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The Weekend Quiz – March 7-8, 2020 – answers and discussion

Here are the answers with discussion for this Weekend’s Special Birthday 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:

While the desire by governments to reduce their public debt ratios through fiscal austerity is ill-founded, the strategy will always succeed but at the cost of higher unemployment.

The answer is False.

Again, this question requires a careful reading and a careful association of concepts to make sure they are commensurate. There are two concepts that are central to the question: (a) a rising fiscal deficit – which is a flow and not scaled by GDP in this case; and (b) a rising public debt ratio which by construction (as a ratio) is scaled by GDP.

So the two concepts are not commensurate although they are related in some way.

A rising fiscal deficit does not necessary lead to a rising public debt ratio.

You might like to refresh your understanding of these concepts by reading this blog post – Saturday Quiz – March 6, 2010 – answers and discussion.

While the mainstream macroeconomics thinks that a sovereign government is revenue-constrained and is subject to the government fiscal constraint, MMT places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue.

However, the framework that the mainstream use to illustrate their erroneous belief in the so-called ‘Government Budget Constraint’ (GBC) is just an accounting statement that links relevant stocks and flows.

The mainstream framework for analysing the so-called “financing” choices faced by a government (taxation, debt-issuance, money creation) is written as:


which you can read in English as saying that Fiscal deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H).

The triangle sign (delta) is just shorthand for the change in a variable.

Remember, this is merely an accounting statement.

In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been corrected added and subtracted.

So in terms of MMT, the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.

For the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).

That interpretation is inapplicable (and wrong) when applied to a sovereign government that issues its own currency.

But the accounting relationship can be manipulated to provide an expression linking deficits and changes in the public debt ratio.

The following equation expresses the relationships above as proportions of GDP:


So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP. A primary fiscal balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.

The real interest rate is the difference between the nominal interest rate and the inflation rate.

A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary fiscal balance is zero, public debt increases at a rate r but the public debt ratio increases at rg.

So a nation running a primary deficit can obviously reduce its public debt ratio over time. Further, you can see that even with a rising primary deficit, if output growth (g) is sufficiently greater than the real interest rate (r) then the debt ratio can fall from its value last period.

Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.

The austerity nations will likely see a rise in their public debt ratios arising from the negative impacts on the fiscal balance arising from the automatic stabilisers as their economies slow down in the face of public spending cuts.

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

Question 2:

The Confederate government in 1861 could have eased the inflationary impact of its war spending by issuing more bonds than it did.

The answer is False.

The key is in understanding that bond sales do not drain demand.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

The textbook argument claims that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a fiscal deficit without issuing debt?

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.

Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).

Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.

Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance.

So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

  • Building bank reserves does not increase the ability of the banks to lend.
  • The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
  • Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

You may wish to read the following blog posts for more information:

Question 3:

When net exports are negative, government deficits will be required if the private domestic sector is to save overall.

The answer is True.

This question is an application of the sectoral balances framework that can be derived from the National Accounts for any nation.

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) + 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.

To help us answer the specific question posed, we can identify three states all involving public and external deficits:

  • Case A: Fiscal Deficit (G – T) < Current Account balance (X – M) deficit.
  • Case B: Fiscal Deficit (G – T) = Current Account balance (X – M) deficit.
  • Case C: Fiscal Deficit (G – T) > Current Account balance (X – M) deficit.

The following Table shows these three cases expressing the balances as percentages of GDP. Case A shows the situation where the external deficit exceeds the public deficit and the private domestic sector is in deficit. In this case, there can be no overall private sector de-leveraging.

With the external deficit set at 2 per cent of GDP, as the fiscal position moves into larger deficit, the private domestic balance approaches balance (Case B). Case B also does not permit the private sector to save overall.

Once the fiscal deficit is large enough (3 per cent of GDP) to offset the demand-draining external deficit (2 per cent of GDP) the private domestic sector can save overall (Case C).

