Michael Hicks: Inflation will make the Legislature’s job difficult

One of the more challenging aspects for any state’s legislature next year will be how it deals with the effects of inflation. This is one area where an economic model can help; in this case, the simpler the model, the better.

Suppose your state is a wholly self-contained island economy, with a fixed amount of currency in circulation. Here, prices are set by supply and demand for individual goods or services. Then, suddenly, a helicopter appears and drops across the countryside an amount of cash equal to the full amount of currency in circulation. Folks scurry to the drop zone, and some are able to really stuff their pockets, while others get just a few dollars.

All of a sudden there is twice the amount of money chasing the same amount of goods. So, prices rise. This is not because these goods have become more expensive, but rather the value of money has declined. That is inflation.

This example is so simple that it almost seems silly, but it isn’t. If you understand this, you understand inflation. Moreover, this simple model allows economists to build pretty effective mathematical models to link inflation to the growth in the money supply. These equations can be used to know where we are in an inflationary cycle, and how much more interest rates might need to increase.

We can make the model more complicated if we wish. For example, we could note that the effect of inflation wasn’t even across people or products. Some items were highly prized, so the price rose more quickly. Other items were not, and so they saw a smaller price increase. Some products were sold by firms in more monopolized markets with some control over prices. Others were sold in competitive markets where firms had little pricing power. That would cause different levels of price increases. We could make the model more complex by having our island trade with other islands facing inflation, or a pandemic, or a war.

These parts of the model require more math, and, yes, they explain more of the complexity of our current world. But, if you really want to understand inflation, the simple part is enough.

There’s a lot of blame cast about inflation, which is normal in politics, but an honest appraisal lays the blame pretty evenly across both parties. Both the Trump and Biden administrations and Congress, contributed mightily to inflation. So did about half of states. Indiana’s stimulus bills this summer helicoptered about 10% of the money into our economy that the Biden Administration did. So, yes, these contributed to inflation.

The budget challenges faced by legislatures are twofold. The first challenge lies in figuring out how much of the current and future tax revenues are simply due to inflation, and how much is due to changes in the economy. Fortunately, Indiana has a very thoughtful approach to forecasting tax revenues. The technical budget forecasting work used by Indiana’s General Assembly delivers what is probably the ‘best-of-class’ predictions. So, I’m pretty confident that Indiana will have as good a forecast as any state will have for the next two years.

That’s good news about our estimate of the actual tax dollars we’ll be receiving over the next two years, with a nearly certain slowdown and inflation. The large budget surplus Indiana now enjoys will act as a buffer over the next biennium. However, at least two-thirds of that surplus is simply due to inflation. All the extra revenue is simply what economists call ‘money illusion,’ which occurs when we don’t perceive the effects of inflation on wages and tax revenues.

The size of the money illusion is huge. With at least 12% unanticipated inflation over the two-year biennium, the total extra revenue that should be held by Indiana’s state and local governments is roughly $8.7 billion. A better way to think of this is that this amount is simply the shortfall of state and local spending caused by inflation. This puts in context the state’s current excess tax dollars. All of a sudden, they don’t look so robust, or solely as the result of fiscal probity.

The second challenge lies in figuring out which parts of government have been hardest hit by inflation. Of course, it’s harder to estimate this in the public sector than in the private sector. The police department and schools cannot raise their prices or wages when demand changes. Because of inflation, every state and local worker in Indiana has faced a pay cut. For some, like teachers, the combined salary reduction by the end of this school year may well approach 14 % of their annual salary. In contrast, the average worker in Indiana has suffered an inflation-induced pay cut of just 1.9% since the summer of 2021, and that is likely to be closer to zero by next summer.

The hardest hit institutions of government are those that are labor intensive and have less flexible levels of labor. This is particularly hard on schools and universities, but also policing, jails and other ‘ hands-on’ services. The challenge lies in figuring out ways to ensure these occupations don’t experience an exodus of workers. For many of them, moving to the private sector is far more lucrative. The sticker shock from this inflation will be enormous. Take education as an example.

Accounting for inflation, Indiana spends roughly the same per student today as we did in 2010. That has Indiana ranking about 38th nationally on education spending per student today. As a share of our state’s economy, our spending has been in steady decline since 2010.

The challenge for the General Assembly is that just getting back to the 2020 per-student level of spending will require an additional $1.03 billion per year over the biennium budget. To raise K-12 spending back to the same share of GDP that we spent in 2010 will cost an additional $1.91 billion over each of the next two years. All these combined means that this will be an enormously difficult General Assembly session.

Michael J. Hicks 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. Send comments to letters@dailyjournal.net.