Ugly Modeling

Will spending cuts ruin or improve America's economy?

In February, the Goldman Sachs economist Alec Phillips predicted on ABCNews.com that a Republican proposal in the House of Representatives to cut $61 billion from the federal budget in fiscal year 2011, would, if enacted, shave two full percentage points off America's gross domestic product in the second and third quarters of this year. A few days later, The Washington Post described a new study by Mark Zandi, the chief economist at Moody's Analytics and an architect of the 2009 stimulus package, a.k.a. the American Recovery and Reinvestment Act. Zandi's amazing verdict: The spending cuts would destroy 700,000 jobs by the end of 2012.

After every newspaper had published the gloomy predictions, Goldman Sachs issued a "clarification" of Phillips' analysis. Phillips now says he was misunderstood by journalists eager to spread a doom-and-gloom message and predicts the impact of spending cuts probably will be mild and temporary. Perhaps he was influenced by Federal Reserve Chairman Ben Bernanke, who testified in March at the Senate Banking and Urban Affairs Committee that Goldman's numbers were incorrect.

Yet even this correction implicitly assumes that government spending is the source of all recovery. The logic, as with Bernanke's and Zandi's analyses, is that government spending cuts reduce overall demand in the economy, which affects growth and then employment. This argument ignores the fact that the government has to take its money out of the economy by raising taxes, borrowing from investors, or printing dollars. Each of these options can shrink the economy.

All these analysts also systematically ignore the fact that GDP numbers include government spending. When the federal government pumps trillions of dollars into the economy, it looks as if GDP is growing. When government cuts spending—even cuts within the most inefficient programs—aggregate GDP shrinks. 

But that's misleading. If Washington spends $1 a year on a bureaucrat's salary, for example, GDP numbers will register growth of exactly $1, whether or not the employee has produced any value for that money. By contrast, if a firm pays an engineer $1, that $1 only shows up in the GDP if the engineer produces $1 worth of stuff to sell. This distinction biases GDP numbers—and the policies based on them—toward ever-increasing government spending.

Furthermore, GDP does not capture changes in personal investment portfolios or changes in private research and development spending. In the last two years, corporate cuts in the latter area have been large but unaccounted for. Also not included in GDP: pension benefits and the U.S. Flow of Funds Accounts balance-sheet information from the Federal Reserve Board. That means that when it comes to GDP, states' grossly underfunded pensions are off the books, along with the loans and purchases conducted under TARP.

Another problem with these analyses: Economists of all persuasions have proven to be really bad at predicting the future, especially when it comes to jobs. Take the stimulus. Forecasters at the White House and the Congressional Budget Office (CBO) predicted the stimulus package would create more than 3 million jobs. And in August 2010, the CBO estimated that the stimulus had indeed created between 1.4 million and 3.6 million extra jobs, thrilling supporters of economic intervention. But unemployment stubbornly remained around 10 percent.

What was wrong with the CBO's numbers? "When the upper limit of your estimate is almost three times the lower limit, you know it is not a very precise estimate," the George Mason University economist Russ Roberts pointed out in testimony to the House Subcommittee on Regulatory Affairs, Stimulus Oversight, and Government Spending in February.

The truth is that there is no way to know the real number of jobs "created or saved" by the stimulus. For that, the CBO would have had to collect data on output and employment while holding other factors constant. But the CBO didn't do that because that's different from its job of "scoring" the possible results of proposed legislation. As the CBO explained in a November 2009 report, "Isolating the effects would require knowing what path the economy would have taken in the absence of the law. Because that path cannot be observed, the new data add only limited information about [the law's] impact." In other words, CBO number crunchers gave it their best guess before the stimulus and arrived at their subsequent numbers by applying their original prediction model. If the model is wrong, so are the numbers.

No one knows what economic output would have been without the stimulus, and no models can tell us the answer. As Roberts testified, "The economy is too complex. Too many other variables change at the same time." 

Also, the Zandi and Phillips models are based on the Keynesian view that government spending produces recovery. According to that theory, $1 in government spending produces substantially more than $1 in growth, a phenomenon known as the "multiplier effect." The Goldman Sachs study assumes a multiplier greater than three—i.e., more than $3 in additional GDP for each dollar of government spending. But a review of the empirical literature reveals that in most cases a dollar in government spending produces less than a dollar in economic growth. And these findings often don't even take into account the impact of paying for that government dollar via increased taxes. 

The Harvard economists Robert Barro and Charles Redlick estimate that the multiplier for stimulus spending is between 0.4 and 0.7. In another study, the Stanford economists John Taylor and John Cogan concluded that the stimulus package couldn't have had a multiplier much greater than zero. Even the multipliers used by Christina Romer, the former chairwoman of the White House Council of Economic Advisers, and Jared Bernstein, economic adviser to Vice President Joseph Biden, in their January 2009 paper "The Job Impact of the American Recovery and Reinvestment Plan," ranged from 1.05 to 1.55 for the output effect of government purchases. More recently, the Dartmouth economists James Feyrer and Bruce Sacerdote, who supported the stimulus, acknowledged that it didn't boost the economy nearly as much as the administration models claimed it would.

The use of these outdated models and unrealistic multipliers explains why Zandi was wrong about how many jobs the stimulus would create. He claimed "the country will have 4 million more jobs by the end of 2010" if the stimulus passed. In truth, by the end of 2010 total payroll jobs had fallen by 3.3 million, and the unemployment rate had risen from 7.8 percent to 9.4 percent. The administration's post-facto claim is that unemployment would have risen even more without the stimulus. To argue this, they again must pretend that they know what would have happened in the absence of a stimulus.

Now what? Many economists and many members of the business community argue that recent policy changes have hampered investment, making a bad situation worse. The prospect of endless future deficits and accumulating debt raises the threats of increased taxes and of government borrowing crowding out capital markets, diverting resources that could be used more productively. As a result, U.S. companies are less likely to build new plants, conduct research, and hire people.

We have tried spending a lot of money to jump-start the economy, and it has failed. Now we need to cut spending and lift the uncertainty paralyzing economic activity. That approach will not just be more fiscally responsible. It will also empower individuals and entrepreneurs. And they are the only ones who can bring on a real recovery. 

Contributing Editor Veronique de Rugy ([e-mail]), a senior research fellow at the Mercatus Center at George Mason University, writes a monthly economics column for reason.