The Weekend Quiz – March 19-20, 2016 – answers and discussion

Here are the answers with discussion for the Weekend 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:

If a national currency-issuing government stopped issuing public debt, then its deficit spending would be more expansionary than if it matched the deficits with new debt issues.

The answer is False.

The answer to this question is one of the insights that Modern Monetary Theory (MMT) provides which you will not find in a mainstream macroeconomics textbook. The mainstream presentation (with all the nuances one might think of) is uniformly wrong.

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.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

You may wish to read the following blogs for more information:

Question 2:

If the external sector is in surplus and thus is contributing to domestic economic growth, then the national government must run a fiscal surplus to stop the economy overheating.

The answer is False.

Note the use of the word must!

First, you need to understand the basic relationship between the sectoral flows and the balances that are derived from them. The flows are derived from the National Accounting relationship between aggregate spending and income.

To refresh your memory the balances are derived as follows. 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).

Expression (1) tells us that total income in the economy per period will be exactly equal to total spending from all sources of expenditure.

We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all taxes and transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).

Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).

Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):

(2) GNP = C + I + G + (X – M) + FNI

To render this approach into the sectoral balances form, we subtract total taxes and transfers (T) from both sides of Expression (3) to get:

(3) GNP – T = C + I + G + (X – M) + FNI – T

Now we can collect the terms by arranging them according to the three sectoral balances:

(4) (GNP – C – T) – I = (G – T) + (X – M + FNI)

The the terms in Expression (4) are relatively easy to understand now.

The term (GNP – C – T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way). In other words, it represents private domestic saving.

The left-hand side of Equation (4), (GNP – C – T) – I, thus is the overall saving of the private domestic sector, which is distinct from total household saving denoted by the term (GNP – C – T).

In other words, the left-hand side of Equation (4) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.

The term (G – T) is the government financial balance and is in deficit if government spending (G) is greater than government tax revenue minus transfers (T), and in surplus if the balance is negative.

Finally, the other right-hand side term (X – M + FNI) is the external financial balance, commonly known as the current account balance (CAD). It is in surplus if positive and deficit if negative.

In English we could say that:

The private financial balance equals the sum of the government financial balance plus the current account balance.

We can re-write Expression (6) in this way to get the sectoral balances equation:

(5) (S – I) = (G – T) + CAD

which is interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAD > 0) generate national income and net financial assets for the private domestic sector.

Conversely, government surpluses (G – T < 0) and current account deficits (CAD < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.

Expression (5) can also be written as:

(6) [(S – I) – CAD] = (G – T)

where the term on the left-hand side [(S – I) – CAD] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.

This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).

The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)) plus net income transfers.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

Thus, when an external deficit (X – M < 0) and public surplus (G – T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process.

Second, you then have to appreciate the relative sizes of these balances to answer the question correctly.

Consider the following Table which depicts three cases – two that define a state of macroeconomic equilibrium (where aggregate demand equals income and firms have no incentive to change output) and one (Case 2) where the economy is in a disequilibrium state and income changes would occur.

Note that in the equilibrium cases, the (S – I) = (G – T) + (X – M) whereas in the disequilibrium case (S – I) > (G – T) + (X – M) meaning that aggregate demand is falling and a spending gap is opening up. Firms respond to that gap by decreasing output and income and this brings about an adjustment in the balances until they are back in equality.

So in Case 1, assume that the private domestic sector desires to save 2 per cent of GDP overall (spend less than they earn) and the external sector is running a surplus equal to 4 per cent of GDP.

In that case, aggregate demand will be unchanged if the government runs a surplus of 2 per cent of GDP (noting a negative sign on the government balance means T > G).

In this situation, the surplus does not undermine economic growth because the injections into the spending stream (NX) are exactly offset by the leakages in the form of the private saving and the fiscal surplus. This is the Norwegian situation.

In Case 2, we hypothesise that the private domestic sector now wants to save 6 per cent of GDP and they translate this intention into action by cutting back consumption (and perhaps investment) spending.

