The Weekend Quiz – July 7-8, 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:

Modern Monetary Theory (MMT) recognises that the unemployed live of the hard work of those that are employed.

The answer is True.

Dispensing with the emotional trappings that this sort of claim might invoke (that is, judging individual motivation etc), this question explores the true relevance of the dependency ratio, which will rise as demographic changes age our populations. It also aims to disabuse the reader of the notion that the income support benefits are paid for by taxes that those in employment (and other income generating activities) might pay.

Initially, we have to be very clear as to what “living off the hard work of those who pay taxes” means. In this sense, it is not a focus on the “income” that the non-workers receive but the command over real good and services that that income provides them with. We will come back to the “funds” issue soon.

So the focus has to be on the real side of the economy because that is, ultimately, the only way our material living standards can be expressed. Nominal aggregates mean very little by themselves.

Income support recipients (who do not work – for whatever reason) clearly command real resources that they have not themselves produced. These real goods and services are produced by those who do work (and the presumption is that most workers pay taxes of some sort or another).

The use of the emotive term “living off the hard work” was deliberate and designed, as a foil, to invoke the idea that governments have created welfare states which provide unsustainable benefits to the poor and marginalised at the expense of those who are materially successful – the classic conservative argument against government welfare provision.

But it doesn’t alter the truth of the statement.

A slight complicating factor is that the income support recipients also pay taxes if there are indirect tax systems in place but that doesn’t alter the story about the provision of real goods and services.

Now the second part of the answer relates to the question of funding. In terms of where the funds come from to provide the income support for those who do not work the answer is simple: no-where.

While taxation raises revenue for national governments it doesn’t “fund” its spending. Currency-issuing governments can spend without revenue should they wish to.

Abba Lerner’s 1951 book The Economics of Employment was really a rewritten version of the 1941 article The Economic Steering Wheel where he elaborated his version of Keynesian thinking. He conceptualised macroeconomic policy as being about “steering” the fluctuations in the economy. Fiscal policy was the steering wheel and should be applied for functional purposes. Laissez-faire (free market) was akin to letting the car zigzag all over the road and if you wanted the economy to develop in a stable way you had to control its movement.

This led to the concept of functional finance and the differentiation from what he called sound finance (that proposed by the free market lobby). Sound finance was all about fiscal rules – the type you read about every day in the mainstream financial press. Sound finance is about balancing the fiscal position over the course of the business cycle and only increasing the money supply in line with the real rate of output growth; etc – noting the approach erroneously assumes the central bank can control the money supply.

Lerner thought that these rules were based more in conservative morality than being well founded ways to achieve the goals of economic behaviour – full employment and price stability.

He said that once you understood the monetary system you would always employ functional finance – that is, fiscal and monetary policy decisions should be functional – advance public purpose and eschew the moralising concepts that public deficits were profligate and dangerous.

Lerner thought that the government should always use its capacity to achieve full employment and price stability. In Modern Monetary Theory (MMT) we express this responsibility as “advancing public purpose”. In his 1943 book (page 354) we read:

The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound and what is unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance …

Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money,” etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability …

Mainstream advocacy of fiscal rules that are divorced from a functional context clearly do not make much sense even though their use dominates public policy these days. It may be that a fiscal surplus is necessary at some point in time – for example, if net exports are very strong and fiscal policy has to contract spending to take the inflationary pressures out of the economy. This will be a rare situation but in those cases I would as a proponent of MMT advocate fiscal surpluses.

Lerner outlined three fundamental rules of functional finance in his 1941 (and later 1951) works.

  • The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
  • By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
  • If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the fiscal position, or limiting the national debt, so much the worse for these principles. The government press shall print any money that may be needed to carry out rules 1 and 2.

So in an operational sense, taxation serves to reduce the spending capacity of the non-government sector to ensure that there is non-inflationary space for government to deliver public services. It doesn’t fund anything.

You might like to read these blogs for further information:

Question 2:

The accumulated spending build-up of annual fiscal deficits does not pose an inflation threat.

