The Goals of Macroeconomic Policy

Martin Prachowny

• Publisher: Routledge
• Year: 2012
• ISBN:
  9781134841431
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Politicians win elections by promising 'Jobs! Jobs! Jobs!' but in practice these promises quickly fall by the wayside. The Goals of Macroeconomic Policy asks why. It begins with the observation that there is no convincing economic argument that full employment should be the primary objective of economic policy in all circumstances. In the light of this it examines whcy policy has failed so consistantly. It explains this by a theory of the labour market which shows why most workers are happy to operate in a way which militates against full employment. It then proceeds to analyse the rather dire consequences of this for the budget deficit.

1

The Theory of Macroeconomic Goals

Despite the genesis of macroeconomic theory as a scientific response to the Great Depression, very little effort has been directed since then toward the specification of precise goals for macroeconomic policy and toward the analytical basis for these goals. Defining and justifying macroeconomic goals is still shrouded in such amorphous terms as “full employment” and “price stability”. Much of macroeconomic analysis has instead been devoted to arguing about the ability or inability of macroeconomic tools, such as fiscal and monetary policies, to influence macroeconomic performance towards exogenously chosen goals, without questioning the arbitrariness of these goals. This state of affairs seems to be tolerated even though there has been a prolonged pre-occupation in microeconomics with the evaluation of policies in terms of Pareto improvements, where at least one person is better off but no one is made worse off.

1.1

The Pareto Optimality of Macroeconomic Goals

To set the stage for the remainder of this chapter, contrast the inattention to optimality in macroeconomic-policy discussions with the rigorous approach on this issue prevailing in other areas, such as international trade theory and policy. The long tradition of debating the merits of free trade and the intellectual acceptance of the “optimum” tariff have been shaped by the clearly specified goal of maximizing a social welfare function. The difficulties in translating such abstract concepts into concrete actions are not to be minimized and less-than-optimal trade policies continue to be implemented by governments certain that they can justify their actions on the basis of some economic reasoning. Nevertheless, academic trade economists understand instinctively that policy intervention must be based on a clearly defined Pareto welfare improvement.¹

Great advances have been made in macrotheory in predicting private behavior in various markets of an economy, but there is virtually nothing to determine the optimal behavior of government in providing stabilization-policy correctives. This chapter will review the limited state of our understanding of macroeconomic goals, starting with Keynes's view as expressed in The General Theory, advancing through the period of “fine tuning”, the “rational expectations” revolution, to the current fascination with “games” between the public and its government as explanations of recent macroeconomic policy initiatives. The emphasis in this critical survey is not on what can be accomplished in the area of macroeconomic policy initiatives, but instead on what should be accomplished and why. The literature on analytical normative macroeconomics as such does not seem to exist; instead macroeconomics has been concerned either with purely descriptive topics or with prescriptive advice. This division of labor between theoretical and policy-oriented macroeconomics has been justified recently by Mankiw (1990, p. 1646): “The observation that recent developments [in macrotheory] have little impact on applied macroeconomics creates at least the presumption that these developments are of little use to applied macroeconomists.” The lack of interest by theorists in the optimality properties of policies, however, remains puzzling. Instead of being able to survey a number of articles or monographs devoted to this specific subject, one must search for incidental discussion and unintentional asides in the whole of the literature.

The framework for this discussion is that macropolicy should use optimal intervention to remove a distortion, just as the optimal tariff is the best response to a country's monopoly power in international trade. When we find that tariffs are most often imposed because it is the best outcome for some special-interest group within the country, we are not at a loss to explain such outcomes in a democratic society, even if the will of the majority should ensure otherwise. Moreover, in cases of repeated disappointment with governments that provide relief to small preferred groups or that are corrupt, there are only rarely demands voiced to impose constitutional restraints on politicians who do not carry out policies that are beneficial to the majority of citizens. The observed toleration of special-interest legislation or political corruption is not based on ignorance or self-deceit; instead, there is an awareness by most citizens that they must make an effort for their special-interest group to receive its rewards and that there is a payoff to that effort. With a heterogeneous population based on differences in tastes or endowments, there will be many special-interest groups vying for attention and preferred treatment. The government is an arbitrator in these public-choice decisions and it tries to avoid the conflict that this creates by attempting to please everyone. The outcomes of public-choice decisions are difficult to predict and are often entirely random, despite median-voter models, as we shall see in Chapters 5 and 6. In the political arena, we look for a voting equilibrium based on majorities within the population. However, if there are fixed costs to participation in the political process, then sheer numbers are not enough to determine the outcome. Typically, a policy change leads to a large number of people suffering small losses and a small group making large gains. If the transactions costs are sufficient to “disfranchise” the losers who do not have enough at stake to get involved in the political decision, the gainers will win the day by lobbying for their preferred result.

