IAS 107: April 14, 2011 Government-Budgets Health-Care Financing Lecture
Barack Obama on the Simple Truth About Fiscal Policy

Republicans. They LIe. All the Time. About Everything

The techocratic and highly competent Macro Advisers on the Republican "estimates" of the Ryan Plan made by the Heritage Foundation:

Macroadvisers: The Economic Effects of the Ryan Plan: Assuming the Answer?: Last week the House Budget Committee, chaired by Congressman Paul Ryan (R, WI) issued a Budget Resolution for fiscal year 2012 along with a Republican blueprint for addressing the nation’s long-term fiscal imbalance.[1] The “Ryan plan” would squeeze discretionary spending and health care entitlements very hard, lower marginal tax rates, and expand the tax base.... The Committee’s report included a simulation analysis showing the economy strengthening immediately as a result of the fiscal contraction; that is, a negative short-run fiscal multiplier. We don’t believe this finding, which was generated by manipulating an econometric model that would not otherwise have produced the result. That analysis implied other questionable results — some of them probably unintended — including over $1 trillion of net new borrowing from abroad over the coming decade and the construction of several million unoccupied houses. We consider the analysis both flawed and contrived....

At the request of the House Budget Committee and using the Global Insights (GI) model of the US economy, analysts at the Center for Data Analysis at the Heritage Foundation simulated the results of implementing the Budget Resolution on top of a baseline reflecting CBO’s Alternative Fiscal Scenario.... Despite meaningful cuts in federal outlays, there is an immediate rise in real GDP which, over the next decade, grows to 2.2% of the baseline value. By 2021 the federal debt is reduced by nearly $10 trillion, and the yield on 10-year Treasury notes is down 84 basis points. This sounds pretty good, but how seriously should we take these results and the analysis that gave rise to them?...

If the analysis shows that trimming $10 trillion of debt by 2021 reduces long-term rates by 84 basis points, then isn’t it the case that in the baseline the $9 trillion expansion of debt after 2016 should keep pushing rates further above 5.4% by 2021? If not, then what is preventing rates from rising?...

There were actually two sets of results. The first showed real GDP immediately rising by $33.7 billion in 2012 (or 0.2%) relative to the baseline, with total employment rising 831 thousand (or 0.6%) and the civilian unemployment rate falling a stunning 2 percentage points, a decline that persisted for a decade.... The decline in the unemployment rate was greeted — quite correctly, in our view — with widespread incredulity. Shortly thereafter, the initial results were withdrawn and replaced with a second set of results that made no mention of the unemployment rate, but not before we printed a hardcopy!... The results showed GDP increasing by 0.2 percent the first year, so a reasonable expectation is that the unemployment rate would fall by about 0.1 percentage point, not twenty times that!... An alternative interpretation of the sudden and persistent drop in the unemployment rate was that it reflected an immediate decline of 2 percentage points or so in the Non-Accelerating-Inflation Rate of Unemployment (NAIRU, which was not reported) that quickly became reflected in the observed unemployment rate as well.

This did seem consistent with the result that inflation remained at the baseline path over the whole decade despite the much lower average unemployment rate initially simulated under the Budget Resolution.... [I]t just seemed incredible to us that this (or any) fiscal plan would immediately reduce the NAIRU to a nonsensical value.

Whatever the explanation of the initially reported decline in the unemployment rate — and there’s more on that just below — the results were confusing. The simulation showed total nonfarm payroll employment rising by 831 thousand in 2012, with the unemployment rate falling 2 percentage points. One way to have produced this configuration of results is for the civilian labor force to have fallen sharply... a decline in the labor force of 2.3 million.... This doesn’t square with discussion of participation rates in the report....

In response, Heritage pulled the initial tabulations and replaced them with new ones that did not show or discuss the unemployment rate but left all the other results unchanged. Then, in a separate update, Heritage published a new path for the unemployment rate averaging 1.5 percentage points higher than the original path, along with the following explanation:

In further response to the Chairman’s letter of February 28, 2011 requesting technical advice and assistance, we have given additional scrutiny to calculations concerning the unemployment rate under the Chairman’s proposed budget plan. As a result of that examination, we are making an adjustment to one variable — the full-employment unemployment rate, which is one component of the equation for the overall unemployment rate....

In any event, the update goes on to say “while the adjustment has an impact on the unemployment rate in the model, the overall results elsewhere in the model do not change significantly”. Of course it can’t be the case that no other variables changed.... [I]f the unemployment rate rises for whatever reason, either household employment must be lower and/or the labor force participation rate must be higher. Is it really the case that in a general equilibrium model such large changes in labor force participation, household employment, and the NAIRU have no other significant impacts? We doubt it....

