Now that the President’s “jobs” speech has been digested by analysts and commentators, most observers wonder whether Congress will be willing to pass legislation to aid the economy even if it provides the President with a substantive political victory. In a moment, the narrative has switched from whether the President’s plan will do any good for the economy to whether the President’s political opponents would allow his plan to do any good for the economy. This is an unfortunate twist considering that there is no reason to believe that a collection of measures to temporarily increase after-tax household and corporate income, transfer more money to state and local governments, and change terms of unemployment insurance would reliably boost growth. In many ways, the focus on political dynamics masks the discussion about economic effectiveness – for which there is little to no empirical basis.
Of course, it’s easy to be misled into believing such evidence exists based on the very precise projections offered by some forecasters. Mark Zandi, one of the most quoted macroeconomists, believes the plan would add 1.9 million jobs, boost GDP growth by 2 percentage points, and cut unemployment by 1 percent. While this may seem like a strong case in favor of swift passage, the dark little secret about Zandi’s predictions is that they’ll be true no matter what actually happens. As professor Robert Barro explained with respect to the previous stimulus, “the administration found the evidence it wanted…by consulting some large-scale macroeconometric models [like Zandi’s], which substitute assumptions for identification.” What this means is that Zandi’s estimates depend on assumptions about the impact of policies on growth that cannot be empirically verified without identifying how the economy would have performed in their absence. Therefore, the forecast is always accurate and non-falsifiable; the adjustment comes from the difference in the strength (or weakness) in the underlying economy.
Here is how this “1.9 million new jobs” forecast works in practice. If the economy, let’s say, generates 4 million net new jobs between passage of the Act and the end of 2013, the economy would have only generated 2.1 million jobs without the “jobs” act. Conversely, if the economy were to shed 1 million net jobs over this period, total job losses would have been 2.9 million without the latest stimulus. This is how Zandi found in 2010 that the 2009 stimulus was a huge success even as output and employment gains fell well below predictions.
At the start of 2011, Moody’s Analytics expected growth this year to exceed 3.5%, or more than three-times faster than the actual (or reported) growth in the first half of the year. If the baseline growth path is this difficult to forecast, how could anyone place a lot of confidence in an estimate of how specific policies impact this baseline? Are we to believe forecasters who cannot reliably predict the growth rate in the absence of policy intervention can somehow miraculously divine the precise growth implication of a temporary payroll tax credit targeted at a small subset of employers?
This is not the first time people have asked these questions. In 1979, professors Robert Lucas and Tom Sargent published a piece entitled “After Keynesian Macroeconomics” that laid out why it was foolish to rely on the results from applied linear models of the sort now used by Zandi. The basic logic of the applied linear (or Keynesian) approach to economic performance depends on “a set of simple, quantitative relationships between fiscal policy and economic activity generally, the basic logic of which could be (and was) explained to the general public, and which could be applied to yield improvements in economic performance benefiting everyone.” By 1979, this basic framework had been shattered, as these models produced forecasts that were wildly inaccurate and proved no better an aide to policymaking than (bounded) guesses. Today’s Keynesian approach encounters the same failures, yet the problematic employment and outlook projections generated by the models continue to be treated with a reverence that seems misplaced, at best.
Rather than return to a Keynesian framework and all its flaws, policymakers should instead look to the insights of Ed Prescott and Finn Kydland, who were awarded the Nobel Prize in economics in 2004. Prescott and Kydland developed “real business cycle” theory – a mathematical abstraction of the real world that reaches a rather commonsense conclusion: it is impossible to fine-tune macroeconomic performance and foolish to even try. The basic message is that policy is generally neutral with respect to short-run economic outcomes and often harmful, on net. Rather than focus on short-term inducements for consumers and businesses to spend or invest, policymakers should worry about getting the big things right. This requires a longer-term view of the economy’s productive capacity and an appreciation for the basic rationality of business managers and households.
The government faces an “intertemporal budget constraint.” This means that increasing deficits today to finance a short-term payroll tax cut or more state and local spending requires more taxes in the future. Households and businesses recognize this. It’s why temporary, deficit-financed tax relief rarely works. It’s also why the plan to extend the Bush tax cuts for two years at the end of 2011 – without corresponding spending cuts – has not done enough to stimulate economic activity in 2011. Today’s ten year Treasury bond yields less than 2%, which is also consistent with precautionary savings in expectation of increased future tax burdens.
Investments take time to bear fruit. New investment may take years to turn a profit; and a lot of taxable income many be generated many years after the investment is actually made. Big questions – like, what is the top federal income tax rate going to be in 2016? – really matter in this context. While a definitive answer to this question is practically impossible to reach today, President Obama is making clear that no one should expect the future rate to be as low as today’s 35% (or 38.8%, including the health care bill’s new surcharge).One-third of business income comes from flow-through businesses taxed at the individual income tax rate, which makes this of paramount importance to business planning.
Businesses considering investment strategies today need policy certainty over the relevant business planning period. The wild and sporadic government intervention of the last few years has left business managers and small business owners unable to form reliable expectations about the future of employment costs, tax rates, credit availability, or labor relations. Research demonstrates that most employment growth comes from small businesses that turn into large businesses. Plans to expand and increase payroll are always beset by basic commercial uncertainties: will new competition emerge? Will new markets embrace the product? Can new production facilities increase productivity to the extent necessary to justify the incremental outlays? On top of these uncertainties, managers must now ask how the mandates introduced by the health care bill will affect the cost of adding new employees? Whose taxes are going to be raised to finance the 20% rise in government spending and 10-fold increase in the deficit since 2007 and how will this impact business, access to capital, or after-tax returns on investment? Who is going to provide the loans and lines of credit necessary to finance capital expenditures in the wake of the Dodd-Frank regulatory expansion?
Does anyone really believe that temporary savings on certain employers’ payroll taxes would be enough to compensate for all of this? Wouldn’t a clear delineation of future policies on taxation, employer-sponsored health care, and credit availability do more to incentivize hiring at this stage of the business cycle than more one-off, hand-outs? It is remarkable this far into the “recovery” that the Obama Administration is still trying to fine-tune economic outcomes with one-off policies, like cash-for-clunkers, the homebuyer tax credit, and now a hiring credit.
The uncertainty impacts multiple levels of economic activity. Investors allocating capital across industries must speculate about how business leaders are going to respond to the policy uncertainty. As explained in a trade journal for investment advisers: “No one can have much confidence in long-term financial plans, given the extraordinary level of economic uncertainty that the lack of action on these issues produces (emphasis added). Investors and their advisers should be prepared to build maximum flexibility into their financial plans until the situation becomes clearer, which, most probably, won't be until after the results of the 2012 elections.” Low interest rates on government bonds are partially explained by these concerns, as investment advisers maintain flexibility by reducing allocations to private sector obligations, which makes capital scarcer for smaller, riskier businesses.
Rather than embrace the Administration’s calls for more fine-tuning, Congress should focus on generating even larger savings through the select committee on deficit reduction. Larger spending reductions would provide businesses and households with some confidence that the government’s share of the income from new investments will not rise substantially or render new projects uneconomic. Congress could also pursue a fundamental re-write of corporate and individual taxes to establish certainty about how labor and capital income are likely to be taxed in the coming years. In the end, policymakers would be wise to eschew Keynes and follow Kydland and Prescott’s advice to put an enduring policy framework in place that encourages work and investment.