Why is the Heritage Forecast of the Ryan Plan so Rosy: Two Thoughts

A lot of people are talking about the implications of Paul Ryan's budget plan for Medicare or for the deficit, but something else has caught my eye: the economic forecasts that Ryan trumpets his plan will bring about. Ryan Avent, Brad DeLong, and Matt Yglesias all point out that they are wildly optimistic. How optimistic? Well, Paul Krugman notes that Ryan is claiming he will achieve unemployment rates so low that we haven't seen them since the early 1950s!! Wow!!

So where did these estimates come from? The Heritage Foundation, of course.

This is the Heritage Foundation's analysis of the Ryan Plan. The Heritage Foundation has been quick to point out that they are using the IHS Global Insight (a mainstream forecasting firm) macroeconomic model to make these forecasts. I'll come back to that later. My first reaction was "how did that model get these results?", so I took a look at their methodology and the answer was fairly obvious: the Heritage Foundation put its thumb on the scales. There are two things I noticed: the labor supply elasticity (which I am a little less clear on and would need some clarification), and the impact on private investment.

1. Labor Supply Elasticity (update below): Economists have known for a long time that if you look at how responsive an individual worker is to a change in income and how responsive an aggregate labor market is to a change in income, you get a different result; the aggregate "elasticities" are higher. Something fishy is going on with the labor supply elasticities in the Heritage model. They write: "Taxes on labor affect labor-market incentives. Aggregate labor elasticity is a measure of the response of aggregate hours to changes in the after-tax wage rate. These are larger than estimated micro-labor elasticities because they involve not only the intensive margin (more or fewer hours), but also, and even more so, the extensive margin (expanding the labor force). The change in the labor supply variables were adjusted by the macro-labor elasticity of two, which is a middle estimate of the ranges. The adjustment to the add factors allowed the variable to continue to be affected both positively and negatively by other indirect effects." So there's nothing wrong with this logic and there's nothing wrong that I'm aware of with a macro-elasticity of two. What concerns me is the bolded section. What "change in the labor supply variables" are they refering to? I think they're refering to the labor supply response from the microsimulation that they reference earlier. I looked through the CBO's simulation of labor supply and they seem to only do a microsimulation, which is then put into a macro model. So it looks like (although I'm not clear on this), Heritage's microsimulation estimates a labor supply response and then they have an "add factor" (an adjustment, essentially) in the macrosimulation to make labor supply respond again using a macro elasticity. I'm just suspicious because (1.) the CBO, which usest he same sort of IHS Global Insight model, doesn't seem to simulate labor supply at the macro level, and (2.) double-counting a labor supply effect would be exactly the sort of thing that would get you unemployment rates so low that we haven't seen them in over half a century.

UPDATE: This labor supply elasticity issue may be related to the dynamic scoring question discussed by Ezra Klein. My personal view is that there's nothing wrong with dynamic scoring - indeed it's a good idea - but it offers the opportunity for puting in a lot of assumptions that help your case. I'm not entirely sure the apparent use of both micro and macro labor elasticities is the same thing as dynamic scoring, though. Dynamic scoring is supposed to impact feedback effects that influence revenue estimates ("tax cuts pay for themselves" type stuff). Since you're looking at aggregated revenue, you're going to want to use a macro-elasticity to predict feedback effects influencing revenue. I'm still not sure if that means that labor supply itself should react twice to tax changes (once in the microsimulation and again in the macrosimulation) as the Heritage methodology seems to suggest it does. In other words - this might make sense for the revenue estimates, but it may still be overly optimistic about the labor force estimates. I'm crossing the above section out since I'm not sure - hopefully people can still read it and provide their own insights.

2. Private Investment: This one should be old hat by now. The Heritage Foundation writes: "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. This can also put upward pressure on the cost of capital (thus helping the model balance the demand and supply effects on the cost of capital)." Yes, government debt crowds out private investment when we're at full employment. I will poll readers on this: do we appear to be at full employment? This is exactly the same assumption that gets theoretical results that say fiscal contraction is expansionary. Yes, if you assume away all the problems that economists are pointing to that we are dealing with right now, things look rosier. That's no surprise. It's also no help in providing an assessment of what to expect from the Ryan plan. Note that this is another "add factor". This is something that they went into an existing, tested, widely acknowledged model and said "I don't like that - I'll change that". These people aren't dumb - they knew exactly which change they were giving themselves when they made that adjustment.

