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Confusing Cause and Effect in the Fiscal Policy Debate

Wednesday, April 10, 2013

Our debate should not be about income redistribution or debt reduction but rather about how to achieve broadly shared growth — because when we achieve that, history shows that the deficit and the middle class will benefit.

The leaders of both parties agree on one point: we do not have an immediate debt crisis. But they disagree about the top priorities for fiscal policy. President Obama’s priority is to “grow the economy from the middle class out”; House Speaker John Boehner says the Republicans’ priority is deficit reduction that leads to a balanced budget in ten years, because “balancing the budget will in fact help our economy.”

Both sides want the economy to generate broadly shared growth at a healthier clip — that’s the common ground. But the key question is how to drive growth. The Democrats view rising middle-class incomes as the driver; for the Republicans, the driver is deficit reduction. By setting those up as primary objectives, both sides are making the mistake known to social scientists as “cause-effect reversal.” Almost everyone agrees that deficit reduction and middle-class income gains are highly desirable — but our experience tells us they are results — not causes — of economic growth.

Cause-Effect Confusion

Early in the morning on a typical summer day at the farm, the rooster crows, the sun rises, and the crops continue growing a little taller. Everyone knows that the rising summer sun is what makes the rooster crow in the morning and the crops grow during the day; almost everyone, that is. A naïve city boy, for example, might consider the evidence, and then decide that the crowing rooster is what causes the sun to rise and the crops to grow. That youngster would be making two mistakes: (1) “cause-effect reversal,” by assuming that the crowing rooster causes the sun to rise, when it’s actually the other way around, and (2) “ignoring a hidden variable,” by assuming the crowing rooster causes the crops to grow, when it’s actually the sun doing that, not the rooster.

Those two types of mistakes might be rare for observers of sunrises on a farm, but they are common when it comes to politicians talking about the economy and fiscal policy. Does the economy’s growth boost middle-class income, or is it the other way around? And does the economy’s growth reduce the deficit, or is it the other way around?

Middle-class Incomes and Overall Growth

Our economic track record shows that overall growth and middle-class income gains happen simultaneously. Annual economic data going back nearly 50 years confirm that ups and downs in median household income are highly correlated with the rise and fall of the overall economy (real GDP per capita). However, correlation doesn’t imply causation, so there are three possible interpretations:

(1) The high correlation between overall growth and middle class income growth is purely coincidence — i.e., just a statistical accident. (Almost nobody subscribes to this interpretation.)

 

(2) When the economic outlook seems predictable and favorable, private enterprises risk more investment capital and hire new workers — who then boost aggregate demand by spending from their new incomes, which strengthens successful businesses and weeds out unsuccessful ones, further improving the economic outlook. (The GOP tends to favor this interpretation.)

 

(3) Temporary government stimulus programs and subsidies boost middle-class incomes, which boosts aggregate demand for non-government products and services, which improves the economic outlook and awakens private-sector business and entrepreneurial investment, which gets the private economy moving again — at which time we can count on government to withdraw its successful-but-temporary stimulus programs. (The Democrats tend to favor this interpretation.)

As noted, the first one is possible, but highly improbable; the second and third delineate the basic philosophies of the GOP and the Democrats, respectively, regarding the preferred method of recovering from an economic slump.

Deficit Reduction and Overall Growth

As for the deficit, quarterly data since 1997 confirm that its size depends largely on changes in tax receipts, which in turn follow the overall economy’s ups and downs by zero to nine months, as shown in Figure 1. Causation is more apparent in this case, because the high correlations happen when tax receipts are lagged by three to six months — that is, when the economy grew larger or smaller, tax receipts tended to change in the same direction three to six months later.

ConoverGraph_4-10-13.jpg

Overall growth precedes tax receipt growth, which in turn reduces the deficit. This is not just a strong argument for the GOP to start giving economic growth a higher fiscal priority than deficit reduction, it’s also a strong argument for the Democrats to back away from their deficit-reduction plank of tax-rate hikes. Both the Republicans and the Democrats should table their deficit-reduction arguments for now, and they should make growth their top fiscal priority and be prepared to defend their respective remedies for jump-starting growth.

Political Calculations

Unfortunately, in spite of the evidence in our track record, neither side has promoted broadly shared overall growth as a common-ground starting point for the fiscal debate. To the Democrats, the debate should be about the right kind of growth: specifically, middle-class income growth, funded in part by higher taxation of the rich — i.e., by income redistribution. To the Republicans, the debate instead is about deficit reduction, largely through spending cuts, or at least substantial reductions in the rate of spending.

Why do both parties focus on the symptoms instead of the real problem of insufficient growth? The simplest explanation is political calculation. One can imagine the Democrats’ summary of their stance: “The Republicans are vulnerable. The middle class is where the votes are, their income stagnated during Bush’s watch, and they tend to blame corporations and the rich — so let’s exploit that vulnerability.” Likewise, one can imagine the Republicans’ summary of their stance: “The Democrats are vulnerable. Big deficits ballooned the debt during Obama’s watch, median income is down, stimulus spending programs haven’t delivered the promised results, and fear of the word ‘debt’ can sway a lot of votes — so let’s exploit that vulnerability.”

The theme of deficit reduction is a big loser with a dismal track record regardless of which side has taken it up.

Both of those arguments have big weaknesses, but the GOP’s is the weaker of the two — not to mention puzzling. The theme of deficit reduction is a big loser with a dismal track record regardless of which side has taken it up, as I explained in a previous article. But even more curious is the GOP’s inexplicable abandonment of the growth debate — inexplicable because the GOP has the winning argument about the proper path to sustainable, shared growth. My article titled “Top-Down versus Bottom-Up” addressed this topic, which can be summarized as follows: The Democrats’ formula for returning to robust growth is a top-down, trust-the-government formula — an approach that amounts to “intelligent design economics” supervised and managed by government’s expert regulators and funding allocators. By contrast, the Republicans’ formula (the Reagan Republicans’ formula, anyway) used to be the bottom-up approach of enabling and trusting motivated, mostly non-rich private-sector innovators who have access to funding sufficient to sustain their trial-and-error innovation processes. Tax reform and investment incentives are two examples of growth-enabling policies. Why the Republicans are rejecting that debate and committing themselves to the losing theme of deficit reduction is an enigma. By giving the losing themes of deficit reduction and budget-balancing top priority, the Republicans are ignoring the most important “hidden variable” of all: robust real growth, driven by private-sector innovation within a competitive environment secure from external threats and supported by a sound legal structure.

In any case, the important debate is not about which side’s wedge issue can capture more votes; it’s not about redistributing income to the middle class, or about scaring the middle class with the word “debt.” Instead, it’s about how best to achieve a higher level of sustainable, broadly shared growth — because when we achieve that, history tells us that the deficit and the middle class will be among the first to benefit. It is time for both sides to give the economic calculation a higher priority than the political calculation — that is, to stop reversing cause and effect, and to stop ignoring hidden variables.

Boosting overall growth is the common ground. The debate about how to achieve it — through government stimulus and supervision, or through private sector experimentation and innovation — is the important one.

Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy.

FURTHER READING:  Conover also writes “Two Budgets, One Point of Agreement, and a Third Way,” “The Budget Debate Simplified,” and “‘Investment’ Means Defense Spending.” Daron Acemoglu discusses “The Growth Imperative” and Michael Barone notes “Spending Cuts May be Answer to Slow Economic Growth.”

Image by Dianna Ingram / Shutterstock / Bergman Group

 

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