Wednesday, April 6, 2011

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 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.

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