National Macroeconomic Goals

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 = C^0.6I^0.2G^0.2 –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.