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Saturday Quiz – May 9, 2015 – 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:

When the government matches a deficit by issuing debt to the private sector this 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.

The answer is False.

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 fiscal 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 2:

Which fiscal 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) Depends on the decomposition of the structural and cyclical components.

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

The question probes an understanding of the forces (components) that drive the fiscal 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 fiscal 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 fiscal 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 fiscal process.

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

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

So if the fiscal position is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the fiscal position 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 fiscal position 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 fiscal 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 fiscal balance are the so-called automatic stabilisers.

In other words, without any discretionary policy changes, the fiscal 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 fiscal balance moves towards deficit (or an increasing deficit).

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

So just because the fiscal position 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 fiscal balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the fiscal position (and the underlying fiscal parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.

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

Question 3:

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.

The answer is False.

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 1 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:

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    This Post Has 5 Comments
    1. Bill, I have been thinking and would it be easier to introduce MMT as a new system? I mean most people don’t accept that government spending works by crediting bank account so what if we said we are going to create a new monetary system – where spending works by “printing money” and taxes “imprint” money, the only constraint is inflation and no “debt” and where banks can make loans before reserves (they already can.) This may be easier for the population to swallow, e.g. in Greece.

    2. Hi Bill thanks for your great and voluminous commentary. The CBO here in the U.S. put out a study last year titled “The Long Run Effects of Federal Budget Deficits on National Savings and Private Domestic Investment” (Jonathon Huntley). Citing a variety of studies, Huntley concludes “on the basis of results
      published in the empirical literature, CBO concludes that for each dollar’s increase in the federal deficit, the effect on investment ranges from a decrease of 15 cents to a decrease of 50 cents, with a central estimate of a decrease of 33 cents”. Huntley’s logic supporting this result is the mainstream view on “crowding out”, which, of course, is false. However, the empirical studies cited are numerous and they usually attempt to adjust for the business cycle and other factors. As you know, these “beliefs” on crowding out impact the “impartial scoring” of every tax and spending bill coming out of the U.S. Congress. I would like to write to the CBO (Huntley specifically) about their logic errors but I don’t have a good answer to these empirical results. Do you have any insights into what these studies may be missing? Thanks much.

    3. I got he answer to question 1 right by second-guessing your intent. But whilst I accept that new bond-issuance doesn’t alter the net portfolio position of existing savers, surely it might attract new savers. In which case it would constitute a leakage from the expenditure system.

    4. “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.”

      Let’s say I save $1,000 in demand deposits in my checking account. This is a leakage, correct?

      Next, the gov’t “borrows” my $1,000 in demand deposits for spending, and I get a $1,000 gov’t bond. Overall, aren’t demand deposits unchanged?

      Also, are demand deposits both medium of account and medium of exchange?

      Lastly, the preview button option is not working for me. Fix, please.

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