Clearly, aggregate demand now falls by 4 per cent of GDP and if the government tried to maintain that surplus of 2 per cent of GDP, the spending gap would start driving GDP downwards.

The falling income would not only reduce the capacity of the private sector to save but would also push the fiscal balance towards deficit via the automatic stabilisers. It would also push the external surplus up as imports fell. Eventually the income adjustments would restore the balances but with lower GDP overall.

So Case 2 is a not a position of rest – or steady growth. It is one where the government sector (for a given net exports position) is undermining the changing intentions of the private sector to increase their overall saving.

In Case 3, you see the result of the government sector accommodating that rising desire to save by the private sector by running a deficit of 2 per cent of GDP.

So the injections into the spending stream are 4 per cent from NX and 2 per cent from the deficit which exactly offset the desire of the private sector to save 6 per cent of GDP. At that point, the system would be in rest.

This is a highly stylised example and you could tell a myriad of stories that would be different in description but none that could alter the basic point.

If the drain on spending outweighs the injections into the spending stream then GDP falls (or growth is reduced).

So even though an external surplus is being run, the desired fiscal balance still depends on the saving desires of the private domestic sector. Under some situations, these desires could require a deficit even with an external surplus.

The answer is False because we included the word must in relation to what the government should do. If the private domestic saving overall is strong, then a fiscal surplus will cause a recession.

You may wish to read the following blogs for more information:

Question 3:

On the day that the government issues debt to match ($-for-$) the increase in its deficit, non-government sector net worth increases.

The answer is False.

This answer is complementary to that provided for Question 1 and relies on the same understanding of reserve operations. So within a fiat monetary system we need to understand the banking operations that occur when governments spend and issue debt. That understanding allows us to appreciate 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 as explained in the asnwer to Question 1. But at this stage, M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. In other words, fiscal 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.

You may wish to read the following blogs for more information:

Spread the word ...
    This entry was posted in Saturday quiz. Bookmark the permalink.

    9 Responses to The Weekend Quiz – March 19-20, 2016 – answers and discussion

    1. himi says:

      The mechanisms by which banks create money appear to be well understood by just about everyone involved /except/ the politicians and the mainstream economics textbooks (though at least some of the people doing mainstream economics appear to understand the reality rather than the textbook model) – why is it that the textbooks and a lot of mainstream economists don’t get it?

      I can kind of understand people not understanding that the government budget constraint isn’t a true description of reality, since no one outside heterodox economics seems to acknowledge it, but the banks all know how their business works, and the reserve banks have to know since they’re an integral part of it – how is this understanding not getting into the brains of so many economics professionals and politicians?

    2. Willem says:

      On the day that the government issues debt to match ($-for-$) the increase in its deficit, non-government sector net worth increases.

      I read the question with the deficit in mind. I know the gov debt issued has no impact on the non-gov net assets, yet i answered True cause the premise is that there is a gov deficit. Hence my confusion.

    3. Jerry Brown says:

      himi, I wonder about that also. It actually concerns me that so many otherwise very intelligent people don’t seem to understand some of the basic premises of MMT. Sometimes it makes me worry that maybe I am the one missing some very obvious points, not them. But every time that happens, I go back and read Bill Mitchell again, and find the logic and reality in his description of how things actually work to be compelling. So I don’t have an answer for you.

      One of these smart people, Simon Wren-Lewis, recently wrote a post in his blog (mainly macro) titled “Does public investment have to pay for itself”. He made some very good points about government investment but he also got a few comments from MMT oriented readers (including me) about how the government doesn’t actually face a financial constraint when investing. So he writes a blog post “MMT: Not so Modern” where he complains that these polite comments are so “annoying” on March 16. Over a hundred replies to this post explaining many MMT points, yet somehow he states in a reply on March 20 to a comment that “MMT people keep insisting that you never, ever need to worry about deficits”. Its unbelievable. It had been pointed out numerous times that MMT says that any excess spending can cause inflation and that deficit spending can be part of that. Talk about “annoying”! So I really, really cant explain the resistance by some to these ideas that MMT explains.

