more cheaply, which mitigates inflation. Improving productivity won’t stop inflation; it will simply dampen its effects. Productivity is simply the value of goods produced in a region, per worker. That GDP-per-worker tells us how ‘good’ our economy and workforce is, with a couple of caveats. GDP-per-worker varies by industry, so capital-intensive industries like manufacturing, logistics and agriculture should be very productive on a per-worker basis. Industries with little physical capital, such as personal services, are far less productive on a per-worker basis. So, Indiana’s workers, a disproportionate share of whom work in factories, warehouses and farms, should be more productive than the average American.

Unfortunately, we are not. The average Hoosier worker produced 16.6 percent less per year than did the average American. The productivity gap is large, with Hoosiers producing roughly $9.10 per hour less in goods and services that than the average American (based on a standard 40-hour week). This gap has grown modestly for more than a decade, indicating a long-term problem in the Indiana economy.

The Hoosier economy should be far more productive than it is. That we aren’t is a result of several public policy mistakes that leave Hoosiers poorer and more susceptible to inflation than the average American.

Having failed to soften the blow of inflation through state policy, we must look to federal policy to do so. Ultimately our federal debt is a very large inflationary risk. Our debt is the sum of all previous federal deficits, or how much more we spend each year on a federal budget than we collect in taxes. Our debt has grown to enormous levels; it now sits at 137 percent of our GDP. Despite what you may hear from political candidates, this debt is a wholly bipartisan endeavor.

Mr. Biden has only had one budget year so far of data, but he added $2.7 trillion to the national debt. Mr. Trump added $5.9 trillion, Mr. Obama added $8.7 trillion, Mr. Bush added $1.9 trillion. From 1950 to 2020, Republican presidents averaged an inflation-adjusted annual increase to the debt of $433 billion, while Democrats added $302 billion on average over the same time. The biggest increase in the deficit occurred during 2020 and 2021 as we recovered from the recent pandemic, with the all-time record going to Mr. Trump, followed by Mr. Biden.

Ironically, both parties have been equally unreliable with tax rates, as with spending. It is this data that is most surprising to many readers. During the Trump presidency, our federal government collected 10.4 percent of GDP in taxes, up from 9.9 percent under Mr. Obama, who was down 10.5 percent from Mr. Bush’s tax collections. Mr. Clinton’s average taxes were 11.6 percent of GDP, while the elder Mr. Bush collected an average of 10.4 percent. The idea of high-tax, high-spending Democrats and fiscally prudent Republicans is empirically without justification.

The combination of too-high spending and too-low tax rates has left the U.S. with a large debt that slowly adds to the risk of inflation in later years. This could be fixed in Congress at any time. All it requires is some capacity for honest arithmetic, the ability to explain difficult fiscal challenges to voters, a bit of integrity, and a tiny snippet of moral courage. In other words, addressing our biggest inflationary risk requires the character traits that were conspicuously absent during our current bout of inflation.

Link to this commentary: https://commentaries.cberdata.org/1173/limiting-future-inflation

Tags: pres. biden administration, budget and spending, cost of living, economic recovery, family and households, federal government, finance, law and public policy, politics, prices and inflation, state and local government, united states of america, value


About the Author

Michael Hicks cberdirector@bsu.edu

Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University. Note: The views expressed here are solely those of the author, and do not represent those of funders, associations, any entity of Ball State University, or its governing body.

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