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The Weekend Quiz – December 1-2, 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:

From the US National Accounts, you find that in 2006, the share of Personal consumption expenditure in real GDP was 69.9 per cent and by 2008 it had fallen to 69.8 per cent. Similarly, the share of Gross private domestic investment on real GDP was 17.2 per cent in 2006 and by 2008 had fallen to 14.9 per cent (and further to 11.8 per cent in 2009). The net export deficit over the same period (2006 to 2008) fell from -5.7 per cent of real GDP to -4.9 per cent in 2008. Finally, the share of Government consumption expenditures and gross investment in real GDP rose from 18.8 per cent in 2006 to 18.9 per cent in 2008 (and 19.7 per cent in 2009). These relative changes tell you that real GDP was lower in 2008 compared to 2006 because the increase in Government spending and the falling negative contribution of net exports were not sufficient to offset the declining contribution from consumption and investment.

The answer is False.

The detail in the question relates to expenditure shares in real GDP and clearly does not tell you anything about the growth in GDP. All that you are being told are that the shares are changing over the period 2006 to 2008 in favour of public spending.

The shares are given by the following equation:

where A(t) is the value of aggregate A in quarter under consideration (say Personal consumption expenditure) and GDP(t) is the value of GDP in the same quarter.

So a change in the public spending share from 18.8 per cent in 2006 to 18.9 per cent in 2008 just says that in 2008 the flow of public spending is a greater proportion of the flow of real output in 2008 than it was in 2006. The rising share could be associated with a declining, constant or growing real GDP.

The fact you know that over this time that real GDP growth in the US was falling is irrelevant – the question asks whether you can conclude from the information before you.

The other related measure is the contributions to GDP growth which tell you each quarter what the expenditure components contributed to the GDP growth in that quarter.

From the Australian National Accounts – December 2009 you can find the definition of the contributions to GDP growth which is represented by the following equation:

where A(t) is as before; A(t-1) – value of aggregate A in previous quarter; and GDP(t-1) – value of GDP in previous quarter.

The ABS indicate that “the contributions to growth of the components of GDP do not always add exactly to the growth in GDP. This can happen as a result of rounding and the lack of additivity of the chain volume estimates prior to the latest complete financial year.

From the US National Accounts data you see that real GDP grew in 2005-06 by 2.7 per cent; then slowed to 2.1 per cent in 2006-07, 0.4 per cent in 2007-08 and plunged to -2.4 per cent in 2008-09. Over the period 2006-2008, real GDP grew overall by 2.6 per cent. The following table breaks down the contributions to that growth by the individual spending components (computed as per the Equation above).

The point of the question (if any) is to warn you into being careful to clarify the concepts being used before drawing conclusions. Too many people think they know what these terms mean and either mis-use them themselves to reach erroneous conclusions or allow themselves to be fooled by others who are touting erroneous conclusions.

If you are interested in more detail on national accounts then the 5216.0 – Australian National Accounts: Concepts, Sources and Methods, 2000 – is the place to go. Recommended reading if you want to get all the concepts and stock-flow relationships really sorted out. The system is universal and used by all statistical agencies.

Question 2:

The solvency risk facing Eurozone nations such as Italy at present is sourced in the restrictions imposed on fiscal deficit and debt ratios by the Stability and Growth Pact and the Fiscal Compact, which member states voluntarily agreed to when they entered into as part of their membership of the common currency.

The answer is False.

The Stability and Growth Pact which is summarised as imposing a rule on EMU member countries that their fiscal deficits cannot exceed 3 per cent of GDP rule and their public debt to GDP ratio cannot exceed 60 per cent. In the links provided below you will find extensive analysis of the nonsensical nature of these rules.

The Fiscal Compact was designed to make the SGP even more restrictive.

Both the SGP and the Fiscal Compact, which came later, during the crisis, were designed to place nationally-determined fiscal policy in a straitjacket to avoid the problems that would arise if some runaway member states might follow a reckless spending policy, which in its turn would force the ECB to increase its interest rates.

