A reader recently suggested I write about the speed with which government policy can affect the economy. I’ve only lightly touched on this topic before, but it is both timely and interesting, and rich with theory and empirics.
The best place to begin is with a timeless warning about the role of public policy on the economy. The 20th century economist Friedrich Hayek warned that government had almost none of the available information needed to effectively plan economic growth. He did so in several books and papers, and I think he argued most convincingly that central planning of economic activity necessarily would result in wasteful, ineffective policies. We have an abundance of federal, state and local programs that bear out his predictions.
Maybe the best examples of this are workforce development spending and investment subsidies to businesses. After a half century of research, there’s scant evidence that either of these expensive programs generate benefits that exceed their costs.
Here in Indiana, the state and federal government spend a billion dollars per year on workforce training. Yet, we have the same claimed “labor shortages” we did a decade or two ago. Moreover, we spend much of that money on occupations with little or no wage growth, and even more dollars remediating middle school reading and math—hardly an ideal outcome. This is not to say someone doesn’t benefit. We have lots of jobs re-training businesses, and doubtless some workers find new fulfilling careers from this spending. Still, if we get a quarter’s worth of benefit from every dollar we spend, we’d be lucky.
Our tax incentive spending is even worse. Indiana taxpayers spend more than a billion dollars per year in state and local incentives. Ironically, the training incentives are probably effective, or at least help create jobs at a relatively low cost. However, the capital incentives neither create jobs nor attract people to our state. In fact, Indiana spends the most on capital incentives on industries that have lost the most jobs over the 21st century. It is probable, if not certain, that the proliferation of tax incentives on businesses has actually cost both employment and population growth.
Now, I know that sounds counterintuitive to many folks, but it shouldn’t. Tax incentives don’t have much, if any, effect on firm location; thus, tax incentives rob tax dollars from local governments, and especially schools. That alone is enough to reduce in-migration of new residents because local schools are the number one reason for household location choice. More importantly, tax incentives reduce the price of capital investment. That makes automating jobs less expensive. Thus, it reduces employment, which is why most of our spending comes in industries with declining numbers of workers.
The point of this is that a lot of government spending on the economy has none of the intended effects. The analytical problem is simply figuring out how long the unintended consequences take to travel through the economy. However, most public policy is only tangentially designed to affect the economy. It has other purposes, and the influence on growth is a happy by-product. The most obvious of these is educational spending, primarily at the state and local level.
Economic growth is primarily caused by the innovation and productivity growth that accompanies better-educated workers. At the same time, places with good schools tend to attract well-educated workers, while places with poor schools tend to repel well-educated workers. So, effective education policies tend to both attract better-educated people while also educating the incumbent population. There’s a lot to educational policy, and Indiana has done a number of things effectively. Still, there are some pretty extensive failures as well. The timing of success and failure differ.
Any policies that influence the success of individuals will have a long time-path to maturity. Education in particular takes years, if not decades, to show results. This makes an earnest treatment of education policies very difficult. Money spent today on early childhood education may show a 5:1 return on investment, but it will take more than a decade before the savings show. Likewise, cutting spending on higher education offers tax savings in the short run, but it can cause deep long-term declines in educational attainment, as we are now discovering.
Thus, policies and spending on such matters as education, public health, mental health treatment and the like take years, if not decades, to generate lasting results. Those time horizons are too long for many families, which is why so much household relocation tends to favor high-spending locales with good schools. Again, I know many people will find that dynamic counterintuitive, but most households value the quality of education more than they value low taxes. That’s why high-tax places are growing quickly, while low-tax places do not. Despite what you may hear on cable TV, high-tax places, whether here in Indiana or anywhere in the nation, are growing much faster than low-tax places.
The most current consideration for policy on the economy and the speed it can take place is inflation. The business cycle of recessions and recovery have long vexed policymakers. Though the long-term rate of growth matters far more to residential wellbeing, booms and busts affect elections. Thus, there’s a lot of focus on mitigating inflation and unemployment.
Our Federal Reserve is designed to depoliticize monetary policy decisions that affect inflation and unemployment. The reason for this is, of all our policy interventions in the economy, the change in interest rates has the quickest effect. A rate change today can affect both bond and stock markets today. That makes them deeply susceptible to short-term political manipulation. Hence, it is far better to leave these short-term decisions to an apolitical body and let Congress set the guidance.
Still, even the short-run influence of the Federal Reserve can extend for years. Higher interest rates take months to affect inflation, as we’ve lately observed. However, they also influence decisions to buy homes or expand businesses. Higher interest rates make home buying more expensive and increase the cost of business expansion. The decision to buy or build a new home is made months or years in advance. Likewise, the decision to open a new plant or purchase new equipment may be planned years in advance.
Thus, much of the current increases in interest rates will still take months, if not years, before their effects are fully felt. So, even if inflation is arrested this year or in early 2023, the effect on new home construction and demand for business equipment will remain dampened through Summer 2024. Thus the timing of policy is so tenuous as to be largely irrelevant to short-term economic outcomes.
Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University.