# Saturday Quiz – December 29, 2012 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you understand the reasoning behind the answers. If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of Modern Monetary Theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

Question 1:

If austerity led to all national governments simultaneously running public surpluses (which is the aim) then it would be impossible for all their respective private domestic sectors to save overall.

The question tests a knowledge of the sectoral balances and their interactions, the behavioural relationships that generate the flows which are summarised by decomposing the national accounts into these balances, and the constraints that is placed on the behaviour within the three sectors that is evident in the requirement that the balances must add up to zero as a matter of accounting.

Once again, here are the sectoral balances approach to the national accounts.

We can view the basic income-expenditure model in macroeconomics in two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.

From the sources perspective we write:

GDP = C + I + G + (X – M)

which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

Equating these two perspectives we get:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero. The sectoral balances derived are:

• The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
• The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
• The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.

A simplification is to add (I – S) + (X – M) and call it the non-government sector. Then you get the basic result that the government balance equals exactly \$-for-\$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances). This is also a basic rule derived from the national accounts and has to apply at all times.

The private domestic sector is only one part of the non-government sector – the other being the external sector.

Most countries currently run external deficits. This means that if the government sector is in surplus the private domestic sector has to be in deficit.

However, some countries have to run external surpluses if there is at least one country running an external deficit. That country can depending on the relative magnitudes of the external balance and private domestic balance, run a public surplus while maintaining strong economic growth. For example, Norway.

In this case an increasing desire to save by the private domestic sector in the face of fiscal drag coming from the budget surplus can be offset by a rising external surplus with growth unimpaired. So the decline in domestic spending is compensated for by a rise in net export income.

So if all governments (in all nations) are running public surpluses and some nations are running external deficits (the majority), public surpluses have to be associated (given the underlying behaviour that generates these aggregates) with private domestic deficits.

Even if the external sector balance was zero, the proposition would still be true. At least one private domestic sector would be unable to save overall.

These deficits can keep spending going for a time but the increasing indebtedness ultimately unwinds and households and firms (whoever is carrying the debt) start to reduce their spending growth to try to manage the debt exposure. The consequence is a widening spending gap which pushes the economy into recession and, ultimately, pushes the budget into deficit via the automatic stabilisers.

So you can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus. Clearly not every country can adopt this strategy given that the external positions net out to zero themselves across all trading nations. So for every external surplus recorded there has to be equal deficits spread across other nations.

You might like to read these blogs for further information:

Question 2:

When the government matches its deficit with debt-issuance it changes the portfolio of wealth held in the non-government sector. The impact on purchasing power is equivalent to a leakage from the expenditure system (akin to taxation, saving or imports) which reduces the expansionary impact of the government deficit spending.

It is true that taxation, imports or saving are all leakages from the expenditure system which reduce the expenditure multiplier effect of exogenous spending such as government expenditure. Please read my blog – Spending multipliers – for more discussion on this point.

However, the same does not apply to debt-issuance.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

They claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

• Building bank reserves does not increase the ability of the banks to lend.
• The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
• Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

The point is that the debt-issuance is merely alters the portfolio composition of the assets held in the non-government sector.

Question 3:

A public employment guarantee program, which required workers to attend a government centre each day and do jigsaw puzzles, would have no impact on national income.

This question allows us to go back into J.M. Keynes’ The General Theory of Employment, Interest, and Money. Many mainstream economics characterise the Keynesian position on the use of public works as an expansionary employment measure as advocating useless work – digging holes and filling them up again. The critics focus on the seeming futility of that work to denigrate it and rarely examine the flow of funds and impacts on aggregate demand. They know that people will instinctively recoil from the idea if the nonsensical nature of the work is emphasised.

The critics actually fail in their stylisations of what Keynes actually said. They also fail to understand the nature of the policy recommendations that Keynes was advocating.

What Keynes demonstrated was that when private demand fails during a recession and the private sector will not buy any more goods and services, then government spending interventions were necessary. He said that while hiring people to dig holes only to fill them up again would work to stimulate demand, there were much more creative and useful things that the government could do.

Keynes maintained that in a crisis caused by inadequate private willingness or ability to buy goods and services, it was the role of government to generate demand. But, he argued, merely hiring people to dig holes, while better than nothing, is not a reasonable way to do it.

In Chapter 16 of The General Theory of Employment, Interest, and Money, Keynes wrote, in the book’s typically impenetrable style:

If — for whatever reason — the rate of interest cannot fall as fast as the marginal efficiency of capital would fall with a rate of accumulation corresponding to what the community would choose to save at a rate of interest equal to the marginal efficiency of capital in conditions of full employment, then even a diversion of the desire to hold wealth towards assets, which will in fact yield no economic fruits whatever, will increase economic well-being. In so far as millionaires find their satisfaction in building mighty mansions to contain their bodies when alive and pyramids to shelter them after death, or, repenting of their sins, erect cathedrals and endow monasteries or foreign missions, the day when abundance of capital will interfere with abundance of output may be postponed. “To dig holes in the ground,” paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services. It is not reasonable, however, that a sensible community should be content to remain dependent on such fortuitous and often wasteful mitigations when once we understand the influences upon which effective demand depends.