The simulation shows real federal nondefense purchases down by $37.4 billion in 2012, but real GDP up by $33.7 billion, so the short-run “fiscal multiplier” is negative. As noted above, that analysis was prepared using the GI model of the US economy.... [W]e doubt that the GI model, used as intended, shows a negative short-run fiscal multiplier. Indeed, GI’s own discussion of its model makes clear the system does, in fact, have positive short-run fiscal multipliers. This made us wonder how and on what grounds analysts at Heritage manipulated the system to produce the results reported....

The incremental strength of GDP is primarily in the components of gross private domestic investment.... [T]he sudden adoption of an expectation of a serious fiscal fix that was not already priced into markets could lower interest rates enough to stimulate the interest sensitive components of aggregate demand.... This can’t be what’s going on here. In 2012, long-term rates are lower by a measly 1 basis point and, by 2014, by only 9 basis points.... [A]s we parsed the simulation results, we couldn’t see what was stimulating aggregate demand at unchanged interest rates and in the face of large cuts in government consumption and transfer payments…until we read this:

Economic studies repeatedly find that government debt crowds out private investment, although the degree to which it does so can be debated. The structure of the model does not allow for this direct feedback between government spending and private investment variables. Therefore, the add factors on private investment variables were also adjusted to reflect percentage changes in publicly held debt....

The model undoubtedly has the standard identities... if government saving rises during a fiscal contraction, there must be a corresponding combination of changes in gross private domestic investment, personal saving, and foreign capital inflows. The usual mechanism by which this re-allocation occurs is through a decline in the interest rate.... Heritage, however, did something additional. It just adjusted up investment demand at every level of the interest rate, as if federal debt appeared directly in these equations.... Are there any genres of models — large scale structural macro models, overlapping generation computable general equilibrium models, dynamic stochastic general equilibrium models — that actually show this direct effect? Not that we’re aware of.... And what is the empirical evidence for this direct effect? The analysis cites two fairly well-known papers — one by Thomas Laubach and the other by Eric Engen and Glenn Hubbard. However, both of these papers examined the relationship between deficits, debt, and interest rates — the conventional channel though which crowding in occurs and the one that already is included in the model. Neither paper says anything about a direct effect (that is, for any given interest rate) of government debt on investment. Indeed, neither paper even discusses investment equations.

In sum, we have never seen an investment equation specified this way and, in our judgment, adjusting up investment demand in this manner is tantamount to assuming the answer....

In the simulation, the component of GDP that initially increases most, both in absolute and in percentage terms, is residential investment. This is really hard to fathom. There’s no change in pre-tax interest rates to speak of.... [A]t today’s real value of approximately $210 thousand per newly completed housing unit, the extra investment is enough to build roughly 425 thousand units in 2012, of which 350 thousand would be empty at a time when we estimate there already is an excess of more than a million units that could be absorbed by new household formation. And this imbalance only worsens through time... by 2021 the real residential housing stock is up $1.023 trillion... an additional 4.4 million units. By the end of 2021 households are up only 379,000, so that 4 million unoccupied housing units have been built....

The usual story one tells about deficit reduction is that as government or government-financed consumption shrinks relative to GDP, domestic interest rates fall, putting downward pressure on the dollar, which in turn encourages higher net exports and hence smaller reliance on borrowing from abroad. In this simulation, however, real net exports immediately decline by $82 billion and eventually by $183 billion.... [O]ne decade into the Republican plan the US has $1.3 trillion or so more net indebtedness to the rest of the world than under the baseline. Without more details we can’t be sure what’s going on here, but it looks as if this is at least partially the result of directly adjusting up domestic demand. With not much decline in interest rates, there’s probably little decline in the dollar (which is not reported) to stimulate net exports. But since domestic demand is adjusted up directly... more imports get sucked in immediately, implying an increase in foreign capital inflows.... [I]s all this extra debt to foreigners a sensible result, one that really is intended? It is our impression that reducing US indebtedness to the rest of the world is supposed to be a major benefit of, and hence motivation for, long-term deficit reduction.

There are other things wrong with this simulation.... We could go on, but won’t. Suffice it to say we see a lot of internal inconsistencies in the analysis.

Political winds and economic realities portend a fiscal contraction. Understanding the macroeconomic implications of both the amount and composition of any fiscal adjustment is critical to designing a good strategy for addressing the nation’s secular budget imbalance. We agree with most other economists that there is a long-run gain to deficit reduction, and that it matters how the deficit is reduced. Furthermore, we understand that there are defensible models that show less short-run pain from a fiscal contraction than does ours. The debate over the modeling of these fiscal effects is one we will eagerly join.

In our opinion, however, the macroeconomic analysis released in conjunction with the House Budget Resolution is not relevant.... [T]he main result — that aggressive deficit reduction immediately raises GDP at unchanged interest rates — was generated by manipulating a model that would not otherwise produce this result... not supported either theoretically or empirically. Other features of the results — while perhaps unintended — seem highly problematic to us and seriously undermine the credibility of the overall conclusions.

This is indeed unfortunate, since it might encourage some legislators to believe that slicing federal debt dramatically can produce long-run gain without short-run pain...

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