For example, from the Stolper-Samuelson theorem in trade theory, we know that owners of the scarce factor gain from a tariff at the expense of owners of the abundant factor. Also, we have convinced ourselves that the gains to the scarce factor are smaller than the losses to others; therefore, the imposition of the tariff makes the average person worse off. Government should not interfere with free trade even if it represents exclusively the owners of the scarce factor because it could implement a nondistortionary transfer payment that makes the owners of the scarce factor as well off as with the tariff but imposes a smaller loss on everyone else. On this basis, we would predict that governments always choose free trade. We also recognize that such nondistortionary taxes and subsidies are impossible to implement, so that these political decisions once again involve a conflict between losers and gainers.

In macroeconomic analysis, the emphasis is on the “representative agent” who has the average tastes and endowments of the economy as a whole. This reliance on homogeneity and universality in macroeconomic theory is only rarely acknowledged as a weakness. Kirman (1992, p. 134) suggests: “Only if we are prepared to develop a paradigm in which individuals operate in a limited subset of the economy, are diverse both in their characteristics and the activities that they pursue, and interact directly with each other, will economics escape from the stultifying influence of the representative agent.” However, he does not provide practical guidelines for the construction of such a “paradigm” that also maintains the best features of current macrotheory. McCandless (1991, pp. 44–5) writes on the diversity of response to government policies:

Almost all government policies involve the improvement of the utility level of some individuals and the reduction of the utility level of others when compared to their situation before the policy. Those who gain belong to the political pressure group that is supporting the policy and those who lose are in the pressure group that is against the policy…The macroeconomics of policy making ignores most of the above issues. With the aggregation of all goods into one good comes the aggregation of all individuals into the one ‘individual’ of the economy.

But the distinction between gainers and losers, as we shall see, is important if we are to understand the difficulties in defining and implementing macroeconomic goals. Theoretical advances on policy issues are necessary, despite Mankiw's contention to the contrary. For example, the theoretical emphasis on disequilibrium in the labor market involves the representative agent not being allowed to work “optimal” hours, but the policy problem involves some individuals being totally and involuntarily unemployed. To provide a theoretical foundation for involuntary unemployment requires the recognition that firms adjust their labor input primarily through alterations in the number of workers while they keep their hours of work relatively fixed. Excess supply in the labor market then creates winners (i.e., those who remain employed and receive a real wage that is too high to clear the market) and losers (i.e., those who are unemployed but willing to work).

1.2

The Benefits of Full Employment

John Maynard Keynes was probably the first economist to provide a justification for full employment as a macroeconomic target by showing that less-than-full employment was an equilibrium position but not an optimal one. He wrote in The General Theory, “The outstanding faults of the economic society in which we live are its failure to provide for full employment…” (p. 372). He defined “full employment” in a number of ways, one of which is the following: “…a situation in which aggregate employment is inelastic in response to an increase in the effective demand for its output.” (p. 26). This would be equivalent to an unemployment rate of zero percent, even though he acknowledges the existence of “frictional” unemployment “…being consistent with ‘full’ employment…” (p. 16). In modern terminology, consider an increase in aggregate demand from a position of full employment; the rising price level in the face of a fixed money wage reduces real wages and provides a stimulus to extra output and employment, made possible with a pool of workers who are “frictionally” unemployed. Only if every potential worker is already employed will aggregate employment be inelastic and this requires that unemployment is completely eliminated. As a consequence, Keynes's view of the labor market would not admit to situations of excess demand, only excess supply, or, at best, full employment; otherwise, with equilibrium requiring zero unemployment, there would have to be a way of creating negative unemployment when demand exceeds supply.

In the 1930s, when 20% of the labor force was involuntarily unemployed, it was, of course, entirely excusable to concentrate on conditions of excess supply in the labor market. Nevertheless, the Keynesian prescription for curing this problem would have been severely biased because it takes a lot less additional aggregate demand to move from 20% unemployment to 5%, if that is the frictional unemployment rate, than to move from 20% to 0%. In fact, in the 1990s, it would probably take almost an infinite increase in aggregate demand to move from 7% unemployment to 0%.

Moreover, Keynes was not precise in detailing the benefits of the goal of “full employment” and seemed content to make generalized statements such as: “So long as a tolerable level of employment could be attained…” (p. 309). At the time, the benefits were considered to be self-evident and did not need explanation: those who were unemployed were suffering a vast reduction in their standard of living, especially in the absence of modern-day unemployment insurance benefits, and putting them back to work would repair that damage. Despite the intolerable conditions of the d...

Table of contents

• Front Cover
• THE GOALS OF MACROECONOMIC POLICY
• Title Page
• Copyright
• Contents
• List of Charts, Figures and Tables
• Preface
• Introduction
• 1 The Theory of Macroeconomic Goals
• 2 The Achievement of Macroeconomic Targets: U.S. Experience, 1948-90
• 3 The Market for Labor Services and the Macroeconomy
• 4 The Welfare Economics of Macropolicy
• 5 Public Expenditures and the Private Interest
• 6 The Macroeconomic Policy Apparatus
• Epilogue
• Bibliography
• Index