How can good outcomes, and not just trade-offs, be achieved through economic policy?

Question

I realise this is a very broad question, and my economic knowledge amounts to 1 year of high school, but it seems as though every economic policy causes trade-offs, and none actually solve issues. As an example:

During COVID-19, the economy rapidly deflated. So, governments lowered interest rates, stimulating the economy. Now, as a consequence of that decision, inflation is extremely high, so governments are raising interest rates. But that also has negative effects on investment and the economy.

Take the tradeoff between inflation and unemployment as another example. It is impossible to have both low unemployment and low inflation. One of the 2 will always be uncomfortably high.

It seems as though the solution to any problem comes with its own equally bad set of problems. At this point, the question arises as to why we bother with economic policy at all.

I can think of 2 theories that would resolve this. The first is that there is some optimal outcome for the economy, some optimal and possible level of economic growth, inflation, unemployment, etc, and we keep swinging back and forward past it, unable to hit it accurately due to the coarse-grained nature of control a government can achieve through economic policy. The second theory is that the optimal economic state varies over time, due to societal and technological factors, and so the purpose of economic policy is to chase that varying state.

Are either of these theories accurate? Is this not really a problem? Any insight would be appreciated.

Answer 1

How can good outcomes, and not just trade-offs, be achieved through economic policy?

This is impossible since there is no agreement on what is a good outcome. There is no policy that maximizes every single welfare criterion (e.g. Rawls Max-Min, Utilitarianism, libertarian criterion, charitable libertarian criterion, etc).

For example, not everyone might agree lowering inflation is 'good'. It depends on what sort of welfare function you pick and as a result tradeoffs are fundamentally inevitable, even when there are Pareto improvements since perhaps that pareto improvement results in less (or heck even more) equal distribution than prescribed under some social welfare function.

Take the tradeoff between inflation and unemployment as another example. It is impossible to have both low unemployment and low inflation. One of the 2 will always be uncomfortably high.

This is not necessarily true. First, inflation can be low simultaneously with unemployment being low. For example, consider standard Philips Curve given by:

$$\pi - \pi_e = - \alpha (u_t-u_n) \tag{*}$$

where $\pi$ is inflation, subscript $e$ indicates expectations and $u_t$ and $u_n$ are the actual and natural rate of unemployment respectively.

The Philips Curve above describes the inflation unemployment trade-off since the more $\pi$ is above $\pi_e$ the lower the unemployment. However, this trade-off does not mean you can't have low inflation and low unemployment. Parameters $\pi =2\%, \pi_e= 2\%, \alpha =1, u_n = 1\%$ will give you unemployment rate of 1%. This is such a low unemployment rate that any politician would brag about it, yet with this 1% unemployment rate inflation is 0%.

The inflation unemployment trade-off just means that to bring unemployment lower than its natural level you need to produce inflation that is higher than expected inflation. Or conversely, to lower the inflation you need to bring unemployment below its natural rate. That is the trade-off. However, combinations of low, low; high, low; low, high; high, high inflation and unemployment respectively are all possible depending on economy's parameters.

It seems as though the solution to any problem comes with its own equally bad set of problems. At this point, the question arises as to why we bother with economic policy at all.

This is sort of like asking why try to plan vacation if there isn't a perfect vacation destination because any place will have at least some negatives and any place will have at least some positives. Just because there are trade-offs it does not mean the smart thing to do is just throw dart on a board and end up somewhere in malaria ridden jungle.

The ideal of science based policy is to enumerate trade-offs for public (e.g. for 0.5% extra inflation we can lower unemployment by 0.3% etc) and then it is up to public to decide what is more important to them.

For example, in US people vote for congress, and congress decided to set up Fed with mandate that it should try to keep some balance between low inflation and high unemployment. In EU people elected their heads of state that signed treaty of Amsterdam giving ECB mandate to keep inflation low regardless of unemployment, because the representatives they elected cared more about price stability than employment.

The purpose of monetary policy is to manage inflation in such way that these objectives are followed. If there would be no monetary policy then people might end up with outcome they don't like (e.g. Europeans with high inflation but low unemployment).

I can think of 2 theories that would resolve this. The first is that there is some optimal outcome for the economy, some optimal and possible level of economic growth, inflation, unemployment, etc, and we keep swinging back and forward past it, unable to hit it accurately due to the coarse-grained nature of control a government can achieve through economic policy. The second theory is that the optimal economic state varies over time, due to societal and technological factors, and so the purpose of economic policy is to chase that varying state.

First of all I wouldn't call this theory since in science that word has more specific meaning, but regarding the arguments:

1. Given some social welfare function (e.g. Rawlsian Max-Min, Utilitarian, Marshallian etc). There will always be some optimal level of growth, inflation, unemployment and whatnot. The problem is that you still face a trade-off between these social welfare functions. That trade-off cannot be eliminated.

2. You are also correct in postulating that IRL government never can precisely hit these optimal values, even if government selects lets say Rawlsian Max-Min criterion. This is just because of uncertainty, limited set of tools etc. Government is not omnipresent and omnipotent. Moreover, governments are not completely benevolent either, even in well developed democracies politicians sometimes pursue self interest at an expense of public interest (e.g. see discussions across Muller Public Choice III).

