The Weekend Quiz – December 30-31, 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:

When the government matches its deficit with debt-issuance it changes the portfolio of wealth held in the non-government sector. The impact on purchasing power 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:

A public employment guarantee program, which required workers to attend a government centre each day to do jigsaw puzzles, would have no impact on national income.

The answer is False.

This question just reprises last week’s question about digging and filling back in holes. We need to reinforce what drives national income rather than what might be productive use of peoples’ time (although jigsaw puzzles are fun).

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 government is paying on-going wages to the workers to solve the jigsaw puzzles then this will be beneficial for aggregate demand (spending).

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 workers’ wages) 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 spending would be stronger and employment higher as a consequence.

But when you think about it, the workers might enjoy solving the puzzles and so job satisfaction is a bonus to the macroeconomic impacts arising from the wage outlays.

The following blogs may be of further interest to you:

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:

Happy New Year for 2018.

Thanks for reading.

That is enough for today!

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

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    4 Responses to The Weekend Quiz – December 30-31, 2017 – answers and discussion

    1. Rob Rawlings says:

      Hi Bill,

      I have a question on q3: You say “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”.

      If the QE program of buying assets drives up the price of these assets then the value of net financial assets in the private sector will have increased. Will this have a positive effect on aggregate demand ?

    2. Mel says:

      “If the QE program of buying assets drives up the price of these assets then the value of net financial assets in the private sector will have increased.”

      I think that if you’re going to profit from the higher price of bonds, then you’re going to have to sell them (for money) to people who have money. But the Treasury, selling the bonds, has taken money out of the private market. Maybe the foreign sector who buy the nation’s exports will have some money that they’re not spending on exports.

    3. Mel says:

      Boy, that was stupid, wasn’t it? Treasury has injected money into the private sector. I have to sit back to figure out how I can think something like that.

    4. Erik says:

      Dear Bill,

      Aren’t govt Bonds also bought by the private sector which causes the amount of deposits to fall and thus, aggregate demand to fall? So there is deflationary potential in issuing govt bonds?

      Thank you very much

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