Long Live Bad Models and Government Spending!

by Veronique de Rugy

Thanks to my recent discovery of Twitter, I see that Slate’s Dave Weigel is repeating the line that the $61 billion in spending cuts just approved by the Republican-controlled House will hurt the economy:

Democrats have been arguing for weeks that the GOP’s spending cuts will be bad for the economy, and in the last week they’ve celebrated two new analyses that bear none of their fingerprints but validate just about everything they’ve been saying.

I am not quite sure what there is to “celebrate” in these two studies.

Many of us have said it before, but it’s worth repeating: Both studies are based on the same faulty models that predicted that the stimulus of 2009 would stimulate economic growth. This theory assumes that $1 in government spending triggers well above $1 in economic growth and creates many jobs. The Goldman Sachs study goes even further: Its estimate seems to imply a multiplier effect greater than 3, well above anything in recent literature. A review of the literature about the value of the multiplier reveals that in most cases, a dollar in government spending produces less than a dollar in economic growth — and these findings often ignore the impact of paying for this government dollar by increasing taxes. Harvard University’s Robert Barro finds a multiplier between 0.4 and 0.7; at Stanford, John Taylor and John Cogan find that the stimulus package couldn’t have had a multiplier much greater than zero. Even the multipliers used by Christina Romer and Jared Bernstein 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, Dartmouth economists James Feyrer and Bruce Sacerdote acknowledged that the stimulus didn’t boost the economy nearly as much as the administration models claimed that it would. These are only some of the many studies on the issues.

Secondly, as economist John Taylor reported yesterday over at Economics One, the Goldman Sachs report is based on inaccurate budget numbers. The report doesn’t seem to understand that changes in budget authority (what Congress requests in a given year) do not translate immediately or equally into what the government ends up spending in a given year. According to the CBO’s calculations, the cuts translate into only a $19 billion spending reduction, which is less than a third of the $60 billion cut the Goldman Sachs report assumes. What’s more, even with these cuts, total budget outlays will increase by 6.7 percent from 2010 to 2011. It is really hard to argue seriously that a budget that will grow by almost 7 percent is too draconian for the economy.

Third, the Goldman Sachs model, like the models used by Zandi to estimate the effects of the stimulus, fails to recognize the economic benefits of cutting spending or reducing spending growth now instead of postponing it to an uncertain date in the future. Numerous studies by economists — not to mention many members of the business community — say that recent policy changes have hampered business investment, making a bad situation worse.  The prospect of endless future debt and deficits raises the threats of increased taxes and government crowding-out of capital markets. As a result, U.S. companies don’t build new plants, they don’t conduct research, and they don’t hire people. People stay unemployed — for weeks, months, years.

Finally, these models ignore a large body of economic literature that looks at the impact spending cuts had on the economies of countries that have adopted them. That literature concludes that spending cuts are often good for the economy. For instance,  in a review of every major fiscal correction in the OECD since 1975, Goldman Sachs economists Ben Broadbent and Kevin Daly found that decisive budgetary adjustments focused on reducing government expenditure have (i) been successful in correcting fiscal imbalances; (ii) typically boosted growth; and (iii) resulted in significant bond and equity market outperformance. Tax-driven fiscal adjustments, by contrast, typically fail to correct fiscal imbalances and are damaging to growth. These results are confirmed by many more economists.

By the way, Mark Zandi is one of the architects of the 2009 stimulus bill and, as it turns out, the best we can say about his assumptions for the benefits of stimulus spending is that they appear to have been wildly optimistic.

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