Six Ways Existing Economic Models Are Killing the Economy

The Pitch: Economic Update for April 13th, 2023

(Note to Pitch readers: Zach is out of office this week. The following article by Nick Hanauer was published in the April 2023 issue of The American Prospect as part of a special investigation into economic models alongside contributors including Senator Elizabeth Warren and Joseph Stiglitz. Click here to read the whole issue and subscribe here to support The Prospect’s good work. Zach will return with a new issue of The Pitch next Thursday.)

Americans have been hammered for decades with an economic message that amounts to this: When wealthy people like me gain even more wealth through tax cuts, deregulation, and policies that keep wages low, that leads to economic growth and benefits for everyone else in the economy. And equally, that investing in you, raising your wages, forgiving your debt, or helping your family would be bad — for you! This is the trickle-down way of thinking about economic cause and effect, and there can be no doubt that it has substantially contributed to the greatest upward transfer of wealth in the history of the world.

You would think that trying to sell such a disastrous outcome for the broad mass of citizens would be incredibly unpopular. No politician would outright say they want to shrink the middle class, make it harder to get by, or reward hard work less. No politician would outright say that rich people should get richer, while everyone else struggles to make a decent life.

But this message has been hidden under the confusing, technical-sounding, and often impenetrable language of economics. Many academic economists do important work trying to understand and improve the world. But most citizens’ experience of economics comes from hearing a story — a narrative that rationalizes who gets what and why. The people who benefit from trickle-down policy the most have deployed economists to work their magic to tell this story, and explain why there is no alternative to its scientific certitude.

One of the trickle-down economists’ main persuasive tools is the economic model, used to predict and assess the outcome of economic policies and other major economic developments. These existing models exert such great force on the political debate in large part because their predictions are treated by politicians and reporters as neutral, technocratic reality — simple economic facts, produced by experts, that reflect our best understanding of economic cause and effect.

What few understand is that these economic models do not, and never can, fully reflect the extraordinary complexity of human markets. Rather, the point is to create useful abstractions to provide decision-makers with a sense of the budgetary and economic impacts of a given policy proposal. More disturbingly, the assumptions baked into these models completely define what the models predict. If the assumptions are wrong, the models will be wrong too.

And these models are deeply and consistently wrong.

But “wrong” doesn’t capture the true problem. The deeper problem is that these models are all wrong in the very same way, and in the same direction. They are wrong in a way that massively benefits the rich, and massively disadvantages everyone and everything else.

The headlines derived from these models consistently reflect this bias: “Raising Minimum Wage to $15 Would Cost 1.4 Million Jobs, CBO Says,” or “Biden Corporate Tax Hike Could Shrink Economy, Slash U.S. Jobs, Study Shows.”

Models serve less as scientific analysis and more as incantations from the cult of neoliberalism, and if politicians and journalists continue to accept them with the same naïve credulity that they always have, they will hamper the astounding middle-out economic progress that the Biden administration has made toward rebuilding a more equitable, prosperous economy for all.

The problem is that few people take the time to explain what these faulty assumptions are, why they all promote the worldview of the rich and powerful, and why they shouldn’t be treated as science but as a trickle-down fantasyland.

Here are six of the assumptions built into most economic models that are among the most pernicious:

1. Models assume that public investments will “crowd out” private investment, and are by definition less productive than private investments.

What happens to the economy if the federal government spends $1 billion? The normal person would say that it depends what they spend it on, and how the policy is designed.

Not so in most economic models. They assume that any government spending will have less of a return than whatever private businesses spend their money on. Always.

But that’s not all. They say that government spending even comes with a penalty: It automatically causes businesses to spend less, leading to lower overall investment. Always.

Essentially, models assume that every increase in public investment is canceled out by the combination of lower returns and reduction in private investment. Taking this assumption to its logical extreme, there’s almost nothing government should ever invest in. It’s a good thing Eisenhower took office before the neoliberal style of thinking came to dominate Washington, or instead of interstate highways we’d still have dirt roads.

These assumptions aren’t even well hidden in models but baked directly into the math. As economist Mark Paul has noted, the Congressional Budget Office model assumes that all public investments are exactly half as productive as private investments. Public investments return 5 percent annually, while the same amount of private investment returns 10 percent.

The first indication that something is amiss here can be sensed in all these round numbers — a flat declaration that public spending is 50 percent less good than private spending. Precisely 50 percent. Every time. Obviously, this is not the result of rigorous data analysis. It’s simply recapitulating the old trickle-down myth that government is by definition wasteful, while private investment is always maximized for the greatest efficiency and return.

And it’s not even a little bit true. Think about health care. The U.S. government invests billions in basic research each year and is responsible for funding an incredible range of innovations, from mRNA vaccine technology to new antibiotics. Everyone benefits from this publicly funded research, sparking further innovations and benefits — much of it carried out by the private sector.

Then consider how Big Pharma invests its profits: with huge marketing budgets, predatory patent enforcement, $577 billion in stock buybacks over five years (more than was spent on research and development), and a 14 percent increase in executive compensation. It’s a bonanza for those corporations, but it’s the opposite of efficiency — except in the make-believe world constructed by economic models.

