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The Weekend Quiz – March 30-31, 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:

Larger fiscal deficits as a percentage of GDP typically mean that there are less real resources available for other productive uses.

The answer is True.

It is clear that at any point in time, there are finite real resources available for production. New resources can be discovered, produced and the old stock spread better via education and productivity growth. The aim of production is to use these real resources to produce goods and services that people want either via private or public provision.

So by definition any sectoral claim (via spending) on the real resources reduces the availability for other users. There is always an opportunity cost involved in real terms when one component of spending increases relative to another.

Unless you subscribe to the extreme end of mainstream economics which espouses concepts such as 100 per cent crowding out via financial markets and/or Ricardian equivalence consumption effects, you will conclude that rising net public spending as percentage of GDP will add to aggregate demand and as long as the economy can produce more real goods and services in response, this increase in public demand will be met with increased public access to real goods and services.

You might also wonder whether it matters if the economy is already at full capacity.

Under these conditions a rising public share of GDP must squeeze real usage by the non-government sector which might also drive inflation as the economy tries to siphon of the incompatible nominal demands on final real output.

You might say that the deficits might rise as a percentage of GDP as a result of a decline in private spending triggering the automatic stabilisers which would suggest many idle resources. That is clearly possible but doesn’t alter the fact that the public claims on the total resources available have risen.

Under these circumstances the opportunity costs involved are very low because of the excess capacity.

The question really seeks to detect whether you have been able to distinguish between the financial crowding out myth that is found in all the mainstream macroeconomics textbooks and concepts of real crowding out.

The normal presentation of the crowding out hypothesis which is a central plank in the mainstream economics attack on government fiscal intervention is more accurately called “financial crowding out”.

At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

At the heart of this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.

This is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.

Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.

According to this theory, if there is a rising fiscal deficit then there is increased demand is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to “clear” the loanable funds market. This chokes off investment spending.

So allegedly, when the government borrows to “finance” its fiscal deficit, it crowds out private borrowers who are trying to finance investment. The mainstream economists conceive of this as the government reducing national saving (by running a fiscal deficit) and pushing up interest rates which damage private investment.

The analysis relies on layers of myths which have permeated the public space to become almost self-evident truths. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1Deficit spending 101 – Part 2Deficit spending 101 – Part 3.

The basic flaws in the mainstream story are that governments just borrow back the net financial assets that they create when they spend. Its a wash! It is true that the private sector might wish to spread these financial assets across different portfolios. But then the implication is that the private spending component of total demand will rise and there will be a reduced need for net public spending.

Further, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. But government spending by stimulating income also stimulates saving.

The flawed notion of financial crowding out has to be distinguished from other forms of crowding out which are possible. In particular, MMT recognises the need to avoid or manage real crowding out which arises from there being insufficient real resources being available to satisfy all the nominal demands for such resources at any point in time.

In these situation, the competing demands will drive inflation pressures and ultimately demand contraction is required to resolve the conflict and to bring the nominal demand growth into line with the growth in real output capacity.

The idea of real crowding out also invokes and emphasis on political issues. If there is full capacity utilisation and the government wants to increase its share of full employment output then it has to crowd the private sector out in real terms to accomplish that. It can achieve this aim via tax policy (as an example). But ultimately this trade-off would be a political choice – rather than financial.

The following blog posts may be of further interest to you:

Question 2:

For a nation running a current account deficit, income adjustments will ensure government fiscal position is in deficit if the domestic private sector seeks to increase its saving overall as a percentage of GDP.

The answer is True.

This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances.

Refreshing the balances (again) – we know that from an accounting sense, if the external sector overall is in deficit, then it is impossible for both the private domestic sector and government sector to run surpluses. One of those two has to also be in deficit to satisfy the accounting rules.

The important point is to understand what behaviour and economic adjustments drive these outcomes.

To refresh your memory the 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:

(1) 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 tax revenue minus total 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 net taxes (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) + CAB

which is interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAB > 0) generate national income and net financial assets for the private domestic sector.

Conversely, government surpluses (G – T < 0) and current account deficits (CAB < 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) – CAB] = (G – T)

where the term on the left-hand side [(S – I) – CAB] 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 what economic behaviour might lead to the outcome specified in the question?

If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative – that is net drain of spending – dragging output down.

Assume, now that the private domestic sector (households and firms) seeks to increase its saving ratio (as a percentage of GDP). Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income. The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.

The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction. But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract – output, employment and income all fall.

The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.

The declining income leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.

So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.

The decline in income then stifles firms’ investment plans – they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further towards and eventually into surplus

With the economy in decline, tax revenue falls and welfare payments rise which push the public fiscal balance towards and eventually into deficit via the automatic stabilisers.

If the private sector persists in trying to increase its saving ratio then the contracting income will clearly push the fiscal position into deficit.

So we would have an external deficit, a private domestic surplus and a fiscal deficit.

The following blog posts may be of further interest to you:

Question 3:

Higher levels of taxation permit the government to increase its real spending.

The answer is True.

The operative qualifier was ‘real’ in spending. Meaning that we are talking about increasing the non-inflationary claim on production rather than just an increase in nominal spending overall.

Clearly, I was tempting the reader to follow a logic such that – Modern Monetary Theory (MMT) shows that taxpayers do fund anything and sovereign governments are never revenue-constrained because they are the monopoly issuers of the currency in use. Therefore, the government can spend whatever it likes irrespective of the level of taxation. Therefore the answer is false.

But, that logic while correct for the most part ignores the underlying role of taxation.

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.

This train of logic also explains 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.

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).

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.

Accordingly, the concept of fiscal sustainability does not entertain notions that the continuous deficits required to finance non-government net saving desires in the currency of issue will ultimately require high taxes. Taxes in the future might be higher or lower or unchanged. These movements have nothing to do with “funding” government spending.

