The Weekend Quiz – December 16-17, 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:

Although we are told that a country is running a small current account deficit and that the private domestic sector is saving overall, we are unable to draw any conclusions about the state of the fiscal balance until we know the relative magnitudes of the other balances.

The answer is False.

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.

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:

(1) 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 tax revenue minus total 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 net taxes (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.

So what economic behaviour might lead to the outcome specified in the question?

If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative – that is net drain of spending – dragging output down. The reference to a “small” external deficit was to place doubt in your mind. In fact, it doesn’t matter how large the external deficit is for this question.

Assume, now that the private domestic sector (households and firms) seeks to increase its overall saving (that is, spend less than it earns) and is successful in doing so. Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income. The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.

The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction. But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract – output, employment and income all fall.

The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.

The declining income 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.

So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.

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 towards and eventually 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.

If the private sector persists in trying to net save then the contracting income will clearly push the fiscal balance into deficit.

So we would have an external deficit, a private domestic surplus and a fiscal deficit.

There will always be a fiscal deficit at any national income level, if the private domestic sector is succeessfully spending less than it earns and the external sector is in deficit.

The following blogs may be of further interest to you:

Question 2:

While a currency-issuing government does not have to issue bonds to match its deficit spending, one of the advantages of raising debt from the private sector is that it provides a boost to private wealth.

The answer is False.

This answer relies on an understanding the banking operations that occur when governments spend and issue debt within a fiat monetary system. 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?

In this situation, 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.

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.

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

Question 3

Fiscal austerity aims to reduce the stock of net government spending by reducing spending and/or increasing taxes.

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.

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 because a sovereign government is never revenue constrained being the monopoly issuer of the currency.

The point is that there is no inflation risk per se with continuous fiscal deficits. The only time inflation becomes a risk from the demand side if nominal spending outstrips the capacity of the real economy to expand output.

A continuously increasing fiscal deficit might create those conditions, but a correctly calibrated continuous fiscal deficit will not because it will be just filling the non-government spending gap.

The following blogs may be of further interest to you:

That is enough for today!

(c) Copyright 2017 William Mitchell. All Rights Reserved.

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    6 Responses to The Weekend Quiz – December 16-17, 2017 – answers and discussion

    1. AndyB says:

      Q2. I believe you have made the point before Bill that bond sales do increase private wealth in that they provide additional interest. That was my thinking.

    2. AndyB says:

      Q3. While a fiscal deficit is an outcome surely fiscal austerity is a political choice that ‘aims to reduce the stock of net government spending…….,’

    3. Derek Henry says:

      Q2 Interest income channels make a difference and interest rate hikes increase bank deposits.

      Interest rate hikes don’t fight inflation or strengthen a currency – They do the opposite

      We’ve been saying this for a long long time now and just before the first FED rate hike we said the following.

      That inflation would increase, the dollar would fall, gold and commodities would rise and Treasuries would be lower.

      The FED have had 4 rate hikes so far since December 2015 and today will be a fifth.

      Let’s have a look.

      December 2015, Dollar Index, 98.
      Today, Dollar Index, 94.

      December 2015, Dollar/yen, 121.00
      Today, dollar/yen, 113.00

      December 2015, Gold, $1050
      Today, Gold, $1240

      December 2015, Oil, $38
      Today, Oil, $57

      December 2015, 10-Yr Treas futures, 127.00
      Today, 10-year Treas futures, 124.00

      December 2015, CPI, 0.7% y-o-y.
      Today, CPI, 2.1% y-o-y.

      None of this is supposed to happen right ? No matter what TV channel you watch or newspaper you read the go to extreme lengths to point out the opposit is true.

      MMT got everything right. It’s all right there. The gold standard mainstream still can’t see it never mind why it has all happened.

      We say interest rate hikes are simply price hikes right across the economy as the price hike get spassed on. We also say the mainstream completely ignore the interest income channels. We say interest rate hikes increase deposits.

      All else equal.