    4. Jerry Brown says:

      I’m starting to feel bad for some mainstream economists who flounder around trying to dispute MMT. So maybe I can point them in the right direction. It seems to me that there are many ways to refute MMT- arguments that everything MMT says is all very well understood by economists is not the right direction. Here are some suggestions as to discrediting MMT-

      Show that Central Banks cannot or do not create money

      Show that a government can never have its Central Bank act in accordance with that government’s needs

      Show that Central Banks do not target an interest rate (or let it fall to zero) as part of their policy

      Show convincingly that the Central Bank controls the money supply through the money multiplier process, and/or show that the Central Bank will not act to preserve the payment system.

      Show that an increase in the money supply always causes an increase in inflation and or demand for goods and services

      Show that loan officers in banks always check that bank’s reserve position before making any loan to any credit worthy customer. Or that they don’t operate like MMT and bankers say they do

      Show that banks always and only act as intermediates- show that they can’t loan money they don’t already have in the form of deposits

      Show that accounting identities do not work, that they are not identities. Or that MMT misrepresents how they work. (these have been the best criticisms I have seen, but fall short IMO)

      I’m sure there are many more ways to refute MMT, but these are obvious ones to me. Knock a big hole in any of these and your mainstream economist has a point. While they are trying to do that, maybe they can come up with a theory of inflation of their own that actually works, instead of criticizing MMT saying MMT’s theory isn’t fully developed. And of course, they could just convincingly show that Keynes was entirely wrong about everything. That would do it. But they have had 80 years to do that so far.

      Sorry for the rant.

    5. bill says:

      Dear Jerry Brown (at 2016/03/21 at 4:21)

      A lot of people have asked me to comment on the ‘mainly macro’ attack on Modern Monetary Theory (MMT). I don’t think it would be a productive exercise (read: it would be a waste of my time).

      The author is a New Keynesian, who has little to offer of relevance to the public debate.

      He suggests that he (and his ilk) knew all of the propositions advanced by MMT all along anyway – so ‘there is nothing new about it’.

      Which then begs the question as to why they are still teaching things like:

      1. The money multiplier.

      2. Crowding out.

      3. Fiscal deficits cause higher interest rates.

      4. Central bank controls the money supply.

      5. Inflation is higher if governments ‘print money’ to match their deficits relative to issuing debt.

      etc

      So they knew all of the myths in the mainstream macroeconomics textbooks all along but still choose to teach them in their courses.

      Apparently, the author claims that MMT academics are averse to mathematics. I, for one, am not averse to using it and have several years of university-level study in mathematics and mathematical statistics. But, the mainstream economists use it for its own sake and, even then, are fairly poor mathematicians (there is a long literature on how unsophisticated the maths that economists use is).

      In the words of Tony Lawson (from the paper ‘What is this ‘School’ Called Neoclassical Economics?’):

      This emergence of the axiomatic method removed at a stroke various hitherto insurmountable constraints facing those who would mathematise the discipline of economics. Researchers involved with mathematical projects in economics could, for the time being at least, postpone the day of interpreting their preferred axioms and assumptions. There was no longer any need to seek the blessing of mathematicians and physicists or of other economists who might insist that the relevance of metaphors and analogies be established at the outset. In particular it was no longer regarded as necessary, or even relevant, to economic model construction to consider the nature of social reality, at least for the time being. Nor, it seemed, was it possible for anyone to insist with any legitimacy that the formulations of economists conform to any specific model already found to be successful elsewhere (such as the mechanics model in physics). Indeed, the very idea of fixed metaphors or even interpretations, came to be rejected by some economic ‘modellers’ (albeit never in any really plausible manner).

      The point is that if there is nothing to gain from using mathematical squiggles to make one’s argument then why use it? To obscure? To eliminate social realities that are contrary to the narrow axioms that one might like to employ?

