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Six Ways Existing Economic Models Are Killing the Economy

Economic models do not, and never can, fully reflect the extraordinary complexity of human markets. 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.

Illustration By Rob Dobi / The American Prospect,

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.

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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.

A semiconductor factory being constructed in Arizona. The CHIPS and Science Act has already sparked $200 billion in private investment.  (KYODO  //  The American Prospect)

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 holds that 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.

But the economic models that control the D.C. policy debate take as absolute truth the trickle-down assumption that people will work less if they are taxed more, and that this effect is very large. Any increase in tax rates on the rich therefore reduces the amount of work performed by the very richest people—and since rich people are in the world of these models the most productive people around, that means a sharp reduction in economic output.

In reality, of course, rich people don’t organize their lives as a tax-avoidance strategy, much less work less if they earn less. The model assumes away any factor that drives people to make a lot of money; ego, to use one example.

A corollary assumption is that high incomes arise in a world of perfect competition, where new products are able to beat out incumbents by force of their genius alone, supply and demand are always in perfect equilibrium, and monopoly is just the name of a board game. In this world, all taxes and regulations must simply reduce productive corporate spending, and thus reduce economic growth.

Models have no way to interpret things that generate economic activity but that we might want less of—for example, carbon emissions or water pollution.

The Tax Foundation’s Taxes and Growth model, for example, arbitrarily assumes that all payroll taxes are fully borne by workers, and corporate income taxes are assumed borne 50 percent by capital and 50 percent by workers. Therefore, corporate tax cuts will always “increase the capital stock and expand the whole economy, including wages and employment,” while a payroll tax cut will do nothing for investment and economic expansion. By contrast, a corporate tax increase would harm investment and growth.

It’s no accident that this is entirely untethered from actual human behavior or productivity measures—it’s the point of the model. In the real world, dominant market players regularly take advantage of their position to extract excessive rents and stifle innovation. Anyone who has flown on a commercial jet or tried to buy concert tickets has experienced the wildly imperfect competition that exists in the American economy.

Well-designed public policy can get at these problems by aiming taxes specifically at those places where rents are extracted, making the entire economy more productive. And antitrust enforcement can similarly spark meaningful competition where it may have been eroded by predatory market actors. The only place where this doesn’t make sense is in the middle of an economic model.

4. Models assume that investing in poor people reduces economic activity, and that immigrants are less productive than domestic American workers.

What happens if the government gives people in need financial help?

If you get $50 for food, will you eat more food? If you get $100 for health care, will you go to the doctor more? If you get $100 for rent, will you be able to afford an apartment? And will any of these benefits enhance your personal well-being?

In the world of models, all of that is irrelevant. No matter what the money is for, the result of any federal assistance is that you will work fewer hours. Always.

While the models insist that rich people must be offered higher wages or lower taxes to incentivize them to work more, they hold that more economic support to lower-income people leads to them working less. In other words, rich people require the promise of even more wealth to motivate them to be productive, but the poor must be threatened with destitution in order to motivate them.

The Baker Institute’s Diamond-Zodrow model makes the explicit assumption that “any increases in government transfers … reduce labor supply as individuals choose to ‘consume’ more leisure because their income level has increased.” The Tax Foundation’s model makes a similar assumption: that people choose between leisure and work, and that such choices are sharply impacted by taxes and transfers. These kinds of assumptions are how the Penn Wharton Budget Model’s analysis of Biden’s Build Back Better proposal could find that “lowering the Medicare age to 60 and making the ACA subsidies more generous lower households’ financial risk, so they save and work less,” and that reducing Medicare drug prices similarly reduces hours worked (and, oddly, reduces household savings as well).

This is nefarious stuff. These models assume negative consequences from the government investing in affordable housing or food security—basic necessities that make it possible for people to participate in society. It’s an Ebenezer Scrooge understanding of the economy: People are poor due to their own laziness, so any dime you flick in their direction just encourages them to do even less.

Most experiments with basic incomechild tax credits, and other transfers find that basic investments enable people to participate more fully in the economy and in their communities. Plus, providing a basic standard of living can also spur future economic gains. Only a sociopath could unequivocally conclude that giving people food always makes them work less.

The models are even more direct when it comes to immigrant workers. The Penn Wharton model incorporates a baseline assumption that, as a natural law of economics, immigrants produce less than American-born workers do.

This is stupid and wrong, not to mention racist. While immigrant workers do tend to get paid less than other workers, there is no data whatsoever showing that they produce less. In fact, research even suggests the opposite: that increased immigration is tied to higher employment, higher incomes, and higher productivity.