In this situation, the fiscal deficits are supporting aggregate spending which allows income growth to be sufficient to generate savings greater than investment in the private domestic sector but have to be able to offset the demand-draining impacts of the external deficits to provide sufficient income growth for the private domestic sector to save.

Sectoral Balance Interpretation of Result Case A Case B Case C
External Balance (X – M) Deficit is negative -2 -2 -2
Fiscal Balance (G – T) Deficit is positive 1 2 3
Private Domestic Balance (S – I) Deficit is negative -1 0 1

For the domestic private sector (households and firms) to reduce their overall levels of debt they have to net save overall. The behavioural implications of this accounting result would manifest as reduced consumption or investment, which, in turn, would reduce overall aggregate demand.

The normal inventory-cycle view of what happens next goes like this. Output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.

The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.

Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms lay-off workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.

At that point, the economy is heading for a recession.

So the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur. Given the question assumes on-going external deficits, the implication is that the exogenous intervention would come from an expanding public deficit. Clearly, if the external sector improved the expansion could come from net exports.

It is possible that at the same time that the households and firms are reducing their consumption in an attempt to lift the saving ratio, net exports boom. A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).

So it is possible that the public fiscal balance could actually go towards surplus and the private domestic sector increase its saving overall if net exports were strong enough.

The important point is that the three sectors add to demand in their own ways. Total GDP and employment are dependent on aggregate demand. Variations in aggregate demand thus cause variations in output (GDP), incomes and employment. But a variation in spending in one sector can be made up via offsetting changes in the other sectors.

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

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.

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    This Post Has 11 Comments
    1. Damn, been worried how I got #3 wrong but it turns out I didn’t. Of course I might be able to come up with alternate definitions of private sector savings if I had to. But it isn’t necessary apparently :)

      Thanks for the quiz.

    2. I got the answer to Q2 right because I know by now the MMT theory but still find it non-intuitive. I have no problem with the various flows that Bill describes where the government spends with and without in parallel selling bonds – they correctly describe what really happens. But I have problems with the denial that bond sales can’ force up interest rates’ which then ‘crowd out some private spending’.

      Here is a thought experiment that I hope clarifies my view:

      Suppose the confederate government creates new money by buying up boots needed for the war effort. This will likely tend to increase the price of boots. Suppose however that the government posted officials at various boot retail outlets and offered people about to buy boots the chance to instead buy a bond that would give them enough money to buy a better pair of boots in a years time. They would increase the level of return until they found people prepared to buy the bonds over the boots. I fail to see how this would not reduce boot sales (and so reduce boot inflation) and increase interest rates. I think this silly example could be generalized to the government increasing interest rates on bonds sold in the bond market and tempting people,to defer overall spending from the current to a future period (and so reducing current inflation) and the same effect could be achieved by increasing IOR.

      I am guessing that MMT denies that selling bonds at an increased rate of interest causes people to defer spending (so that in my example people would buy the bonds and then go right ahead and buy the boots anyway) . If so I would like to understand the economics behind that claim as just explaining the flows in the banking system fails to do that,

    3. Q3: I was marked wrong when I answered true but now it says that is correct. But now I think it should be false because nothing is said about foreign investment. There seems to be a bit of inconsistency about how the sectoral balance is expressed or what net exports means.

    4. Rob Rawlings – What you’re describing is a real resource shortage – nothing to do with bonds, per se.

      The confederate government could either invest in a new boot-making factory, or seize every X pair of boots created, for example – one of which would decrease inflation, one of which would increase inflation, but totally unrelated to bond issuance.