The point isn’t that government spending always returns more than private spending, just that the flat assumption that it is always worse by 50 percent simply doesn’t map to reality. We should assess policy by what it proposes to do, not who proposes to do it.

The other idea, that public investment leads to lower private investment, is usually expressed with a fancy term: “crowd out.” It is a bedrock principle of neoliberal economics, and most models simply assume it’s true. The Penn Wharton Budget Model, for example, explicitly holdsthat government investments reduce the amount of private capital investment. Because the model also assumes that private investment is “productive” and public spending is “unproductive,” this automatically results in any large-scale government investment causing lower growth and lower returns. That informs their budget model’s analyses that the bipartisan infrastructure law will somehow lead to a 0.2 percent decline in productive private capital, that the $2 trillion Build Back Better proposal would reduce GDP by 0.2 percent, and that the COVID relief package would also reduce GDP by a similar amount.

The State Tax Analysis Modeling Program (STAMP) from the Beacon Hill Institute makes an even stranger decision, modeling government simply as a pass-through entity that causes “no indirect or induced effects” whatsoever.

Thankfully, President Biden rejects this nonsense. A central plank of Biden’s middle-out approach is to attract private investment in key industries through the strategic use of public dollars. As Secretary of Commerce Gina Raimondo explained about the implementation of the CHIPS and Science Act, “If we do our job right, the $50 billion of public investment will crowd in$500 billion or more of private investment of additional funding for manufacturing, for research and development, for startups” (emphasis added).

This strategy is already working. According to the Semiconductor Industry Association, the CHIPS and Science Act has already sparked $200 billion in private investment. The Climate Smart Buildings Initiative — created by the Inflation Reduction Act — is expected to attract over $8 billion of private-sector investment for modernizing federal buildings. The Biden administration has allocated $2.8 billion in public funds for investments in battery manufacturing for electric vehicles, which has already leveraged $9 billion in additional private investments. The story is much the same across the Biden administration’s constellation of strategic middle-out investments — public dollars are attracting private dollars, not displacing them, wholly disproving model assumptions in the court of reality.

2. Models assume workers’ wages are a direct reflection of their productivity.

Does Jamie Dimon produce 917 times what the average JPMorgan Chase worker produces? Does the CEO of McDonald’s produce 2,251 times the average cook or cashier? The answer is obviously no.

People are not paid what they are worth. They are paid what they have the power to negotiate. You don’t ask for a raise when the company just laid off an entire division and unemployment is high. If the company just posted a bunch of job openings? That’s a good time. We’d like to think that our hard work and worth to the company determines our salary, but just look around the office. Most of the time, bargaining power, not the value that worker provides, tells the story.

But the Econ 101 assumptions embedded in these budget models claim that wages are a direct and perfect reflection of a worker’s economic contributions — that every worker is paid exactly what they’re worth.

There’s no discrimination in the alternate universe created by models, so structurally lower pay for women, immigrants, and people of color must necessarily reflect their lower productivity. Separately, Wall Street speculators — who produce pretty much nothing of value for anyone but themselves — are of the highest economic value because they get paid the most. Does anyone really believe that private equity barons are more productive in society than teachers? The models do, because they assume wages perfectly reflect productivity.

If the models correctly understood that power plays the primary role in wages, they would see raising the minimum wage as correcting for the power imbalance of a loose labor market or an exploitative industry. But since the models connect wages with productivity, raising the minimum wage, by definition, lifts a worker’s income above their economic value, and thus should cause substantial job losses. That’s just what the REMI model and the synthetic University of Washington model and the Employment Policies Institute model and the CBO model said. The Baker Institute’s Diamond-Zodrow model even reached the ludicrous conclusion that a higher minimum wage negatively impacts children’s health, modeling that a 1 percent increase in minimum wage caused a 0.1 percent decrease in their height-for-age, in spite of empirical evidence to the contrary.

These predictions occurred throughout the Fight for $15 as minimum wages rose across the country. And if the models were right, Seattle and California and New York and Florida would have seen substantial job losses. But guess what? It never happened. On the contrary, businesses, particularly those affected by the minimum wage, like restaurants, boomed. Not once did these increases cause predicted job losses in the real world.

That reflects a simple fact about the economy. When more workers have more money, they will spend at more businesses. And that broad-based consumer demand sparks growth and innovation, which in turn drives productivity. In other words, higher wages are a cause of productivity, not a reflection of it.

3. Models assume that higher taxes on corporations and high-income people reduce growth and investment.

While corporate lobby groups and the zillionaires they represent regularly complain that taxes kill jobs and slow overall economic activity, no such relationship is detectable in the historical record. If anything, the opposite is closer to the truth: When the top marginal tax rate was above 90 percent in the 1950s, overall economic growth was remarkably strong and broad-based. When the top rate was slashed to 28 percent in Reagan’s trickle-down revolution, inequality exploded, and growth sagged for decades as money was redistributed upward…

[Click here to continue reading this piece at the American Prospect.]