The Weekend Quiz – January 6-7, 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:

A rising fiscal deficit indicates an expansionary shift in government policy and the challenge is to ensure the nominal demand stimulus does not exceed the real capacity of the economy to respond by increasing real output.

The answer is False.

This question has two premises – a statement and a related consequence. In this case the statement that “rising government deficit indicates an expansionary shift in policy” is false and the related consequence that “the challenge is to calibrate that expansion to ensure nominal demand growth does not exceed the real capacity of the economy to respond by increasing real output” is true.

Taken together the answer is false.

First, it is clearly central to the concept of fiscal sustainability that governments attempt to manage aggregate demand so that nominal growth in spending is consistent with the ability of the economy to respond to it in real terms. So full employment and price stability are connected goals and MMT demonstrates how a government can achieve both with some help from a buffer stock of jobs (the Job Guarantee).

Second, the statement that a “rising government deficit indicates an expansionary shift in policy” is exploring 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 fiscal balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the fiscal outcome 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 outcome is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the fiscal outcome 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 outcome 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 outcome in a recession and contracting it in a boom.

So just because the fiscal outcome goes into deficit 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 change in nomenclature is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.

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

You might like to read these blogs for further information:

Question 2:

The imposition of taxes by the national government creates unemployment, other things equal.

The answer is True.

First, to clear the ground we state clearly that a sovereign government is the monopoly issuer of the currency and is never revenue-constrained. So it never has to “obey” the constraints that the private sector always has to obey.

The foundation of many mainstream macroeconomic arguments is the fallacious analogy they draw between the budget of a household/corporation and the government fiscal policy. However, there is no parallel between the household (for example) which is clearly revenue-constrained because it uses the currency in issue and the national government, which is the issuer of that same currency.

The choice (and constraint) sets facing a household and a sovereign government are not alike in any way, except that both can only buy what is available for sale. After that point, there is no similarity or analogy that can be exploited.

Of-course, the evolution in the 1960s of the literature on the so-called government ‘budget’ constraint (GBC), was part of a deliberate strategy to argue that the microeconomic constraint facing the individual applied to a national government as well. Accordingly, they claimed that while the individual had to “finance” its spending and choose between competing spending opportunities, the same constraints applied to the national government. This provided the conservatives who hated public activity and were advocating small government, with the ammunition it needed.

So the government can always spend if there are goods and services available for purchase, which may include idle labour resources. This is not the same thing as saying the government can always spend without concern for other dimensions in the aggregate economy.

For example, if the economy was at full capacity and the government tried to undertake a major nation building exercise then it might hit inflationary problems – it would have to compete at market prices for resources and bid them away from their existing uses.

In those circumstances, the government may – if it thought it was politically reasonable to build the infrastructure – quell demand for those resources elsewhere – that is, create some unemployment. How? By increasing taxes.

So to answer the question correctly, you need to understand the role that taxes play in a fiat currency system.

In a fiat monetary system the currency has no intrinsic worth. Further the government has no intrinsic financial constraint. Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. The starting point of this new understanding is that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

In this way, it is clear that the imposition of taxes creates unemployment (people seeking paid work) in the non-government sector and allows a transfer of real goods and services from the non-government to the government sector, which in turn, facilitates the government’s economic and social program.

The crucial point is that the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. Accordingly, government spending provides the paid work which eliminates the unemployment created by the taxes.

So it is now possible to see why mass unemployment arises. It is the introduction of State Money (government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages).

Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account, but doesn’t desire to spend all it earns, other things equal. As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

The purpose of State Money is for the government to move real resources from private to public domain. It does so by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets). From the previous paragraph it is also clear that if the Government doesn’t spend enough to cover taxes and desire to save the manifestation of this deficiency will be unemployment.

Keynesians have used the term demand-deficient unemployment. In our conception, the basis of this deficiency is at all times inadequate net government spending, given the private spending decisions in force at any particular time.

So the answer should now be obvious. If the economy is to remain at full employment the government has to command private resources. Taxation is the vehicle that a sovereign government uses to “free up resources” so that it can use them itself. But taxation has nothing to do with “funding” of the government spending.

To understand how taxes are used to attenuate demand please read this blog – Functional finance and modern monetary theory.

The following blogs may be of further interest to you:

Question 3:

The automatic stabilisers work in a counter-cyclical fashion and ensure that the government fiscal balance returns to its appropriate level following a recession.

The answer is False.

The factual statement in the proposition is that the automatic stabilisers do operate in a counter-cyclical fashion when economic growth resumes. This is because tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this increases when there is an economic slowdown.

The question is false though because this process while important may not ensure that the government fiscal balance returns to its appropriate level.

The automatic stabilisers just push the fiscal balance towards deficit, into deficit, or into a larger deficit when GDP growth declines and vice versa when GDP growth increases. These movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

We also measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

This decomposition provides (in modern terminology) the structural (discretionary) and cyclical fiscal balances. The fiscal components are adjusted to what they would be at the potential or full capacity level of output.

So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the fiscal balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.

If the fiscal outcome is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual fiscal outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently.

So you could have a downturn which drives the fiscal outcome into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal outcome and it arises because the economy is deviating from its potential.

In some of the blogs listed below I go into the measurement issues involved in this decomposition in more detail. However for this question it these issues are less important to discuss.

The point is that structural fiscal balance has to be sufficient to ensure there is full employment. The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work for all of us to advance public purpose.

In this context, one of the most important elements of public purpose that the state has to maximise is employment. Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment.

Given the non-government sector will typically desire to net save (accumulate financial assets in the currency of issue) over the course of a business cycle this means that there will be, on average, a spending gap over the course of the same cycle that can only be filled by the national government. There is no escaping that.

So then the national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a fiscal surplus will be possible.

But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the fiscal outcome towards increasing deficits.

Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The fiscal outcome will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.

So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – which I define as 2 per cent unemployment and zero underemployment.

Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).

So it will not always be the case that the dynamics of the automatic stabilisers will leave a structural deficit sufficient to finance the saving desire of the non-government sector at an output level consistent with full utilisation of resources.

The following blogs may be of further interest to you:

That is enough for today!

(c) Copyright 2018 William Mitchell. All Rights Reserved.

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    2 Responses to The Weekend Quiz – January 6-7, 2017 – answers and discussion

    1. Chris Herbert says:

      My view regarding question number one is that the ‘full capacity’ position has never been reached. I cannot recall exactly when Keynes wrote this, but in effect he said classical economic theory could only be true at full capacity, which never exists.

    2. CS says:

      I appreciate the long explanations that always remind me that there’s a lot more to each answer than the basic mmt ideas that I think I now get.

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