The Weekend Quiz – March 16-17, 2019 – 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:

The only way that unbalanced external accounts across nations (some countries with surpluses and other deficits) can exist is because the surplus countries desire to hold financial assets denominated in the currency of the deficit countries.

The answer is True.

Many economists do not fully understand how to interpret the balance of payments in a fiat monetary system. For example, most will associate the rise in the current account deficit (exports less than imports plus net invisibles) with an outflow of capital. They then argue that the only way Australia (if we use it as an example) can counter this is if Australian financial institutions borrow from abroad.

They then assume that this is a problem because it means, allegedly, that Australia is “living beyond its means”. It it true that the higher the level of Australian foreign debt, the more its economy becomes linked to changing conditions in international credit markets. But the way this situation is usually constructed is dubious.

First, exports are a cost – a nation has to give something real to foreigners that it we could use domestically – so there is an opportunity cost involved in exports.

Second, imports are a benefit – they represent foreigners giving a nation something real that they could use themselves but which the local economy will benefit from having. The opportunity cost is all theirs!

So, on balance, if a nation can persuade foreigners to send more ships filled with things than it has to send in return (net export deficit) then that is a net material benefit to the local economy.

We say the real terms of trade are in the importing nations favour.

I am abstracting from all the arguments (valid mostly!) that says we cannot measure welfare in a material way. I know all the arguments that support that position and largely agree with them.

So how can we have a situation where foreigners are giving up more real things than they get from the local economy (in a macroeconomic sense)?

The answer lies in the fact that the local nation’s current account deficit “finances” the desire of foreigners to accumulate net financial claims denominated in $AUDs.

Think about that carefully.

The standard conception is exactly the opposite – that the foreigners finance the local economy’s profligate spending patterns.

In fact, the local trade deficit allows the foreigners to accumulate these financial assets (claims on the local economy).

The local economy gains in real terms – more ships full coming in than leave! – and foreigners achieve their desired financial portfolio. So in general that seems like a good outcome for all.

The problem is that if the foreigners change their desire to accumulate financial assets in the local currency then they will become unwilling to allow the “real terms of trade” (ships going and coming with real things) to remain in the local nation’s favour.

Then the local econmy has to adjust its export and import behaviour accordingly. If this transition is sudden then some disruptions can occur. In general, these adjustments are not sudden.

This bi-lateral example extends to multi-lateral situations which become more complicated in terms of who is holding what but the underlying principle is the same.

A net exporting must be desiring to accumulate financial assets denominated in the currencies of the nations it runs surpluses with. It may then trade these assets for other claims (not necessarily in the original currency) but that doesn’t alter the basic motivation.

The following blogs may be of further interest to you:

Question 2:

Like anything in abundance, it is true that when there is more “money” in the economy its value declines.

The answer is False.

While there are rare situations where the statement might hold, the categorical “it is true” is incorrect.

The question requires you to: (a) understand the difference between bank reserves and the money supply; and (b) understand the Quantity Theory of Money.

The mainstream macroeconomics text book argument that increasing the money supply will cause inflation is based on the Quatity Theory of Money. First, expanding bank reserves will put more base money into the economy but not increase the aggregates that drive the alleged causality in the Quantity Theory of Money – that is, the various estimates of the “money supply”.

Second, even if the money supply is increasing, the economy may still adjust to that via output and income increases up to full capacity. Over time, as investment expands the productive capacity of the economy, aggregate demand growth can support the utilisation of that increased capacity without there being inflation.

In this situation, an increasing money supply (which is really not a very useful aggregate at all) which signals expanding credit will not be inflationary.

So the Maybe relates to the situation that might arise if nominal demand kept increasing beyond the capacity of the real economy to absorb it via increased production. Then you would get inflation and the “value” of the dollar would start to decline.

The Quantity Theory of Money which in symbols is MV = PQ but means that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and Q is always at full employment as a result of market adjustments.

In applying this theory the mainstream deny the existence of unemployment. The more reasonable mainstream economists admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.