      As I have said in the past – Garbage In, Garbage Out (GIGO). See:

      1. http://bilbo.economicoutlook.net/blog/?p=5079 – Mainstream macroeconomic fads – just a waste of time (specific critique of New Keynesian economics)

      2. http://bilbo.economicoutlook.net/blog/?p=5307

      3. http://bilbo.economicoutlook.net/blog/?p=10875

      4. http://bilbo.economicoutlook.net/blog/?p=18093

      We also provided a detailed (with some mathematics even) critique of the sort of frameworks (NK DSGE) that the MMT critique was based on in our 2008 book – Full Employment abandoned.

      Finally, the author is clearly too lazy to read all the relevant MMT literature and instead draws as authority the rather disengenous ravings of a disaffected character from the US. I dealt with his criticisms of MMT here – http://bilbo.economicoutlook.net/blog/?p=22701

      These characters have built an image of MMT in their own minds from some garbled accounts etc and choose to hide behind a few crude and incorrect propositions that they attribute to MMT academics (such as, ‘deficits do not matter’) to make themselves feel comfortable that they know everything anyway and still have a body of economics that is relevant.

      The lack of scholarship is astounding – but then what would you expect when you examine the course material they offer their students and the sort of statements they make on the public record.

      So that is as much as I am going to say about the issue.

      best wishes
      bill

    6. Jerry Brown says:

      Professor, you have the patience of a saint. I for one am tired of being called rude and annoying just for pointing out things that an argument doesn’t address. Maybe there is a new definition of annoying I need to learn. And its not even my views being mischaracterized or snubbed as being things everybody knew all along but are unimportant even though correct. So I thank you for what you do here on this blog and have tremendous respect for you. And hope that you continue to persevere. Thank you for the reply. I am truly honored.

    7. Magpie says:

      Prof. Mitchell,

      An excellent reply. Kudos.

      With this you demonstrate not only the value of MMT, but also your own personal value: a real teacher, a gentleman, and an example we all should follow.

    8. himi says:

      Jerry Brown, your comments about Simon Wren-Lewis really disappoint me, just like a lot of the things I’ve heard about Paul Krugman in response to heterodox economics – I’ve read both of those people with interest in the past, as they’ve appeared to speak with a useful mix of authority and humility. The more I’ve learned, though, the more that appearance has wavered, and seeing things like this make me pretty comfortable ignoring their commentaries in the future.

      I’m still at a loss as to how we might convince the world to accept what MMT is saying.

    9. larry says:

      himi, perhaps it will help if you have a look at Bill Black’s excoriation of Krugman and 4 other mainstream economists and their attempt to smear Gerald Friedman, an economist at U of Mass at Amherst. Have a look at these. By the way, Black is an MMTer at UMKC though not an economist per se. He was once director of a regulatory agency for the S&L’s and assisted in putting around a thousand or so people in jail for finance fraud. Anyway, here are the links. Krugman’s involvement in this is nauseating, not to mention the other four.

      http://www.huffingtonpost.com/william-k-black/krugman-and-the-gang-of-4_b_9286520.html

      [Bill notes: I deleted a link here to a site I do not wish to promote and edited the text accordingly to maintain context]

      I would hope Wren-Lewis would never stoop this low into the gutter. Personally, I have always been irritated by Krugman and was absolutely astonished when he wrote in his column that he taught econ students IS-LM, considering it a good introduction to the subject. Eh? They have to unlearn it soon afterwards, and its author, John Hicks, rejected the framework toward the end of his life. Let me just say that this shows an unacceptably cavalier attitude to the subject on Krugman’s part, if not a kind of contempt for the unorthodox.

      [Bill notes: you can find the article (that was at the link I deleted)] … on New Economic Perspectives, go there, click on Bill Black’s name on the right and hopefully you will be able to locate it.

    Leave a Reply

    Your email address will not be published. Required fields are marked *

    *
    To prove you're a person (not a spam script), type the answer to the math equation shown in the picture.
    Anti-spam equation

    This site uses Akismet to reduce spam. Learn how your comment data is processed.