In
considering macroeconomic ‘good’ and ‘bad,’ consumption and investment
expenditure are clearly in the ‘good’ column. Equally clearly, unemployment and
inflation are in the ‘bad’ column. But other ‘goods’ and ‘bads’ exist which are
less clear. Some amount of government expentiture is clearly good; government
must at a minimum establish the rule of law, and deal with market failures such
as public goods and externalities. However, a large spending defecit is generally
considered a ‘bad.’ International trade is also generally a ‘good’ because it
permits higher living standards than would be possible in a closed economy.
However, it is not clear what the ideal balanace of trade would be. Would you
prefer X>Z, a sign of strength like Japan or Germany, or Z>X, a higher
use of foreign resources? Or would you prefer to maintain X=Z, resulting in a
stable currency on foreign exchange markets?
Having
identified all the ‘good’ and ‘bad’ goals, we must now weight them. Since many
of the ‘goods’ and ‘bads’ are interrelated, this will probably involve
trade-offs. A political party’s election platform is an attempt to specify the
weightings and tradeoffs considered most desirable. Consider the following
‘welfare function’ where W is national welfare (similar to individual utility
from microeconomics):
W = C0.6I0.2G0.2
–U2 –INF3 – 10|G-T|
This states
that C, I and G are all ‘good’ but the optimum distribution between them is 60%
C, 20% I and 20% G; that unemployment is a ‘bad’ but inflation is worse, and
that an unbalanced budget is a ‘bad’ no matter which direction it is
unbalanced. To maximize W, the naïve answer is to make GNP as large as
possible, allocate GNP among C, I and G in 3/1/1 ratio, have a zero
unemployment rate, a zero inflation rate and a balanced budget. This
interpretation is naïve because a zero unemployment rate is not possible, and U
and INF are interdependent; some difficult calculations must be performed to
determine the optimal rate of both U and INF on a given Phillips curve
(assuming you believe a Phillips curve exists). The trade-off is also not
simply between U and INF. The higher U, the lower GNP, hence the lower C, I and
G as well. And whatever actions you take may result in an unbalanced budget, with
its own effect on the equation. Balancing the budget is, for all the obvious
reasons, neither simple nor easy.
Also,
strange interactions may exist that are not obvious at first. Suppose a
balanced budget is a priority and the only apparent way to achieve this is to
raise taxes. Some economists believe in the Laffer Curve:
Laffer’s
argument is that if the income tax rate were 100%, nobody would be willing to
work since all wages and salaries would go in taxes; government tax revenue
would therefore be zero. As tax rates decreased, some people would begin to
work and tax revenues would increase, to some maximum at some point; below that
point, decreasing tax rates would begin to result in decreased revenues, again
reaching zero when the tax rate is zero. Some tax rate X exists where maximum
revenue is achieved. If the government is already taxing at this rate, any
change, positive or negative will result in reduced revenues. Moreover, if the
government is already taxing above this rate, an increase in tax rates will be
accompanied by a decrease in revenues; the budget-balancing action in this case
would be to reduce tax rates. Hence Reaganomics and ‘voodoo economics.’ If you
believe in the Laffer curve, then any increase or decrease in the tax rate must
be based on a good estimate of where the economy is currently positioned.
Another
problem is that if you are trying to maximize the sum of national welfare
across a span of years, then maximizing welfare this year might not be the
correct approach; some less-than-maximal value for W this year might lead to
the potential for higher values for W in future years than would otherwise have
been possible.
Different
political parties believe in different national welfare functions; the items in
these functions are generally similar but the weightings are radically
different. Evidence suggests that the state of an economy is a major factor in
deciding which party gets elected, and as a result elected governments may
enact policies to ‘solve’ economic problems in election years, regardless of
what problems may be caused down the road.