3. Regarding the second 'theory'; again the observations are not incorrect. Once you select the social welfare function there is some optimal value for each parameter, and this optimal value will constantly change due to state of economy changing as it is perturbed by shocks such as new technology.

   However, incorrect part in your arguments is to assume that there is some the optimal value. There are various optimal values corresponding to various social welfare functions. Social welfare functions are derived from moral philosophy. There is no agreement on a moral philosophy that would be 'uber alles'. Even if we discard all unpleasant moral philosophies such as let's old Norse moral philosophy where raping and pillaging was ok as long as it was not done to other members of a tribe, you are still left with a plethora of moral philosophies that are widely considered palatable in modern democracies (e.g. philosophies based on Rawls, Nozik, Bentham, Aristotle and so on).

Answer 2

Underlying your question is a contrast between trade-offs on the one hand and good outcomes or solving issues on the other. One thing that is missing here is the recognition that, among the possible trade-offs between two (or perhaps more) variables, some may be - usually are - better than others.

Suppose a policy-maker can choose the level of some variable $x$. Suppose further that there are benefits $B(x)$ and costs $C(x)$ associated with any level of $x$. Thus there is a trade-off between the benefits and the costs. Typically, both $B(x)$ and $C(x)$ will be increasing in $x$, so the 'ideal' solution - maximum benefits and zero costs - will not be available. Instead, the policy-maker can try to find the level of $x$ which maximises net benefit, that is, benefits less costs. This will depend on the shape of the net benefit function.

Exceptionally, it might be the case that $B(x)$ and $C(x)$ both increase with $x$ at the same rate, so that net benefit is the same whatever level of $x$ is chosen. More typically, however, the shapes of these functions differ. A common scenario is that, as $x$ increases, the rate of increase of $B$ slows down (mathematically, $\frac{dB}{dx}>0$ but $\frac{d^2B}{dx^2}<0$). Suppose for example $x$ is the area of publicly-funded parks in a city: many people enjoy parks, but beyond a certain point, their enjoyment is unlikely to double if the area of parks is doubled. On the cost side, as $x$ increases the rate of increase of $C$ may increase ($\frac{dC}{dx} > 0$ and $\frac{d^2C}{dx^2}>0$). Too much space devoted to parks, for example, would involve not only a high cost of park maintenance, but eventually also an unacceptable opportunity cost in terms of land being unavailable for important alternative uses.

In scenarios such as above, the optimum level of the choice variable will be that at which net benefit is maximised. Admittedly that will typically involve a trade-off between benefits and costs. But the fact that there is a trade-off should not be a reason to denigrate such a choice. On the contrary, the optimal trade-off is the best outcome in the circumstances. Economic policy which identifies and achieves such an optimum is benefiting society.

Answer 3

I'll answer to the best of my knowledge as an undergraduate student, which may not be adequate.

The negative relationship between inflation and unemployment is a long-standing controversy in economics. It was announced empirically in the 1950s as the Phillips curve and supported theoretically by Keynesian economists. However, since the 1970s, supply shocks have empirically discredited the Phillips curve, and the introduction of rational expectations theory has led to skepticism about its theoretical underpinnings. Nevertheless, in the short run, the Phillips curve is somewhat significant, so if we assume that it is, then your first theory, that the central bank conducts monetary policy for an optimal inflation-unemployment level, seems plausible. However, since the central bank's inflation target is always fixed (2% per annum in the case of the US FED), your second theory is not entirely correct.

Now let's come back to the present and see how much the above idea can explain the current situation. The debate is still on whether the high inflation rates of the last few months are due to expansionary monetary policy before and during the COVID19 period, or to supply shocks caused by a series of wars, etc. The former is widely accepted by many economists, and while we did not expect such steep inflation, it is clear that we have been paying for inflation to get something over the last period. However, expansionary monetary policy during the COVID-19 crisis was largely implemented to ease the crisis in credit markets rather than to reduce unemployment. In the case of the U.S. economy, it seems long past time to consider the relationship between inflation and other variables rather than the inflation-unemployment rate in the inevitable exchange driven by monetary policy. On the other hand, the lack of labor supply in the service sector, especially after COVID-19 in the U.S., is driving wage growth and inflation, which has prompted us to rethink the relationship between unemployment and inflation. My personal opinion is that the lack of service sector labor supply and the unprecedentedly low unemployment rate are more likely to be caused by other economic and political reasons than by monetary policy, and it shows how robust the US economy is.

Answer 4

TLDR I too dislike washing the dishes and support a central planning committee

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1. Some trade-offs are really sensible and one will make the choice regardless of their presence. E.g. most people have some meals at home, despite having to wash the dishes, some high traffic bridges are built even though not all tax payers use them, etc.

2. A lot of things that don't require coordination/consultation and difficult government decisions are already being done and do not require the appointment of an official by the government, e.g. there is no government committee for bringing food relatively close to you, a store will do that. (Though the private agent is probably affected by several government policies, as life is complex and aspects of it are subject to regulation.)