Germany, in particular, wanted fiscal constraints put on countries like Italy and Spain to prevent reckless government spending which could damage compliant countries through higher ECB interest rates.

In a 2006 book I published with Joan Muysken and Tom Van Veen – Growth and cohesion in the European Union: The Impact of Macroeconomic Policy – we showed that it is widely recognised that these figures were highly arbitrary and were without any solid theoretical foundation or internal consistency.

The GFC exposed the myth that the SGP would provide a platform for stability and growth in the EMU.

In my 2008 book (published just before the crisis) with Joan Muysken – Full Employment abandoned – we provided evidence to support the thesis that the SGP failed on both counts – it had provided neither stability nor growth.

The GFC echoed that claim very loudly.

The rationale of controlling government debt and fiscal deficits were consistent with the rising neo-liberal orthodoxy that promoted inflation control as the macroeconomic policy priority and asserted the primacy of monetary policy (a narrow conception notwithstanding) over fiscal policy.

Fiscal policy was forced by this inflation first ideology to become a passive actor on the macroeconomic stage.

But these rules, while ensuring that the EMU countries will have to live with high unemployment and depressed living standards (overall) for years to come are not the reason that the EMU countries risk insolvency.

That risk arises from the fact that when they entered the EMU system, they ceded their currency sovereignty to the European Central Bank (ECB) which had several consequences.

First, EMU member states now share a common monetary stance and cannot set interest rates independently. The former central banks – now called National Central Banks are completely embedded into the ECB-NCB system that defines the EMU.

Second, they no longer have separate exchange rates which means that trade imbalances have to be dealt with in monetary terms not in relative price changes.

Third, and most importantly, the member governments cannot create their own currency and as a consequence can run out of euros!

So imagine there was a bank run occuring in Australia or the UK.

While this situation would signal mass frenzy, the Australian or British governments have the infinite capacity to guarantee all deposits denominated in $A or £, should they choose to do so.

If the superannuation industry collapsed in Australia, the Australian government could just guarantee all retirement incomes denominated in $A if it choose to do so. The same goes for any sovereign government (including the US and the UK).

But an EMU member government could not do this and their banking or public pension systems could become insolvent.

Further, it could reach a situation where it did not have enough euros available (via taxation revenue or borrowing) to repay its debt commitments (either retire existing debt on maturity or service interest payments). In that sense, the government itself would become insolvent.

A sovereign government such as Australia or the US could never find itself in that sort of situation – they are never in risk of insolvency.

So the source of the solvency risk problem is not the stupid fiscal rules that the EMU nations have placed on themselves but the fact they have ceded currency sovereignty.

The following blogs may be of further interest to you:

Question 3:

Take the following situation reported in a nation’s Labour Force data. Employment grew by only 400 in net terms in the previous month. Other highlights were that unemployment rose by 10,700 and that the labour force participation rate fell by 0.1 per cent. Taken together this data tells you that:

(a) The labour force grew faster than employment but not as fast the working age population.

(b) The working age population grew faster than employment and offset the decline in the labour force arising from the drop in the participation rate.

(c) The labour force grew faster than employment but you cannot tell what happened to the working age population from the information provided.

The answer is Option (a) The labour force grew faster than employment but not as fast the working age population.

If you didn’t get this correct then it is likely you lack an understanding of the labour force framework which is used by all national statistical offices.

The labour force framework is the foundation for cross-country comparisons of labour market data. The framework is made operational through the International Labour Organization (ILO) and its International Conference of Labour Statisticians (ICLS). These conferences and expert meetings develop the guidelines or norms for implementing the labour force framework and generating the national labour force data.

The rules contained within the labour force framework generally have the following features:

  • an activity principle, which is used to classify the population into one of the three basic categories in the labour force framework;
  • a set of priority rules, which ensure that each person is classified into only one of the three basic categories in the labour force framework; and
  • a short reference period to reflect the labour supply situation at a specified moment in time.

The system of priority rules are applied such that labour force activities take precedence over non-labour force activities and working or having a job (employment) takes precedence over looking for work (unemployment). Also, as with most statistical measurements of activity, employment in the informal sectors, or black-market economy, is outside the scope of activity measures.