      They are price adjustments, pure and simple. Higher rates equate to higher prices and higher prices mean higher inflation. Inflation is not good for currency. Higher inflation is good for inflation-sensitive stuff like gold and commodities as well as some stocks.

      Currencies are a bit like bonds, the only difference being they have zero maturity. Everyone seems to understand that when rates go up bond prices go down. It’s an inverse relationship. The discount to par reflects the implied yield and that discount increases as rates go up.

      Same with currencies. The spot price of a currency can be considered par. In a rising-rate environment the forward prices of a currency are lower. The market is literally pricing in a lower exchange rate. The degree of discount to par reflects the implied yield. Buy a forward and hold it over time until it converges to spot and you will earn the implied yield.

      Gold and commodities exhibit the opposite behavior. They don’t earn. They cost you to hold. There are interest payments and storage costs so the natural “curve” of gold and commodity markets has a positive slope. (Deferred contracts are priced higher than spot.)

      In a rising-rate environment, forward contracts for gold are priced higher. That reflects the “cost” of holding, which equals the interest rate plus storage, etc. Prices rise in a rising-rate environment and they fall in a falling rate environment.

      Of course this does not reflect short-term portfolio shifts based on traders’ beliefs. Many believe that lower rates are bullish for gold or bearish for a currency and vice-versa. As a result, they act on those beliefs and buy and sell accordingly. However, that’s not the true fundamental effect. That’s why so many people lost money buying gold when they believed rate cuts would be inflationary. Similarly, they wrongly sold the dollar. These mistakes are being repeated now, only in reverse.

      The Fed thinks it is fighting inflation when actually it is feeding it via these rate hikes. Any commodity curve will show this in reaction to a rising-rate environment. The curve will instantly reflect higher future costs.

      In addition, their policy and statements seem to reflect a lack of understanding of the government being a net payer of interest. They talk about being on guard against further fiscal stimulus when it is the Fed itself that is doing the stimulating. It is paying. That is income added, not removed. While some may find it harder to borrow because of the higher cost of credit, that is offset by the additional income earned by creditors and savers. There is net income received by the economy and that is by no means a brake on economic activity.

      If you were a cynic You could possibly go further and say that central banks with their current policies show that the ONLY manifestation of inflation that they are interested in will actively try to stamp out is a rise in your wages.

      They tell everyone they are increasing interest rates to fight inflation but the reality of the situation is they are increasing inflation albeit slowly as the data suggests but destroy your income at the same time. Because your income can’t keep up with the growth in inflation they are causing.

      It’s as if Mankwi was tasked by the corporate sector to write an economic textbook that says black is white and white is black but ultimately no matter what colour it is everything will serve the corporate sector whilst we send the herd the other way. He got paid a lot of money for doing so.

    4. LloydK says:

      Fiscal austerity aims to reduce the stock of net government spending by reducing spending and/or increasing taxes.
      The answer is False.

      If I understood the explanation correctly, changing stock to flow would make this a true statement.

    5. Mona Williams says:

      AndyB, I thought like you on Q2 and Q3.

    6. Derek Henry says:

      Warren’s speech in Italy below

      Maybe there’s some connection with the ECB, the European Central Bank, as they lower rates, the currency has been stronger. Is it possible the central banks have it backwards? With all those multiple PhD’s, and all the research, the hundreds of millions of Euro they spend on research, could they have it backwards? All the evidence says yes. And the countries with the higher rates, as they raise rates it doesn’t seem to work. It seems to make inflation worse and the currency low.

      So what are they overlooking? Who is the largest payer of interest? The government. And what happens when rates go up? Government pays more interest to the economy. And when rates go down governments pay less interest to the economy.

      The economy loses interest income when the rates go down, and everybody who has money in the bank knows that. It helps the borrower, but it hurts the saver. But there are more savers than borrowers. The government debt in Italy is over 100% of GDP. That’s mostly somebody’s savings. Okay, that’s all ‘net savings’. When the interest rates goes up, that savings earns more money. When interest rates goes down the economy earns less money on the interest. So when interest rates goes down, the budget deficit goes down, and people earn less money.

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