So while the narrative style is typical Keynes (I actually think the General Theory is a poorly written book) the message is clear. Keynes clearly understands that digging holes will stimulate aggregate demand when private investment has fallen but not increase “the real national dividend of useful goods and services”.

He also notes that once the public realise how employment is determined and the role that government can play in times of crisis they would expect government to use their net spending wisely to create useful outcomes.

Earlier, in Chapter 10 of the General Theory you read the following:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

Again a similar theme. The government can stimulate demand in a number of ways when private spending collapses. But they should choose ways that will yield more “sensible” products such as housing. He notes too that politics might intervene in doing what is best. When that happens the sub-optimal but effective outcome would be suitable.

So the answer is True. As long as the government is paying on-going wages to the workers to solve jigsaw then this will be beneficial for aggregate demand. The workers employed will spend a proportion of their weekly incomes on other goods and services which, in turn, provides wages to workers providing those outputs. They spend a proportion of this income and the “induced consumption” (induced from the initial spending on the workers’ wasges) multiplies throughout the economy.

This is the idea behind the expenditure multiplier.

The economy may not get much useful output from such a policy but aggregate demand would be stronger and employment higher as a consequence.

But when you think about it, the workers might enjoy solving the puzzles and so job satisfaction is a bonus to the macroeconomic impacts arising from the wage outlays.

The following blogs may be of further interest to you:

Question 4:

Which budget deficit outcome is the least expansionary?

(a) 1 per cent of GDP.

(b) 2 per cent of GDP.

(c) 3 per cent of GDP

(d) Cannot say because it depends on the decomposition of the structural and automatic stabiliser components.

The answer is Option (a) – 1 per cent of GDP.

The question probes an understanding of the forces (components) that drive the budget balance that is reported by government agencies at various points in time.

Option (d) is included to cast doubt in your mind because if you were asked which outcome signalled the most expansionary discretionary position adopted by the government the Option (d) would be correct.

In other words, you cannot tell from the information provided anything about the discretionary fiscal stance adopted by the government

But in outright terms, a budget deficit that is equivalent to 3 per cent of GDP is the most expansionary.

To see the difference between these statements we have to explore the issue of decomposing the observed budget balance into the discretionary (now called structural) and cyclical components. The latter component is driven by the automatic stabilisers that are in-built into the budget process.

The federal (or national) government budget balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. It is a simple matter of accounting with no theory involved.

However, the budget balance is used by all and sundry to indicate the fiscal stance of the government.

So if the budget is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit we say the fiscal impact expansionary (adding net spending).

Further, a rising deficit (falling surplus) is often considered to be reflecting an expansionary policy stance and vice versa. What we know is that a rising deficit may, in fact, indicate a contractionary fiscal stance – which, in turn, creates such income losses that the automatic stabilisers start driving the budget back towards (or into) deficit.

So the complication is that we cannot conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty clearly relates to the operation of the automatic stabilisers.

To see this, the most simple model of the budget balance we might think of can be written as:

Budget Balance = Revenue – Spending.

Budget Balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)

We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the budget balance are the so-called automatic stabilisers.

In other words, without any discretionary policy changes, the budget balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the budget balance moves towards deficit (or an increasing deficit).

When the economy is stronger – tax revenue rises and welfare payments fall and the budget balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.

So just because the budget goes into deficit or the deficit increases as a proportion of GDP doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.

To overcome this uncertainty, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. The Full Employment Budget Balance was a hypothetical construct of the budget balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.

So a full employment budget would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity. If the budget was in surplus at full capacity, then we would conclude that the discretionary structure of the budget was contractionary and vice versa if the budget was in deficit at full capacity.

The calculation of the structural deficit spawned a bit of an industry in the past with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.

Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s. All of them had issues but like all empirical work – it was a dirty science – relying on assumptions and simplifications. But that is the nature of the applied economist’s life.

As I explain in the blogs cited below, the measurement issues have a long history and current techniques and frameworks based on the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) bias the resulting analysis such that actual discretionary positions which are contractionary are seen as being less so and expansionary positions are seen as being more expansionary.

The result is that modern depictions of the structural deficit systematically understate the degree of discretionary contraction coming from fiscal policy.

So the data provided by the question could indicate a more expansionary fiscal intent from government but it could also indicate a large automatic stabiliser (cyclical) component.

But it remains true that the total deficit outcome (the sum of the structural and cyclical components) tells us the public sector impact on aggregate demand and the higher that is as a proportion of GDP the more expansionary is the impact of the government sector.

You might like to read these blogs for further information:

If the government reduces its net spending by say \$10 billion, the net financial assets destroyed by this fiscal withdrawal could be replaced by the central bank engaging in a \$10 billion quantitative easing program.

Quantitative easing then involves the central bank buying assets from the private sector – government bonds and high quality corporate debt. QE involves the central bank swapping financial assets with the banks – that is, they sell their financial assets and receive back in return extra reserves. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.

You should read the answer to Question 2 to reflect on how fiscal policy adds net financial assets to the non-government sector by way of contradistinction to QE.

The following blogs may be of further interest to you: