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.
Italy is currently in crisis and would have to undergo a period of austerity if it restored its currency and renegotiated all Euro debts into the New Lira (that is, defaulted) because investors would be reluctant to purchase Italian government debt.
The answer is False.
Once the Italian government reinstated its currency sovereignty and allowed the New Lira to float freely then it could choose whatever net spending position it desired irrespective of the desires or otherwise of the private investors for its debt and the assessments of the ratings agencies.
To get to that point it would have to renegotiate all Euro-denominated public liabilities but Argentina showed in 2001-02, the defaulting nation in this case holds all the cards.
For its own citizens it could also exchange New Lira for euros (at some fair rate) for those who wanted their wealth to be preserved in the local currency.
Please read my blog post – Exiting the Euro? – for more discussion on this point.
The Italians would have to then take measures – such as reforming their tax base to ensure stable growth was achievable. That is, with the significant leakage into the cash economy, the effectiveness of fiscal policy in attenuating demand growth is reduced. So whether they stay in the Eurozone or leave, tax reform is required as a matter of urgency.
As noted in the blog, the tax reform, would have nothing to do with increasing the capacity of the Italian government to “raising funds” to allow it to spend. Once they exited the EMU the Italian government would be sovereign again and face no revenue-constraints on its spending. Rather, the tax reforms would give it more flexibility to control aggregate demand and align it better with real output capacity.
It is likely that bond markets would retaliate and boycott Italian government debt issuance. The Government would then have two options – both of which would be completely within its power.
First, it would have to reform the central bank arrangements to ensure that the elected government restored influence on monetary policy. One of the pre-conditions placed on nations desiring to enter the EMU was that requirement that the central bank was made completely independent. Independence on steroids was how one commentator at the time described the arrangements.
So with new legislation, the elected government could instruct the central bank of Italy to manage the yield curve should the bond markets boycott the issues.
Second, more sensibly, the Italian government could ignore the rating agencies altogether and dispense with the unnecessary practice of issuing any debt. This would give it some more scope for improving employment and welfare within the inflation constraint.
An exit and resulting flexible exchange rate would also allow the nation to realign its traded-goods sector with those of its trading partners without having to scorch the domestic economy and impoverish its workforce.
Many would predict that a fairly substantial depreciation of the newly-introduced New Lira would occur.
But that is unlikely to happen in the short-term because there would be no volume of New Lira in the foreign exchange markets initially.
People would be scrambling to get it to ensure they could meet their tax obligations to the state and would be selling euros to fulfill that aim.
That act combined with the short supply would likely push the exchange rate up initially.
Eventually, once volume rose in the foreign exchange markets the currency would move according to trade and capital flow volumes. It might depreciate somewhat against the euro (if the euro survived an Italexit) to adjust for productivity differences between Italy and Germany.
But then a growing economy would also attract foreign direct investment (capital inflow).
Any subsequent depreciation would reduce the capacity of Italians to purchase foreign goods and would add some price pressure (albeit finite and small) to the Italian economy. But the inflationary impact is not likely to be substantial if managed correctly.
This should ease the worries that some people have who think that the depreciation would be inflationary. As I explained in this blog post – When you’ve got friends like this … Part 3 – there is “no mechanical link between the exchange rate and the inflation rate” (Source: Bank of England’s inflation outlook).
It is clear that any depreciation would drive a once-off adjustment to the terms of trade and so imported goods (like military equipment) would become more expensive. This doesn’t necessarily result in inflation if the consequences are sequestered from the distributional system and the nation takes the “real” cut in living standards that is implied.
This real cut can be attenuated by increased government provision of non-traded goods. Further, the domestic non-traded goods sector suffers no negative impacts and goods and services emanating from that sector form the bulk of private consumption anyway.
Further, the real cut via the depreciation is likely to be of a much smaller magnitude than the austerity plan they have in place at present.