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.

Any flow of spending (public or private) can pose an inflation threat. But as long as the flow of net spending from the public sector is consistent with filling the non-government spending gap then a nation can absorb continuous fiscal deficits without inflationary pressures building.

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. A sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

The point is there is no such things an an “accumulated spending build-up” (a stock). Spending is a flow.

The following blogs may be of further interest to you:

Question 3:

Which scenario represents a more expansionary outcome:

(a) A fiscal deficit equivalent to 5 per cent of GDP (including the impact of automatic stabilisers equivalent to 3 per cent of GDP).

(b) A fiscal deficit equivalent to 3 per cent of GDP.

(c) You cannot tell because you do not know the decomposition between the cyclical and structural components in Option (B)

The answer is Option (a).

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 and how to correctly interpret a fiscal balance.

In outright terms, a fiscal deficit that is equivalent to 5 per cent of GDP is more expansionary than a fiscal deficit outcome that is equivalent to 3 per cent of GDP irrespective of the cyclical and structural components.

In that sense, the question lured you into thinking that only the discretionary component (the actual policy settings) were of interest. In that context, Option (c) would have been the correct answer.

To see the why Option (a) is the best answer 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:

Fiscal Balance = Revenue – Spending.

Fiscal 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 unambiguously points to Option (a) being the more expansionary impact – made up of a discretionary (structural) deficit of 2 per cent and a cyclical impact of 3 per cent. The cyclical impact is still expansionary – lower tax revenue and higher welfare payments.

Option (b) might in fact signal a higher structural deficit which would indicate a more expansionary fiscal intent from government but it could also indicate a large automatic stabiliser (cyclical) component.

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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    3 Responses to The Weekend Quiz – July 7-8, 2018 – answers and discussion

    1. PhilipO says:

      That explanation “seals the deal” for me. A very well designed foil Bill, It almost caught me out…..sneaky!

    2. Kent says:

      Bill or who ever can answer
      We know sovereign currency issuing entities are not currency space limited i.e the federal Australian goverment. In the case of the oz states who are currency users what could the states do to impliment the mmt goals of full emplyment with a job guarantee or is this restricted to the federal goverment only. The reason being the federal goverment current and future of both persuations appear to be neoliberal hard core LNP and neoliberal 100% ALP so the alternatives are non existent as we head down the worst path of the USA via outsource monopoly services to well connected mates, cutbacks in services and a general fall in the lived experience of the 99% the 1% appear to be doing very nicely!

    3. N says:

      Another point to consider about the first question: some of “the unemployed” (who live off the work of everyone else) are the idle rich: those of “independent means”.
      Also, some of the employed are doing useless (or even harmful) work which does not provide or produce anything that they or others can live off (not even indirect production by helping others do their jobs better). Those people also live off the work of others.
      On Q2, I believe I understand what’s going on, but I’m puzzled at the answer being “false”.
      The question asks about this statement: “The accumulated spending build-up of annual fiscal deficits does not pose an inflation threat.”
      We know the deficit is a flow which can contribute to risk of inflation: that’s clear and simple.
      That flow goes into a stock which can accumulate over time. (The stock might be “money” or “debt” depending on whether the government chooses to issue debt to match deficits.)
      My reading of the question is that it asks whether the size of this stock poses an an inflation threat. My understanding is that it does not, so the answer should be “true”.
      Alternatively, if we take the view that “there is no such thing as an accumulated spending build-up” then that non-existent thing cannot pose an inflation threat, so the answer should still be “true”.
      Kent, they might not be allowed under national/federal law, but in principle they could introduce their own currency, or something similar to a currency.
      They could pay it to their workers as part of the salary, and then start demanding local taxes paid in that currency (or maybe it would be enough just to give people the option to pay local taxes either in the local currency or in normal Australian dollars).

      A historical example, one which used “demurrage” (like a negative interest rate) to encourage people to spend the currency rather than accumulate it:
      See also

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