Paid activities take precedence over unpaid activities such that for example ‘persons who were keeping house’ as used in Australia, on an unpaid basis are classified as not in the labour force while those who receive pay for this activity are in the labour force as employed.

Similarly persons who undertake unpaid voluntary work are not in the labour force, even though their activities may be similar to those undertaken by the employed.

The category of ‘permanently unable to work’ as used in Australia also means a classification as not in the labour force even though there is evidence to suggest that increasing ‘disability’ rates in some countries merely reflect an attempt to disguise the unemployment problem.

The following diagram shows the complete breakdown of the categories used by the statisticians in this context. The definitions vary a little across nations, but essentially this framework is universal.

The yellow boxes are relevant for this question.

So the Working Age Population (WAP) is usually defined as those persons aged between 15 and 65 years of age or increasing those persons above 15 years of age (recognising that official retirement ages are now being abandoned in many countries).

As you can see from the diagram the WAP is then split into two categories: (a) the Labour Force (LF) and; (b) Not in the Labour Force – and this divisision is based on activity tests (being in paid employed or actively seeking and being willing to work).

The Labour Force Participation Rate is the percentage of the WAP that are active. So if the participation rate overall is 65.2 per cent this means that 65.2 per cent of those persons above the working age are actively engaged in the labour market (either employed or unemployed).

You can also see that the Labour Force is divided into employment and unemployment. Most nations use the standard demarcation rule that if you have worked for one or more hours a week during the survey week you are classified as being employed.

If you are not working but indicate you are actively seeking work and are willing to currently work then you are considered to be unemployed. If you are not working and indicate either you are not actively seeking work or are not willing to work currently then you are considered to be Not in the Labour Force.

So you get the category of hidden unemployed who are willing to work but have given up looking because there are no jobs available. The statistician counts them as being outside the labour force even though they would accept a job immediately if offered.

The question gave you information about employment, unemployment and the labour force participation rate and you had to deduce the rest based on your understanding.

In terms of the Diagram the following formulas link the yellow boxes:

Labour Force = Employment + Unemployment = Labour Force Participation Rate times the Working Age Population

It follows that the Working Age Population is derived as Labour Force divided by the Labour Force Participation Rate (appropriately scaled in percentage point units).

So if both Employment and Unemployment is growing then you can conclude that the Labour Force is growing by the sum of the extra Employment and Unemployment expressed as a percentage of the previous Labour Force.

The Labour Force can grow in one of four ways:

  • Working Age Population growing with the labour force participation rate constant;
  • Working Age Population growing and offsetting a falling labour force participation rate;
  • Working Age Population constant and the labour force participation rate rising;
  • Working Age Population falling but being offset by a rising labour force participation rate.

So in our case, if the Participation Rate is falling then the proportion of the Working Age Population that is entering the Labour Force is falling. So for the Labour Force to be growing the Working Age Population has to be growing faster than the Labour Force.

But given both employment and unemployment are rising, we know the labour force is rising despite the falling participation rate.

So this must mean that the Working Age Population is growing and offsetting a falling labour force participation rate.

Of the second option:

The working age population grew faster than employment and offset the decline in the labour force arising from the drop in the participation rate.

Clearly impossible if both employment and unemployment both rose.

And of the third option:

The labour force grew faster than employment but you cannot tell what happened to the working age population from the information provided.

Clearly you can tell what happened to the working age population by deduction.

That is enough for today!

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

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    This Post Has 3 Comments
    1. Thanks for good explanations. The first two I was on the right track.The ratio stuff in labour forces etc should be straight forward but somehow I struggle to clearly work out the overall impact of different rates of growth/decline, how one offsets the other etc. Area to work on to fill in the hours whilst underemployed

    2. I could kick myself for missing Q1. While reading the question I was clear enough in my thinking……Nothing behavioral here, no causation etc. Yet at the end, I fell into the “what appeared to be logical” trap……What a good warning that question was.

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