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

So to make the point clear – the taxes do not fund the spending. They free up space for the spending to occur in a non-inflationary environment.

You might say that this only applies at full employment where there are no free resources and so taxation has to take those resources off the non-government sector in order for the government to spend more. That would also be a true statement.

But it doesn’t negate the overall truth of the main proposition.

Further, you might say that governments can spend whenever they like.

That is also true but if it just kept spending the growth in nominal demand would outstrip real capacity and inflation would certainly result.

The following blog posts may be of further interest to you:

That is enough for today!

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

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    This Post Has 12 Comments
    1. Off topic but, it came to my mind while watching an economics youtube video.
      Would it help the policy makes and those [like me] who think about what policies we need to see adopted, for the 3 sectors to be increased to 4 by splitting the Private Sector into 2 parts?
      . . . One part would be the people, that is the households, small businesses and such.
      . . . The 2nd part is the Corporations and the 1% or the 0.1% who have most of the wealth.
      It seems to me that currently the corps. and 1% are getting most of the income and all of the income growth. And it seems they have no idea what to do with it that would either make them wealthier or even help the rest of us. So, they hoard it. They don’t invest it because they don’t see a likely return on the investment [because the rest of us lack the money to create economic-demand].

    2. For question 1.- The US is currently experiencing larger fiscal deficits. This is usually considered to be the result of the Trump tax cuts at least as much as any increase in government spending. Is it fair to say that larger deficits due to decreases in tax rates would not imply that less real resources are available for other purposes?

    3. Jerry,
      I’ll go out on a limb and say —
      Well, the tax cuts mean that there is more money in the Private Sector to spend in ways [other than paying their taxes] and so when they spend or invest it this will suck up more resources than if their taxes had not been cut.
      So, maybe there are actually less resources left after all spending at the end of the year.

    4. I think that Steve is making a valid and important point, and I hope that MMT economists will respond to it as they continue to refine their explanations of a fiat money economy. “The private sector as distinguished from the public sector” is simply too blunt and facile a conceptual framework to begin to capture the perverse character and dynamics of our current socioeconomic system, where a tiny fraction of “citizens” (individual and corporate) control an overwhelming amount of private sector resources and thereby acquire similar near-monopolistic control over the public sector. I love the overall clarity of the MMT lens, but here it seems to have a smudge that cries out for polishing.

    5. Thanks Steve. Yes it does seem reasonable that lower taxes would allow, and maybe lead to, the private sector increasing its demand for idle real resources. But that is not what I think the question actually asks.

      Question 1:
      Larger fiscal deficits as a percentage of GDP typically mean that there are less real resources available for other productive uses.

      I think the real issue in whether this statement is true or false is just how much of the total real resources available to the economy that the government is diverting towards its purposes through its spending.

      Assume the economic potential of the economy is the same in these two scenarios. Assume the government spending budget diverts 50% of this total potential to the public purpose and runs no deficit. That leaves 50% for the private sector to potentially use. Now alternate scenario- the government spending diverts 30% of potential through spending but only taxes 20% so there is a deficit. But 70% of those real resources are still available for the private sector to use. Whether they use them or not is irrelevant for this question. So the answer would be false in this case.

      But this case may not be ‘typical’. And I know that economies rarely use 100% of their available resources.

    6. I agree with Steve that the private sector needs to be split into two sub-sectors. In fact I constructed a spreadsheet some time ago that explained how the government can spend into the economy and then withdraw exactly the same amount in tax and bonds but still stimulate it. The thing is that the people who receive the monetary injection are not the same ones that buy the bonds, so there is a stimulus to those who are in immediate receipt of the government’s spending (or more particularly their employees), whereas the people who buy the bonds are swapping financial assets they already had for a different one. I sent it to Warren who didn’t disagree but he didn’t exactly agree either.

    7. Steve and Nigel.
      There is no stopping one from splitting the “domestic private sector” or the “domestic public sector” for that matter, into any number of useful “sub-sectors”, provided one is able to acquire the related data. The sectoral balances however, is concerned only with the aggregated flows of the three sectors. (public, private and rest of world)

    8. Nigel, I often wonder that MMT doesn’t talk more about distributional effects. For one thing, it’s an argument for the flexibility of fiscal policy over monetary policy. But I do believe that AOC has actually breached that topic (talking about propensity to spend of rich vs poor), and brought down wrath upon her head…

    9. Yes, four sectors perhaps:
      Government sector: creates the national laws and the national money.
      Household sector (inaccurate) or Market sector (after John K. Galbraith _The New Industrial State_, etc.): uses the national money and lives under the national laws.
      Power sector, or Planning sector per Galbraith, or something else: uses the national money, influences national laws, and ignores the laws they don’t like.
      External sector: uses the money, and is largely but maybe not entirely exempt from the national laws.

    10. Newton et al – Then the opinionated arguments whether this or that belongs in this or that sector would begin. You can’t get any easier than private-external-government, it leaves no room for misinterpretation.

    11. Matt B,

      But it doesn’t help with questions like “What spending would stimulate the economy?” Troubled-Asset Relief Program spending, AFAIK, was massive, but didn’t touch most of the economy by population. Mainly inflated an asset bubble in housing, and priced shelter out of the range of many people.

    12. Question 3 is the same as saying: “In the equation a+b+c=0, if a=-3 and b=+6 then c must be -3”. From such trivial ex post accounting identities no predictions about the behaviour of economic agents can made (at least this is what my old professor Wynne Godley used to say). Note that these accounting identities are true only by definition, i.e. they depend on how we defined them ex ante. They can be no basis for economic theory.

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