In general, the Monetarists (the most recent group to revive the Quantity Theory of Money) claim that with V and Q fixed, then changes in M cause changes in P – which is the basic Monetarist claim that expanding the money supply is inflationary. They say that excess monetary growth creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).

One of the contributions of Keynes was to show the Quantity Theory of Money could not be correct. He observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed. There is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will react to the increased nominal demand by increasing output.

The mainstream have related the current non-standard monetary policy efforts – the so-called quantitative easing – to the Quantity Theory of Money and predicted hyperinflation will arise.

So it is the modern belief in the Quantity Theory of Money is behind the hysteria about the level of bank reserves at present – it has to be inflationary they say because there is all this money lying around and it will flood the economy.

Textbook like that of Mankiw mislead their students into thinking that there is a direct relationship between the monetary base and the money supply. They claim that the central bank “controls the money supply by buying and selling government bonds in open-market operations” and that the private banks then create multiples of the base via credit-creation.

Students are familiar with the pages of textbook space wasted on explaining the erroneous concept of the money multiplier where a banks are alleged to “loan out some of its reserves and create money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations.

Please read my blog post – Money multiplier and other myths – for more discussion on this point.

The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the central bank does not have the capacity to control the money supply. We have regularly traversed this point. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

So when we talk about quantitative easing, we must first understand that it requires the short-term interest rate to be at zero or close to it. Otherwise, the central bank would not be able to maintain control of a positive interest rate target because the excess reserves would invoke a competitive process in the interbank market which would effectively drive the interest rate down.

Quantitative easing then involves the central bank buying assets from the private sector – government bonds and high quality corporate debt.

So what the central bank is doing is swapping financial assets with the banks – 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.

For the monetary aggregates (outside of base money) to increase, the banks would then have to increase their lending and create deposits.

This is at the heart of the mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment.

The recent experience (and that of Japan in 2001) showed that quantitative easing does not succeed in doing this.

This should come as no surprise at all if you understand Modern Monetary Theory (MMT).

The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves.

That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.

The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards.

If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window.

They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

Those that claim that quantitative easing will expose the economy to uncontrollable inflation are just harking back to the old and flawed Quantity Theory of Money.

This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase.

Should quantitative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.

So the fact that large scale quantitative easing conducted by central banks in Japan in 2001 and now in the UK and the USA has not caused inflation does not provide a strong refutation of the mainstream Quantity Theory of Money because it has not impacted on the monetary aggregates.

The fact that is hasn’t is not surprising if you understand how the monetary system operates but it has certainly bedazzled the (easily dazzled) mainstream economists.

The following blogs may be of further interest to you:

Question 3:

The imposition of a fiscal rule at the national government level that the fiscal position is required to be in balance at all times would eliminate fiscal swings driven by the automatic stabilisers.

The answer is False.

The final fiscal outcome 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:

Budget Balance = Revenue – Spending = (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 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.

The first point to always be clear about then is that the fiscal balance is not determined by the government. Its discretionary policy stance certainly is an influence but the final outcome will reflect non-government spending decisions. In other words, the concept of a fiscal rule – where the government can set a desired balance (in the case of the question – zero) and achieve that at all times is fraught.

It is likely that in attempting to achieve a balanced fiscal position the government will set its discretionary policy settings counter to the best interests of the economy – either too contractionary or too expansionary.

If there was a balanced fiscal rule and private spending fell dramatically then the automatic stabilisers would push the fiscal position into the direction of deficit. The final outcome would depend on net exports and whether the private sector was saving overall or not. Assume, that net exports were in deficit (typical case) and private saving overall was positive. Then private spending declines.

In this case, the actual fiscal outcome would be a deficit equal to the sum of the other two balances.

Then in attempting to apply the fiscal rule, the discretionary component of the fiscal position would have to contract. This contraction would further reduce aggregate demand and the automatic stabilisers (loss of tax revenue and increased welfare payments) would be working against the discretionary policy choice.

In that case, the application of the fiscal rule would be undermining production and employment and probably not succeeding in getting the fiscal position into balance.

