Economy and Jobs Watch Update

A familiar theory to students of political economy is one that was put forth in a paper by William Nordhaus in 1975. Nordhaus described what the path of the economy might look like if presidents were able to manipulate the economy for electoral gain.

His theory was that presidents, to the extent that they can influence the private economy, would have a strong incentive to boost total economic output just prior to an election. By cutting taxes or increasing spending just before the election, their chances of reelection are improved, and the full negative consequences of the policy would not be felt until after the election.

The result, according to the Nordhaus theory, is a "political business cycle" in which, every 4 years, the economy goes through a boom and bust cycle where the booms come just prior to the election, and busts come just after the election (to reduce inflation and prep the economy for a strong recovery).

In Nordhaus' model, the delayed cost of boosting the economy was higher inflation. In light of the current economic and political situation, the full long-run consequences of continuing current policy include a ballooning deficit that will eventually lead to higher interest rates, and the need for cutbacks in Social Security, Medicaid, and other domestic programs. Since the federal government can run annual deficits, these problems can be pushed off until after the next election - but they will materialize eventually. At the very least, current policy has all but killed serious Social Security and Medicare reform, and has precluded expanding vital domestic programs including education, scientific research, park services, national highway and infrastructure improvements, and many, many others.

While Nordhaus' article was intended to present a descriptive model of the political business cycle, it could also be viewed as a manual for how to win reelection. The first step is to throw the economy into a recession in the early years, and then to seek recovery just prior to the election. While it is impossible to know if this was indeed the intention of the current administration, the facts seem to fit this story rather well.

• The path of real GDP (see below) shows a weak economy in the first part of the administration - average annual growth was just 1.5% during the first two years of the administration. Some signs point to a quicker pace this year and next.
• The tax cut policy proposed by the president in 2001 contained very little stimulus for that year - most of the benefits were phased in over time. (The tax rebate idea originated from the Democrats.)
• More recently, the administration is requesting $87 billion in additional military spending. If you had to pump a large sum of money into the economy quickly so as to improve output growth, the easiest way is to give it to the defense department - an agency that is very skilled at spending large sums of money very quickly. In fact, in the second quarter of this year, defense spending increases accounted for over half of total output growth.
• The economy is currently much weaker than in the period prior to the 2001 inauguration - yet the administration has been touring the country telling everyone how strong the economy is - and how the recovery is well underway. This is in contrast to the doom and gloom picture painted by the vice president and others in late 2000, when the economy was actually much stronger. The administration perhaps believes that now is the right time to convince people, businesses, and even congress to spend, spend, spend - perhaps hoping to improve their 2004 election chances.

The fly in the administration's ointment, however, appears to be the path of employment. Based on historical comparisons, employment should be considerably higher at this point in the business cycle than it is. Currently, employment is 1.1 million below the level at the start of the recovery. In contrast, on average, recoveries after World War II have seen a net increase in 3.8 million jobs by this point in the cycle - which means that we are currently 4.9 million jobs behind schedule.

It is impossible to know if Norhaus' theory will prove to be correct this time around, but with millions of lost jobs, and half a trillion in deficits, the country cannot afford to have our leaders play reelection politics with the economy.

(A note to the economists reading this article. The Nordhaus model was built on a framework of an old-fashioned Phillips curve unemployment, inflation tradeoff. Once we take expectations into account, we would see more pronounced cycle in inflation and less of a cycle in output - in the extreme case of rational expectations would imply no cycle in output. Kenneth S. Rogoff and Anne Sibert in a 1985 paper were able to reintroduce output cycles even when expectations were rational by incorporating differing levels of presidential competence which were not directly observable. In addition, the work of Douglas Hibbs and Alberto Alesina create political business cycles that result from differences in the preferences for economic outcomes between political parties.)