Wednesday, October 10, 2007

Does Money Influence Economic Policy Debates?

by Dean Baker

Beat the Press usually does not deal with comments in book reviews, but an NYT review of Naomi Klein's new book, The Shock Doctrine: The Rise of Disaster Capital, demands some attention.

The review concludes by dismissing an assertion by Klein that progressive ideas have not lost out in a battle of ideas, but rather in large part they have lost out because the right-wing could finance think tanks that promulgated right-wing views, thereby drowning out those on the left.

This may not be the whole story of U.S. politics in the last three decades, but it is a big part of it. In economic policy debates in which I have been deeply involved, I can think of several occasions in which utter nonsense was treated with great respect by the political and intellectual establishments. This nonsense happened to serve the interest of the wealthy. It is hard to not believe that there was a causal relationship.

The Social Security debate provides the most obvious example. Consider the effort to change the post-retirement indexation formula in the mid-nineties, which had support from the Clinton administration, many prominent members of Congress (Senator Daniel Moynihan led the crusade), and many of the country's most respected economists.

The argument was that the consumer price index (CPI) overstated the true rate of inflation by approximately 1 percentage point, so therefore Social Security benefits to retirees should rise each year by approximately 1 percentage point less than the rate of inflation shown by the CPI, rather than the CPI, as is the case under current law.

While the evidence for their claim was weak as I argued in my book, Getting Prices Right: The Debate Over the Consumer Price Index, there was a more basic issue that there were huge and unavoidable implications of this claim that none of its advocates were willing to accept. Specifically, if their claim was true, then most of the people who would see their benefits cut by the change in the indexation formula had grown up in poverty. Furthermore, the future generations who they wanted to protect by reducing the deficit were actually going to be far richer than we could possibly have imagined.

The logic is simple. If the CPI overstated inflation by 1 percentage point annually, then real incomes had been rising much more rapidly than the official data show. Instead of rising by about 2.0 percent annually over the prior forty years, if inflation had been overstated by 1.0 percentage point, real per capita income had actually risen by 3.0 percent annually. (That's arithmetic - if nominal income had risen by 5.0 percent, and the real inflation rate was 2.0 percent, rather than the 3.0 percent shown by the CPI, then real income rose by 3.0 percent.) If real income had been rising by 3.0 percent instead of 2.0 percent, then we were much poorer 40 years ago relative to the present than the official data show. In fact, if we go back 40 to 50 years with this adjustment, the median family was below the current poverty line.

On the other side, if the yardstick against which we are measuring future income growth is overstating inflation by 1 percentage point annually, then we should adjust upward our projections for future income growth accordingly. This means that our children and grandchildren will be hugely richer than our current projections show - we can't even think of any economic policies that we would expect to lift income growth by a full percentage point.

Anyhow, virtually all the leading lights of the economic profession were prepared to completely ignore the logical implication of their own claim about the CPI in the effort to force a reduction in Social Security benefits. The drive was only halted by the refusal of Richard Gephardt, then the leader of the Democrats in the House, to go along with the scheme. At the time Gephardt was considering a challenge to Vice-President Al Gore for the 2000 Democratic presidential nomination. There could have been no better issue for Gephardt in the Democratic primaries than the defense of Social Security against the guy who cut it. Therefore, the Clinton administration nixed the benefit cut.

Note that all the economists who lined up behind the cut to Social Security are not currently expressing concern about the enormous distortions in our official data that result from the fact that the CPI has not been "fixed." (The CPI overstatement would contaminate all price and quantity data over time.) They also don't adjust for this error in their own work.

The other simple arithmetic problem afflicting elite economists is the projection of stock returns in the context of Social Security and other policy debates. Over the long-term, stock returns are determined by the current price-to-earnings ratios and projections of profit growth. Proponents of Social Security privatization consistently assumed that stocks would provide a real rate of return between 6.5-7.0 percent over the future, in spite of the fact that price to earnings ratios have been far higher in the last decade than their historic average of 14.5 to 1, and future profit growth is projected to be far lower than past profit growth.

Determining rates of return is extremely simple. You just have to add two numbers together: projections for dividend yields and projections of capital gains. Yet, most of the experts on Social Security (including the actuaries in the Social Security Administration) proved themselves incapable of this simple arithmetic, flunking the "No Economist Left Behind Test." They made assertions about the potential rate of return from investing Social Security money in the stock market that were not true. These projections of exaggerated returns of course supported the case for privatizing Social Security.

In these two cases, it is very hard to believe that considerations of money and power did not influence economic positions that were promulgated by many of the country's most highly respected economists. Surely these people know how to do simple arithmetic, but they argued positions that defied arithmetic and logic in order to advance positions favored by the wealthy.

There are many other cases in which it is easy to see the influence of money in economic policy debates. Would we really be arguing whether the U.S. health care system - which costs twice as much per person as the rich country average, yet ranks near the bottom in life expectancy - needs fundamental changes, if not for the influence of powerful interests like the insurance and pharmaceutical industry? Would there be any debate about the merits of special tax breaks to hedge and equity fund managers, if not for the power these people command?

I haven't read Klein's book, so I will not comment on the merits of her overall case, but I don't see how any serious person can dispute the role that money has played in determining policy debates over the last three decades. It is not the whole story (I'm wasting my time if it is), but on this point, Klein is absolutely on the mark in pointing a finger at the evil doers.

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