    5. I had wondered about Confederate bonds sold for gold, which ought to have had a curbing effect on inflation. Apparently there were very few such issues, but info on-line seems to want to talk overwhelmingly about bond prices, and not volumes. A page at the Economic History Association says that bonds issued internationally only funded 1% of war expenditures.
      There seem to have been two bond issues. One was a form of “junk bond” denominated in sterling, issued in Amsterdam, and seemingly not bought, because of Europeans’ qualms about supporting slavery.
      The other was a “cotton bond”, denominated in sterling but also redeemable in cotton to be picked up in a Confederate port. It’s possible that there was quite a bit of redemption in cotton, so the net effect would be as cotton exports, not as borrowing. One source states that the Cotton Bonds brought in $8.8 million worth of Pounds Sterling.
      Cumulative bond issues of all types through the war totaled over $500 million, so the greatest debt was issued domestically, for domestic currency, therefore was ruled by MMT principles.

      As far as I can figure out.

    6. @Matt B: Thanks for the answer but the real resource issue would not exist in the present period (or at least would exist to a lesser extent) if bond sales successfully pushed some real resource purchases into a future period. I’m looking for an answer as to why MMT theory holds that bond sales do not do this.

    7. Rob, my understanding is that MMT views bond issuance by governments as they are currently done do not significantly reduce private sector ability to spend- or in other words they don’t reduce effective demand. So they do not free up resources needed for the additional government spending that they ‘supposedly’ finance and allow and therefore do nothing to reduce demand induced inflation.

      The reasons given are that first of all this was money that people had already decided to save rather than spend. Another reason is that the bonds are highly liquid assets that can be sold whenever a saver changed their mind and decided to spend. They also make for excellent collateral for borrowing against if the purchaser wished to do that rather than sell them and borrowing from a bank does not limit anyone’s consumption the way things work with bank lending.

      Now I don’t think that a bond could not possibly be structured in such a way that it actually would prevent the purchaser from spending that money until its redemption date- I think war bonds sold by the US in WW2 probably helped reduce current civilian demand but also depended on citizens patriotism. And I don’t know enough about the confederacy monetary history to speculate if they could have done the same. But I wouldn’t doubt that Bill does.

    8. Thanks Jerry.

      I see that increased interest rates on government bonds (which as you say tend to be quite liquid assets) may lead people to simply hold a greater share of their wealth in bonds while leaving their spending on other tings unchanged. I can even see the possibility that the prospect of an increased flow of interest payments to bond holders may lead some to spend more even in the present period.

      However I am still left with the intuition that increased interest rates will cause some spending (at the margin) to be deferred from the present to the future and it would seem likely that this negative effect on current spending would be greater than the positive effect of increased interest rates – though it would I suppose be an empirical matter which would predominate.

    9. OK, after some time browsing various old posts from this blog I found this:

      ‘In MMT, there is less confidence that changes in policy interest rates within normal ranges alter spending dramatically. One has to realise that there are two sides to consider. The cost of funds side – whereby an increase in the interest rate will possibly reduce the demand for funds (for a given expectation of revenue flow arising from the investment) – and the income side – whereby an increase in the interest rate provides a boost to fixed income recipients and may, in turn, boost spending. This would impact back on investment because investors would not only face higher costs of borrowing but would likely feel more confident about future income flows.

      So these distributional complexities make it difficult to conclude unambiguously that interest rate changes are an effective way to manipulate aggregate demand. They also work more slowly and indirectly anyway and make it very hard to disentangle from other impacts on demand.’

      While this focuses on the effect of interest rates on lending rather than deferred spending I think it does largely address my question. (Arguably it also means that the answer to Q2 should have been ‘it depends’ , but I will let that pass for now !)

    10. We might have to adjust our mental model after we ask just who is holding government bonds.? It might be literal people who are trading off saving against consumption. Or it might be financial institutions that think differently. I imagine a retail business, say, borrowing all its operating cash, planning to repay the loans out of future sales, and holding treasury bonds as iron-clad collateral to prove that they’re reliable borrowers.

    11. Rob,

      Another way to think of it is the only thing modern bonds promise is money, and a currency issuing government has effectively unlimited money. Unlimited supply means unlimited demand can be met without inflation.

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