The Weekend Quiz – June 17-18, 2017 – answers and discussion

Here are the answers with discussion for this Weekend’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:

National income would rise each year even if the workers were engaged by government to dig large holes and fill them in again on a daily basis.

The answer is True.

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 road builder is paying on-going wages to construct, tear up and construct the road again 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 road) 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.

The following blogs may be of further interest to you:

Question 1:

Which fiscal position outcome is the least expansionary?

(a) A deficit of 1 per cent of GDP

(b) A deficit of 2 per cent of GDP

(c) A deficit of 3 per cent of GDP

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

The answer is Option (a) – A deficit of 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:

Premium Question 5:

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.

The following blogs may be of further interest to you:

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    7 Responses to The Weekend Quiz – June 17-18, 2017 – answers and discussion

    1. Rob Rawlings says:

      The answer to question 1 seems to provide an explanation of why hole digging and filling may cause national income to be higher than it would be in some circumstances compared to the situation without it,

      But there could be circumstances where:

      – We are a full-employment and the hole digging simply “crowds out” other spending
      or
      – Hole digging activities merely prevent national income falling.

      This (especially given the occasional nit-picky nature of these questions!) I do not see how the answer can be “true”.

    2. Jerry Brown says:

      Rob Rawlings, I guess you might as well ask what would happen if the government forced otherwise employed individuals to engage in the hole digging “activities” at lower rates of pay (or no pay) than they were previously receiving. Why not?- it could happen. I think something similar happened during the Cultural Revolution in China. Or maybe that was Cambodia under Pol Pot. How’s that for being nit-picky? :)

      But if you assume that by “engage” you mean a voluntary acceptance of employment, wouldn’t you expect that in order to engage workers in an activity as boring and difficult as digging holes, the government would have to offer already employed people a higher wage than they were already receiving? That would increase national income at least initially (if not overall national welfare).

    3. Jerry Brown says:

      Even forcing unwilling workers into completely useless and harmful and low paying activities seems to be consistent with rising national income. A prime example would be the draft during the Vietnam War in the US. And WW2, although I don’t think that was useless.
      https://fred.stlouisfed.org/graph/?id=A023RC1A027NBEA,

    4. Rob Rawlings says:

      Applying some logical analysis:

      The statement can be rewritten as “National income would rise each year whether workers were engaged by government to dig large holes and fill them in again on a daily basis or whether they are not engaged by government to dig large holes and fill them in again on a daily basis”.

      One concludes that hole digging has no bearing on the matter of national income.

      This renders the second part of the statement redundant and it can be simplified to “National Income rises every year” which it clearly does not – so the whole;e statement is “false”.

    5. Rob Rawlings says:

      BTW: I hope this doesn’t sound like trolling – I like these weekly tests of “thinking like a MMTer”

    6. Brendanm says:

      Regarding Q2, why were we expected to assume that options (a) to (c) referred to the same government in the same year?

    7. Brendanm says:

      Bob: Actually the statement reduces to

      “National income will rise each year if the government provides employment to those not needed by the private sector, whether that employment be digging and filling in holes or whether it it not.”

      Obviously the second clause of the condition reduces to true, but the need to ensure full employment remains.

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