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Saturday Quiz – August 2, 2014 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you work out why you missed a question or three! 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 Australian government has just introduced harsh new measures against the unemployed. The government is exploiting the popular view that the unemployed on income support benefits live off the hard work of those who pay taxes. The popular view has validity.

The answer is True.

Dispensing with the emotional trappings that this sort of claim might invoke (that is, judging individual motivation etc), this question explores the true relevance of the dependency ratio, which will rise as demographic changes age our populations. It also aims to disabuse the reader of the notion that the income support benefits are paid for by taxes that those in employment (and other income generating activities) might pay.

Initially, we have to be very clear as to what “living off the hard work of those who pay taxes” means. In this sense, it is not a focus on the “income” that the non-workers receive but the command over real good and services that that income provides them with. We will come back to the “funds” issue soon.

So the focus has to be on the real side of the economy because that is, ultimately, the only way our material living standards can be expressed. Nominal aggregates mean very little by themselves.

Income support recipients (who do not work – for whatever reason) clearly command real resources that they have not themselves produced. These real goods and services are produced by those who do work (and the presumption is that most workers pay taxes of some sort or another).

The use of the emotive term “live off the hard work” was deliberate and designed, as a foil, to invoke the idea that governments have created welfare states which provide unsustainable benefits to the poor and marginalised at the expense of those who are materially successful – the classic conservative argument against government welfare provision.

But it doesn’t alter the truth of the statement.

A slight complicating factor is that the income support recipients also pay taxes if there are indirect tax systems in place but that doesn’t alter the story about the provision of real goods and services.

Now the second part of the answer relates to the question of funding. In terms of where the funds come from to provide the income support for those who do not work the answer is simple: no-where.

While taxation raises revenue for national governments it doesn’t “fund” its spending. Currency-issuing governments can spend without revenue should they wish to.

Abba Lerner’s 1951 book The Economics of Employment was really a rewritten version of the 1941 article The Economic Steering Wheel where he elaborated his version of Keynesian thinking. He conceptualised macroeconomic policy as being about “steering” the fluctuations in the economy. Fiscal policy was the steering wheel and should be applied for functional purposes. Laissez-faire (free market) was akin to letting the car zigzag all over the road and if you wanted the economy to develop in a stable way you had to control its movement.

This led to the concept of functional finance and the differentiation from what he called sound finance (that proposed by the free market lobby). Sound finance was all about fiscal rules – the type you read about every day in the mainstream financial press. Sound finance is about balancing the fiscal balance over the course of the business cycle and only increasing the money supply in line with the real rate of output growth; etc – noting the approach erroneously assumes the central bank can control the money supply.

Lerner thought that these rules were based more in conservative morality than being well founded ways to achieve the goals of economic behaviour – full employment and price stability.

He said that once you understood the monetary system you would always employ functional finance – that is, fiscal and monetary policy decisions should be functional – advance public purpose and eschew the moralising concepts that public deficits were profligate and dangerous.

Lerner thought that the government should always use its capacity to achieve full employment and price stability. In Modern Monetary Theory (MMT) we express this responsibility as “advancing public purpose”. In his 1943 book (page 354) we read:

The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound and what is unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance …

Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money,” etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability …

Mainstream advocacy of fiscal rules that are divorced from a functional context clearly do not make much sense even though their use dominates public policy these days. It may be that a fiscal surplus is necessary at some point in time – for example, if net exports are very strong and fiscal policy has to contract spending to take the inflationary pressures out of the economy. This will be a rare situation but in those cases I would as a proponent of MMT advocate fiscal surpluses.

Lerner outlined three fundamental rules of functional finance in his 1941 (and later 1951) works.

  • The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
  • By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
  • If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the fiscal balance, or limiting the national debt, so much the worse for these principles. The government press shall print any money that may be needed to carry out rules 1 and 2.

So in an operational sense, taxation serves to reduce the spending capacity of the non-government sector to ensure that there is non-inflationary space for government to deliver public services. It doesn’t fund anything.

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Question 2:

A potential problem with running continuous fiscal deficits is that the spending builds up over time which adds to inflationary pressures.

The answer is False.

This question tests whether you understand that fiscal deficits are just the outcome of two flows which have a finite lifespan. Flows typically feed into stocks (increase or decrease them) and in the case of deficits, under current institutional arrangements, they increase public debt holdings.

So the expenditure impacts of deficit exhaust each period and underpin production and income generation and saving. Aggregate saving is also a flow but can add to stocks of financial assets when stored.

As long as the flow of net spending from the public sector is consistent with filling the non-government spending gap then a nation can absorb continuous fiscal deficits without inflationary pressures building.

Under current institutional arrangements (where governments unnecessarily issue debt to match its net spending $-for-$) the deficits will also lead to a rise in the stock of public debt outstanding. But of-course, the increase in debt is not a consequence of any “financing” imperative for the government. A sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

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Question 3:

If private domestic investment is less than private domestic saving and the external sector is draining aggregate demand then the government fiscal balance has to be in deficit no matter what level of GDP is produced.

The answer is True.

This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances.

Refreshing the balances (again) – we know that from an accounting sense, if the external sector overall is in deficit, then it is impossible for both the private domestic sector and government sector to run surpluses. One of those two has to also be in deficit to satisfy the accounting rules.

The important point is to understand what behaviour and economic adjustments drive these outcomes.

So here is the accounting (again). The basic income-expenditure model in macroeconomics can be viewed in (at least) 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.

So what about the situation posed in the question?

If the external sector is draining aggregate demand it must mean the current account is in deficit. That is , spending flows out of the local economy are greater than spending flows coming into the economy from the foreign sector.

If private domestic investment is less than private domestic saving, then the private domestic sector is running a surplus overall – that is, they are spending less than they are earning.

The following graph shows the sectoral balances for seven periods based on different levels of the private balance (as a per cent of GDP) and a constant external deficit (to keep things simple).

You can see that in Periods 1 to 3, the private sector is in surplus while the external sector is in deficit. The fiscal balance (G – T) is in deficit in each of those periods. The fiscal balance only goes into surplus (with a 2 per cent of GDP external deficit) when the injection into aggregate demand from the private domestic sector is greater than the spending drain from the external sector (Period 7).

The reasoning is as follows. If the private domestic sector (households and firms) is saving overall it means that some of the income being produced is not be re-spent. So the private domestic surplus represents a drain on aggregate demand. The external sector is also leaking expenditure. At the current GDP level, if the government didn’t fill the spending gap resulting from the other sectors, then inventories would start to increase beyond the desired level of the firms.

The firms would react to the increased inventory holding costs and would cut back production. How quickly this downturn occurs would depend on a number of factors including the pace and magnitude of the initial demand contraction. But the result would be that the economy would contract – output, employment and income would all fall.

The initial contraction in consumption would multiply through the expenditure system as laid-off workers lose income and cut back on their spending. This would lead to further contractions.

Declining national income (GDP) leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.

The decline in income then stifles firms’ investment plans – they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further into surplus

With the economy in decline, tax revenue falls and welfare payments rise which push the public fiscal balance towards and eventually into deficit via the automatic stabilisers.

So with an external deficit and a private domestic surplus there will always be a fiscal deficit.

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