The Weekend Quiz – March 24-25, 2018 – 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:

One interpretation of the sectoral balances decomposition of the national accounts, is that it is impossible for all governments (in all nations) to run public surpluses without impairing growth because it is likely that the private domestic sector in some countries will desire to save overall.

The answer is False.

The question has one true statement in it which if not considered in relation to the rationale for the true statement would lead one to answer True. But the rationale presented in the question is false and so the overall question is false.

The true statement is that “it is impossible for all governments (in all nations) to run public surpluses without impairing growth”. The false rationale then is that the reason the first statement is true is “because it is likely that the private domestic sector in some countries will desire to save overall”.

To refresh your memory the sectoral 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.

So you might have been thinking that because the private domestic sector desired to save, then the government would have to be in deficit and hence the answer was true. But, of-course, the private domestic sector is only one part of the non-government sector – the other being the external sector.

Most countries currently run external deficits. This means that if the government sector is in surplus the private domestic sector has to be in deficit.

However, some countries have to run external surpluses if there is at least one country running an external deficit. That country can depending on the relative magnitudes of the external balance and private domestic balance, run a public surplus while maintaining strong economic growth. For example, Norway.

In this case an increasing desire to save by the private domestic sector in the face of fiscal drag coming from the fiscal surplus can be offset by a rising external surplus with growth unimpaired. So the decline in domestic spending is compensated for by a rise in net export income.

So it becomes obvious why the rationale is false and the overall answer to the question is false.

It is impossible for all governments (in all nations) to run public surpluses without impairing growth because not all nations can run external surpluses. For nations running external deficits (the majority), public surpluses have to be associated (given the underlying behaviour that generates these aggregates) with private domestic deficits.

These deficits can keep spending going for a time but the increasing indebtedness ultimately unwinds and households and firms (whoever is carrying the debt) start to reduce their spending growth to try to manage the debt exposure. The consequence is a widening spending gap which pushes the economy into recession and, ultimately, pushes the fiscal outcome into deficit via the automatic stabilisers.

Please read my blogs – Stock-flow consistent macro modelsBarnaby, better to walk before we runNorway and sectoral balancesThe OECD is at it again! – for more discussion on the sectoral balances.

So you can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus. Clearly not every country can adopt this strategy given that the external positions net out to zero themselves across all trading nations. So for every external surplus recorded there has to be equal deficits spread across other nations.

Question 2:

A rising government deficit will always allow the private domestic sector to increase its saving in nominal terms.

The answer is False.

This answer should be read as a complement to the discussion in Question 2 as it also can be considered in terms of the sectoral balances.

If the external balance is zero (that is, net exports equal zero) the there is a one-to-one correspondence between the government balance and the private domestic sector balance such that, for example, a 2 per cent fiscal deficit must be associated with a 2 per cent private domestic sector balance surplus.

So in this circumstance the answer would be true.

But things get complicated when we introduce positive or negative external balances. Then a 2 per cent fiscal deficit might be associated with a 3 per cent external deficit and so the private domestic sector balance will be in deficit.

So the answer is only true if the fiscal deficit is larger (as a percent of GDP) than the external balance and growing faster.

Question 3:

A rising government deficit indicates an expansionary shift in policy and 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.

The answer is False.

Again 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:

That is enough for today!

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

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    One Response to The Weekend Quiz – March 24-25, 2018 – answers and discussion

    1. ThorLeif says:

      “So you can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough.”

      Like Sweden for example!

      I misread Question 1 by not recognizing “it was about a closed world economy”(the total world sectors).

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