The ten-year budget window shortchanges investments in children that pay off over their lifetimes.

5. Models work on ten-year budget horizons that force short-term thinking.

By the rules of Congress, the country’s best-known model, the CBO model, is required to estimate budget impacts of policy proposals over a ten-year window. For this reason, Penn Wharton, the Tax Foundation, and others follow suit. That decade-long window creates the jaw-dropping multitrillion-dollar numbers that make headlines when Congress debates economic policy.

This arbitrary time frame is the worst of both worlds. It’s long enough that the accuracy of the estimates becomes highly questionable, and it’s also far too short to even begin to assess the economic impact of interventions on generational issues like climate change or early-childhood education.

For example, essentially everyone agrees that universal pre-K produces extraordinary benefits to children’s education, and essentially everyone agrees that these investments will create better outcomes for the entirety of a child’s life.

But over ten years, that investment won’t be realized. Children enrolled in pre-K at three years old are still in middle school ten years later—not really time to see much (if any) economic impact, now that child labor is (generally) frowned upon. So universal pre-K is basically worthless to these models, no matter how much economic growth it may create over the next six or seven decades. Investments in children are mostly thought to pay for themselves, except in the case of a budget model.

Some policies have a short enough scope that the impact is realized in the budget window. But the arbitrary ten-year cutoff cannot possibly be appropriate for all policy interventions. It literally shortchanges long-term planning, which is about as wrongheaded as you can get.

6. Models measure GDP and revenue rather than well-being.

Economic growth is generally a good thing. It brings more people into the economy, and creates more resources to produce solutions to human problems. This is fundamental to how markets work.

But not every positive human outcome can be measured in terms of growing GDP or increased revenue. As Bobby Kennedy so eloquently pointed out in his March 1968 remarks at the University of Kansas, an exclusive focus on these strictly numerical measures of the economy counts napalm and nuclear weapons as positives, ignores the value of health, education, and community, and ​“measures everything, in short, except that which makes life worthwhile.”

This measurement gap stubbornly persists in today’s budget models, which have no way to interpret things that generate economic activity but that we might want less of—for example, carbon emissions or water pollution. Viewed as a model input, reduced carbon emissions and pollution could tend to reflect less economic activity—a net negative.

It’s certainly true that the economic value of these reductions is hard to measure solely in terms of dollars. And it might not even be desirable for economic models to attempt to calculate a literal price on mass shootings or the net present value of a climate apocalypse. But to the extent that we continue to let the numerical results of these flawed models drive our economic decision-making, we preclude even the possibility of reducing the factors we want less of in order to build a better society for generations to come.

WHEN WE CLARIFY THE EXTENT TO WHICH the dominant economic models we use to judge policy are rigged against working families and the broader economy, the cause of the extraordinary upward transfer of wealth in the past four decades becomes much easier to understand. Policymakers in Washington have based their decisions on models that are consistently biased toward the status quo, the rich, and private capital. They often amount to little more than a Mad Libs version of trickle-down economics, their exalted status in media and politics notwithstanding.

The basic structure of these models always remains fixed. Government is too inefficient and public investments are too expensive to make a difference; competition is perfect, market concentration is imaginary, and corporate power should be left alone; discrimination does not exist, all markets are at equilibrium, and wages perfectly correspond to productivity. The adjectives, policies, and numbers may vary a bit, but the story is always the same. Any policy benefiting capital, industry, or the rich is an unalloyed good. Any policy that benefits people directly is inefficient, kills incentives, and will harm the overall economy.

By tilting the playing field to restrict investment, undermine regulation, push down taxes, and lower wages, these economic models are doing their best to kill the economy. They may produce dense economic jargon and elegant mathematics that sounds super-impressive and scientific when it’s quoted on the front page of The New York Times. But on closer inspection, it looks a lot more like a protection racket for the rich and powerful than a social science.

Until we build models that reflect how the economy really grows, our leaders and the media should eye models from mainstream economists with skepticism. Models trying to convey the effects of policy should reflect the basic understanding that when more people have more money, that’s good for business. We need models that understand the basic principle that when the economy grows from the middle out, that’s good for everyone, and when more people participate in the economy, their consumer demand drives job creation and sparks innovation. In other words, our economic models must reflect the world as it really is—not as it was portrayed in the trickle-down Econ 101 classrooms of the 20th century.

[Nick Hanauer is a Seattle-based entrepreneur and venture capitalist, and the founder of Civic Ventures, a public-policy incubator.]

This article appears in the April 2023 issue of The American Prospect magazine. Subscribe here.

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