But every time a discretionary policy change was made the impact on aggregate demand and hence production would then trigger the automatic stabilisers via the income changes to work in the opposite direction to the discretionary policy shift.

You might like to read these blogs for further information:

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.

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    10 Responses to The Weekend Quiz – March 16-17, 2019 – answers and discussion

    1. Adam K says:

      Dear Bill,
      Unfortunately I disagree with the statement that “The only way that unbalanced external accounts across nations (some countries with surpluses and other deficits) can exist is because the surplus countries desire to hold financial assets denominated in the currency of the deficit countries.” This might be true for the US, Australia and the UK. Sadly, a lot of developing countries have accumulated unsustainable levels of dollar-denominated debt and succumbed to virtual slavery to (mostly) American financial (and political) institutions. This explains the “America’s exorbitant privilege” (Valéry Giscard d’Estaing). Virtually nobody would hold financial assets denominated in the currency of a developing deficit country and a lot of these countries run unsustainable trade deficits often as a result of bad luck or failed investment policies (often caused by corruption). It is easy to say “just do not borrow in USD”. But it happens anyway. This is precisely what happened in Poland (and Romania) in the 1970s. One of the reasons the so-called socialist economic system collapsed there in the late 1970s – 1980s was an increase in the interest rates on the foreign-denominated debt and a change in the terms of trade (Poland was mainly exporting commodities then). We cannot just ignore or gloss over these issues. It wasn’t marginal. It was and it is at the core of the global historic and socioeconomic processes. Turkey and Venezuela are good examples that foreign dollar-denominated debt still matters. China is an example of a country which has built a stock of foreign reserves large enough to withstand a so-called market pressure in 2015 or 2018. But what about the Belt and Road? Do all the roads lead to Hambantota? Is there no historic alternative to the clash of two “super-imperialisms”?
      Now about the “hard numbers”. Regarding the corporate sector US dollar-denominated debt, RBA published a paper in 2015, “US Dollar Debt of Emerging Market Firms”. While some debt is naturally hedged, some is not. The stock of corporate debt in mid-2015 was about US$3.1.
      According to an article in “Market Watch” from Aug 23, 2018 “In its latest quarterly report, the Bank of International Settlements found that U.S. denominated debt to non-bank borrowers reached $11.5 trillion in March 2018 — the highest recorded total in the 55 years the bank has been tracking it.”

    2. Mel says:

      So would it be fair to regard “desire to hold” as a loaded phrase? That it would be better to say “are willing to hold”, or “are resigned to holding”, or “are unable to escape holding”?

    3. Jerry Brown says:

      For question 1. So I have come up with a couple of arguments why the answer could be ‘False’. The first is that there is some element of time involved in any trade. The seller of any good may not desire to hold the currency he receives in exchange for the good at the time of the sale. And will end up holding the currency for some short time period more or less involuntarily at that point. But the trade deficit takes place immediately upon the sale. I’m not sure this is much of an argument.

      But my better argument is that the seller could exchange his currency proceeds for say houses or land or corporate stock shares in the deficit country. He is not holding the currency and the trade deficit imbalance is still occurring. The wealth of the deficit country is declining. Theoretically, this could go on for a long time depending on the stock of assets owned by the deficit country.

    4. Adam K says:

      Dear Jerry,
      Let us consider 2 economic entities, A and B. If there is an imbalance in trade between A and B, borrowing / lending must occur as a matter of accounting identity. Please draw balance sheets for A and B. Every single transaction changes 4 cells, assets and liabilities/equity positions of A and B. Any transaction must also not upset the balance Assets=Liabilities+Equity for both A and B. We can have multiple transactions and we look at the state of the balance sheets at the end of the experiment. If A sells more consumer goods and B sells more real assets, for example land, to offset it then there is no imbalance in the external accounts. Only if A sells more goods and B doesn’t offset it then A accumulates financial claims on B (B owes A some “money”). Now let us assume that A and B are countries. The objection which I raised is whether claims are denominated in the currency of B or whether it can be the currency of A (or something else, like gold). The question was whether “surplus countries desire to hold financial assets denominated in the currency of the deficit countries”. In your example if I understand it correctly, there is no surplus/deficit.

