Saturday Quiz – June 28, 2014 – 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:

The automatic stabilisers built into the fiscal framework always work in a counter-cyclical fashion and if not unencumbered by discretionary policy changes, such as fiscal austerity, will eventually ensure that the government fiscal balance returns to its appropriate level.

The answer is False.

The factual statement in the proposition is that the automatic stabilisers do operate in a counter-cyclical fashion when economic growth resumes. This is because tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this increases when there is an economic slowdown.

The question is false though because this process while important may not ensure that the government fiscal balance returns to its appropriate level.

The automatic stabilisers just push the fiscal balance towards deficit, into deficit, or into a larger deficit when GDP growth declines and vice versa when GDP growth increases. These movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

We also measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

This decomposition provides (in modern terminology) the structural (discretionary) and cyclical fiscal balances. The fiscal components are adjusted to what they would be at the potential or full capacity level of output.

So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the fiscal balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.

If the fiscal balance is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual fiscal outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently.

So you could have a downturn which drives the fiscal balance into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal outcome and it arises because the economy is deviating from its potential.

In some of the blogs listed below I go into the measurement issues involved in this decomposition in more detail. However for this question it these issues are less important to discuss.

The point is that structural fiscal balance has to be sufficient to ensure there is full employment. The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work for all of us to advance public purpose.

In this context, one of the most important elements of public purpose that the state has to maximise is employment. Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment.

Given the non-government sector will typically desire to net save (accumulate financial assets in the currency of issue) over the course of a business cycle this means that there will be, on average, a spending gap over the course of the same cycle that can only be filled by the national government. There is no escaping that.

So then the national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a fiscal surplus will be possible.

But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the fiscal outcome towards increasing deficits.

Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The fiscal balance will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.

So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – which I define as 2 per cent unemployment and zero underemployment.

Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).

So it will not always be the case that the dynamics of the automatic stabilisers will leave a structural deficit sufficient to finance the saving desire of the non-government sector at an output level consistent with full utilisation of resources.

The following blogs may be of further interest to you:

Question 2:

The decision by the government to issue debt to the non-government sector to match its fiscal deficit instead of selling the same debt to the central bank:

(a) increases the financial assets (the bonds) that are held by the non-government sector $-for-$.

(b) has no impact on the overall holdings of financial assets held by the non-government sector $-for-$.

(c) reduces the capacity of the non-government sector to borrow from banks by draining bank reserves in return for the bonds.

The answer is Option B – it has no impact on the overall holdings of financial assets held by the non-government sector $-for-$..

National governments have cash operating accounts with their central bank. The specific arrangements vary by country but the principle remains the same. When the government spends it debits these accounts and credits various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at their bank. It is the same effect as if it had have all been done electronically.

All federal spending happens like this.

You will note that:

  • Governments do not spend by “printing money”. They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is “printed” but that is a separate process from the daily spending and taxing flows.
  • There has been no mention of where they get the credits and debits come from! The short answer is that the spending comes from no-where but we will have to wait for another blog soon to fully understand that. Suffice to say that the Federal government, as the monopoly issuer of its own currency is not revenue-constrained. This means it does not have to “finance” its spending unlike a household, which uses the fiat currency.
  • Any coincident issuing of government debt (bonds) has nothing to do with “financing” the government spending.

All the commercial banks maintain reserve accounts with the central bank within their system. These accounts permit reserves to be managed and allows the clearing system to operate smoothly.

The rules that operate on these accounts in different countries vary (that is, some nations have minimum reserves others do not etc). For financial stability, these reserve accounts always have to have positive balances at the end of each day, although during the day a particular bank might be in surplus or deficit, depending on the pattern of the cash inflows and outflows. There is no reason to assume that these flows will exactly offset themselves for any particular bank at any particular time.

The central bank conducts “operations” to manage the liquidity in the banking system such that short-term interest rates match the official target – which defines the current monetary policy stance. The central bank may: (a) Intervene into the interbank (overnight) money market to manage the daily supply of and demand for reserve funds; (b) buy certain financial assets at discounted rates from commercial banks; and (c) impose penal lending rates on banks who require urgent funds, In practice, most of the liquidity management is achieved through (a). That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non-government sectors.

Fiscal policy impacts on bank reserves – government spending (G) adds to reserves and taxes (T) drains them. So on any particular day, if G > T (a fiscal deficit) then reserves are rising overall.

Any particular bank might be short of reserves but overall the sum of the bank reserves are in excess. It is in the commercial banks interests to try to eliminate any unneeded reserves each night given they usually earn a non-competitive return.

Surplus banks will try to loan their excess reserves on the Interbank market.

Some deficit banks will clearly be interested in these loans to shore up their position and avoid going to the discount window that the central bank offers and which is more expensive.

The upshot, however, is that the competition between the surplus banks to shed their excess reserves drives the short-term interest rate down.

These transactions net to zero (a equal liability and asset are created each time) and so non-government banking system cannot by itself (conducting horizontal transactions between commercial banks – that is, borrowing and lending on the interbank market) eliminate a system-wide excess of reserves that the fiscal deficit created.

What is needed is a vertical transaction – that is, an interaction between the government and non-government sector. So bond sales can drain reserves by offering the banks an attractive interest-bearing security (government debt) which it can purchase to eliminate its excess reserves.

However, the vertical transaction just offers portfolio choice for the non-government sector rather than changing the holding of financial assets.

Option (a) “increases the financial assets (the bonds) that are held by the non-government sector $-for-$” is thus incorrect.

Option (c) “reduces the capacity of the non-government sector to borrow from banks by draining bank reserves in return for the bonds” is clearly not correct.

This is based on the erroneous belief that the banks need deposits and reserves before they can lend. Mainstream macroeconomics wrongly asserts that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But this is an incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The following blogs may be of further interest to you:

Question 3:

The ability of a central bank to target a positive interest rate as an expression of its monetary policy stance is independent of the volume of debt it might purchase from the treasury (via primary issue) to match the government’s fiscal deficit.

The answer is False.

Central banks conducts what are called liquidity management operations for two reasons. First, they have to ensure that all private cheques clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. Second, they must maintain aggregate bank reserves at a level that is consistent with their target policy setting given the relationship between the two.

So operating factors link the level of reserves in the banking system to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.

Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also can set a support rate which is paid on commercial bank reserves held by the central bank (which might be zero).

Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan and the US have typically not offered a return on reserves until the onset of the current crisis.

If the support rate is zero then persistent excess liquidity in the cash system (excess reserves) will instigate dynamic forces which would drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.

The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.

Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.

The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.

So the fundamental principles that arise in a fiat monetary system are as follows.

  • The central bank sets the short-term interest rate based on its policy aspirations.
  • Government spending is independent of borrowing which the latter best thought of as coming after spending.
  • Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
  • Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
  • The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.
  • Government debt-issuance is a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.

Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.

However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.

The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.

The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.

However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.

But whatever arrangement is in place, the monetary policy settings are not independent of the debt issuing operations of government.

The following blogs may be of further interest to you:

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    One Response to Saturday Quiz – June 28, 2014 – answers and discussion

    1. tonyw says:

      I don’t understand question 2(a). You seem to equate the financial assets held by the private sector with bonds. Firstly, I understand that this is meant to be net financial assets, but also I understood that the financial assets of the private sector included more than bonds.

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