Macro Model Controversies: One interesting thing about this Heritage forecast is that it uses an adjusted IHS Global Insights model, which is the same model that predicted that stimulus would be stimulative. This model, and others much like it, got a lot of criticism in the libertarian community, because the model results are essentially determined by the assumptions about how the macroeconomy would respond (things like the labor supply elasticity and the response of private investment). Russ Roberts called the IHS Global Insight model and models like it a "hoax" and "not meaningful" when it predicted a positive impact on the stimulus. His point was the same as mine, that they are dependent on the assumptions that we feed into them. Unlike me, though, he thinks this makes them illegitimate. I think they're perfectly legitimate as a statement of the implications of our theory - we just need to know the assumptions that underly them and dispute or promote those assumptions. When IHS Global Insight, CBO, Macroeconomic Advisors, and Moody's Economy.com came out with their positive assessment of the stimulus, Russ wrote a post called "The Great Stimulus Hoax" criticizing them and suggesting that these sorts of models aren't meaningful. If Russ had any consistency at all, I'd like to see him write a post today called "The Great Austerity Hoax", providing essentially the same critique of the Ryan plan analysis which was done using the same methods.

I'm not holding my breath on that one. Cafe Hayek is a quite political blog, and on top of that a graduate from the George Mason University economics department and a former president of the Institute for Humane Studies at George Mason University were both authors of the Heritage report.

The Problem with the King Hearing on Muslim Radicalization

I got a chance to listen to about half of the hearing on Muslim radicalization that Rep. King held, and found it disappointing to say the least.

It's not a bad idea at all to have a hearing to investigate Muslim radicalism. It could have been productive to have law enforcement personnel, and perhaps members of the Muslim community involved in combating radicalization come in and review the status, and activities of radical groups here, and perhaps in comparable communities abroad (such as UK, where I gather this is more of a problem). It would have been nice for law enforcement to brief the House on the run-up to the various terrorist attacks (Ft. Hood shooter, Times Square bomber, etc.), and other incidents. It would have been nice for law enforcement to testify on different protocols that are in place to deal with domestic radicalism if it were to strike. Any of this would have made for a very productive hearing on Muslim radicalization.

That wasn't what happened. The whole discussion was a discussion of whether it's appropriate to talk about radical Islam. What a waste of time! The conclusion was Muslim Americans are good Americans, radical Muslims don't represent American Muslims, and Muslims should cooperate with law enforcement. Rep. King and his fellow Republicans protested repeatedly that they were not anti-Muslim, and Democrats continued to be frustrated with the fact that the hearing was even going on. I don't know if King is anti-Muslim, but I can understand the frustration of the Democrats. Rep. King may not be anti-Muslim but he certainly shows no interest in actually addressing real questions of radical Islam. It seems reasonable to conclude, then, that he just wants to talk about the idea of talking about radical Islam. That discussion has a higher political payoff for him than actually doing something productive - something that presumably both parties would actively participate in. Far better for Rep. King's election prospects to have a bombastic title and then spend the whole time talking about whether we can talk about something. Can you blame a few of the Democrats for being frustrated? King may not be anti-Muslim, but he sure is cynical and apparently unconcerned with addressing real threats.

What Andolfatto said about Ron Paul

Bob Murphy provides a link to the text that was taken down. The sacred cow that is Ron Paul needs to be approached head on. When I was born in 1984, Ron Paul was my representative in Congress. He'd been in power a little under a decade at that point, and he's been in power ever since. The man's life is about getting votes and sitting in Congress. He doesn't think very highly of his colleagues in Washington. He's explicitly said Obama is not a "socialist", strictly speaking, but that he is "socialistic" and "authoritarian", and noted in the same paragraph that the Nazis were another group that was authoritarian with socialistic leanings even if they weren't strictly socialists. I'm confident Obama thinks more highly of Paul than vice versa. And don't think for a minute this view of Paul's is reserved for Obama alone (that's just an easy one to find a quote for).

This man is a politician and he's a very frustrating, condescending politician. But most important, he's simply a politician! We need to speak bluntly to politicians when they're wrong. Andolfatto did that - he pointed out that the emperor (or to use Dan Klein's words, the "overlord") has no clothes, and people who care about liberty should celebrate someone willing to do that. Andolfatto didn't pile it on. He didn't paint a Hitler mustache on Paul. He called him a "pinhead", that's all. That's nothing. And then he followed it up with several paragraphs outlining why he thought Paul largely has no idea what he's talking about when he talks about monetary policy. Not only did Andolfatto speak truth to power - he said it to the politician that controls the committee that oversees the Fed (where Andolfatto works). That takes balls, people. I'm genuinely disappointed libertarians are rushing to Paul's defense over this. I'm shocked people are angered by a relatively tame blog post, and I'm sick of people fawning over Paul (one supporter being interviewed on one of the networks said he was today's Thomas Jefferson!!!).

Anyway, I'm glad Andolfatto said it. I understand he's in a tough position, but I wish he hadn't taken it down. This is what he said:

I can appreciate Ron Paul’s libertarian philosophy. And because this is so, it pains me all the more to say what I am about to say. The guy can be a real pinhead at times. And this is never so evident as in his persistent “attacks” against the Fed.

Now, of course, I work at the Fed, so maybe you think I’m just complaining for the sake of defending my employer. If you think that, I can understand why you do. It is because you do not know me.

There are legitimate arguments one could make against the Fed as an institution and/or about the conduct of Fed policy. And then there are the stupid arguments, for example, the one contained on pg. 25 of his book End the Fed:

"One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy."

One might indeed say that, Mr. Congressman. But if one did, one would behaving like an opportunistic politician, which I know you are not.

Now, let us examine what is wrong or misleading in the statement above.

First, with the exception of the last sentence (which he weasels around with his “one might say”), there is nothing factually incorrect. Indeed, the data source cited by Paul is (ironically enough) the Federal Reserve Bank of St. Louis. (I’m glad he trusts us enough for some things.)

So the question is not whether he has his facts straight on this matter. The question is whether these facts matter at all.

There is this old idea in monetary theory called money neutrality. Money neutrality means that larger quantities of money ultimately manifest themselves in the form of higher nominal prices (and wages), and not on real quantities. No serious economist disputes the idea of long-run money neutrality.

Yes, what cost $1 in 1913 now costs $20. But so what? Money neutrality states that if you were earning $1 per hour in 1913, you are now earning $20 per hour (and even more, if labor productivity is higher).

So there you go, the Fed is responsible for increasing your nominal wage by a factor of 20. How do all you workers out there like them apples? Ron Paul wants to rob you of these wage increases!

Here is another example of the Congressman misleading the public (perhaps unintentionally); see his recent interview here with CNBC’s Larry Kudlow: Fed Under Fire.

At the 3:50 mark, Kudlow asks Paul: “Would oil be at $102 a barrel now if we had a sound dollar policy?” Paul’s reply is that, if Bretton Woods had not been abandoned (in 1971), oil would now be trading closer to $5 a barrel.

I ask you…how embarrassing of an answer is that? I mean, maybe oil would be trading at $5 a barrel. But what he is implicitly suggesting is that your nominal wage would not be scaled back in proportion. That is, he is suggesting that by cutting the value of paper, the Fed has somehow diminished the purchasing power of your labor over the past 100 years. Can he be serious?

The Congressman evidently suffers from money illusion. It is an affliction that can be forgiven in most people. But not one who likes to think of himself as a person learned in the finer principles of monetary theory.

And, as an aside, am I the only one who chuckles whenever he berates the Fed for creating money “out of thin air?” (I reiterate, there may be many legitimate complaints one could make against the Fed, but the “out of thin air” charge…well, let’s just say it…lacks substance).

Is it not true that the Treasury also creates its debt “out of thin air?” Do you think getting rid of the Fed (which, in conducting monetary policy, is simply swapping one form of thin air for another) will prevent Congress from issuing its own thin air? Do you really believe that a gold standard would mitigate the government’s ability to tax? (Seigniorage revenue for the U.S. is peanuts as a fraction of total taxation. Moreover, keep in mind that the inflation tax is collected off of foreigners as well.)

Let me conclude by saying that I think that America is, on the whole, well-served by having a voice like Ron Paul in Congress. I’d like to invite him to the SL Fed for lunch one day. I’d ask him to tone down his rhetoric and present his (frequently very good) arguments in a more sober manner.

But maybe this is too much to ask of a politician. Even a libertarian one.