    5. Jerry Brown says:

      Yes Adam K, if the sale of real assets like land count as part of the ‘external account balance’, then my argument would be wrong. Hopefully they don’t count or at least not in this instance. I will argue they don’t count in this situation. Don’t ask my reasoning please :)
      Anyways- you’re ruining my chances of getting partial credit on this. I figure that if I make enough arguments Bill will eventually give me credit for at least one of my wrong answers. Hasn’t happened yet but I still have some hope. Just because that hope has been crushed numerous times does not mean I have given up yet.

    6. Mel says:

      I’d like to see your reasoning. It would be buying and selling by foreigners.

      The loophole I could imagine is that we could define the external sector as buyers and sellers who use the national currency but don’t live under control of the national laws; then foreigners who bring their export receipts back to buy real estate or businesses could be said to join the domestic sector. But then the money they spend should be counted as foreign direct investment, and make up part of the net invisibles that subtract from the amount of money spent offshore to calculate the trade balance.

    7. Jerry Brown says:

      Mel, I’ve been arguing all day with people who are smarter than me and better at arguing than I am. So why stop now. At least you haven’t questioned my integrity. Although here at this time that would be a reasonable question just because of the quiz thing and my desire to have Bill admit I might possibly be right about something at some point. Even just once.

      But back to the topic- I admit right away that I don’t know if when a foreign company or individual buys a piece of property just how that would be accounted for in the ‘external account balance’. So most of my reasoning is going to be based on hopefulness and some maybe-type logic.

      So I’m thinking it is really difficult to export land to a different country. Maybe there is a ship that can manage that but I don’t know about it. And so since the land will pretty much remain inside the country no matter who owns it, then that sale would not be part of the ‘external’ balance. This is the shaky part of my argument. But not the shipping part of the land- I think I am on firm ground there :)

      So if that land asset sale does not count as an ‘external’ thing (and why should it) then my argument is good. I think. And just in case this is totally wrong- I warned ahead of time not to ask for my reasoning.

    8. Kingsley Lewis says:

      A couple of additional possibilities are listed below:
      A current account deficit can be “balanced” in the capital account by:
      – a. Loans with interest and repayments denominated in the borrower’s currency
      (This requires “a desire to hold financial assets denominated in the currency of the deficit countries” as described by Prof. Mitchell)
      – b. Portfolio investment by foreigners
      (This requires “a desire to hold financial assets denominated in the currency of the deficit countries” as described by Prof. Mitchell)
      – c. Loans with interest and repayments denominated in a foreign currency
      (Described by Adam K above)
      -d. Direct foreign investment, e.g. property purchases by foreigners
      (Mentioned above by Jerry Brown)
      -e. Decline in reserves of foreign exchange and precious metals
      -f. Sale of foreign assets, e.g. from a Sovereign Wealth fund.

    9. Mel says:

      I think of this blog as a kind of graduate seminar, where somebody has left the door open, and people like me can wander in, and sometimes butt in. We are doing each other favors by presenting and developing our arguments.
      I just came from that blowout 38-comment thread at the other good economics blog. What a mess!

    10. Richard Genz says:

      Bill: “the local nation’s current account deficit “finances” the desire of foreigners to accumulate net financial claims denominated in $AUDs.”

      This one trips me up so I’ll try to think of it operationally, like MMT does. Start with the actual exporting firms. A Korean auto company desires to maximize profit. It sees a market in Australia. It knows its cars will be bought with $AUD. The firm needs Korean Won to pay its workers and suppliers, so it exchanges the $AUD for Won at the Central Bank. The Central Bank then invests the $AUD in Australian securities.

      At the level of the firm, there’s no desire for Australian dollar assets. But there must be a willingness on the part of the Korean Central Bank to hold them. Otherwise, I suppose the terms of the currency swap between the automaker and the CB could make exporting cars to Australia unprofitable.

      So at the apex of an exporting country’s financial system, the central bank, there must indeed be a desire to accumulate net financial assets denominated in the local (importing) economy’s currency.

      Have I got this straight?

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