Finally, the improving terms of trade will make the Italian export products including its tourist and shipping industries more attractive and net exports would likely be boosted adding to domestic growth.
So upon exit, the Italian government would become responsible for maintaining aggregate demand and could increase employment and income without having to engage in a drawn out and very damaging austerity program.
There would clearly be ructions associated with leaving the EMU but the government would be better placed to attenuate them.
The following blog posts may be of further interest to you:
- Euro zone’s self-imposed meltdown
- A Italian tragedy …
- España se está muriendo
- Exiting the Euro?
- Doomed from the start
- Europe – bailout or exit?
- Not the EMF … anything but the EMF!
- EMU posturing provides no durable solution
If policy makers use NAIRU estimates to compute the decomposition between structural and cyclical fiscal balances and these estimates are above the true full employment unemployment rate, then the estimated impact of the automatic stabilisers will always be biased downwards.
The answer is True.
The following graph plots the actual unemployment rate for Australia (blue line) from 1959 to June 2009 and the Australian Treasury estimate of the NAIRU (red line). The data is available from the RBA.
You can see how ridiculous the estimated NAIRU is. Suddenly it jumps up just as actual unemployment rises although for such a jump to occur (according to the logic of the concept) there has to be major structural changes occurring. Historically, there is nothing that might convincingly explain that jump. Other estimation techniques give even more nonsensical estimates (they tend to just track the movement in the official unemployment rate).
This graph show how little correspondence there is between the inflation rate and the NAIRU gap (measured as the difference between the estimated NAIRU and the actual unemployment rate). The left-panel is the actual inflation rate (vertical axis) whereas the right-panel is the change in the actual inflation rate (vertical axis). There has always been some dispute in the literature as to whether the Phillips curve (the relationship between the NAIRU gap and inflation) should be specified in terms of the actual level of inflation or the acceleration in the level.
I also tried various lags in the inflation measures (to allow for frictions) and you get the same general picture. If the mainstream economic theory was correct, then the NAIRU gap should be negatively related to inflation (whichever measure you like). That is, when the unemployment rate is above the NAIRU inflation should be falling and vice versa. The conclusion from the data is that no such relationship exists. There is no surprise in that – the NAIRU is one of the most discredited concepts in the mainstream toolkit. The problem is that governments have been significantly influenced by it to the detriment of all of us.
To see why this is the case, the next graph plots three different measures of labour market tightness:
- The gap between the actual unemployment rate and the NAIRU (blue line), which is interpreted as estimating full employment when the gap is zero (cutting the horizontal axis.
- The gap between the actual unemployment rate and our 2 per cent full employment rate (red line), again would indicate full employment if the line cut the horizontal axis.
- The gap between the broad labour underutilisation rate published by the ABS (available HERE), which takes into account underemployment and our 2 per cent full employment rate (green line).
The NAIRU estimates not only inflate the alleged full employment unemployment rate but also completely ignore the underemployment, which has risen sharply over the last 20 years.
For example, in the June-quarter 2006 the NAIRU gap was zero whereas the actual unemployment rate was still 2.78 per cent above the full employment unemployment rate. The thick red vertical line depicts this distance.
However, if we considered the labour market slack in terms of the broad labour underutilisation rate published by the ABS then the gap would be considerably larger. Thus you have to sum the red and green vertical lines shown at June 2008 for illustrative purposes.
This means that the Australian Treasury are providing advice to the Federal government claiming that in June 2008 the Australian economy was at full employment when it is highly likely that there was upwards of 9 per cent of willing labour resources being wasted. That is how bad the NAIRU period has been for policy advice.
But in relation to this question, in June 2008, the Australian Treasury would have classified all of the federal fiscal balance in that quarter as being structural given that the cycle was considered to be at the peak (what they term full employment).
However, if we define the true full employment level was at 2 per cent unemployment and zero underemployment, then you can see that, in fact, the Australian economy would have been operating well below the full employment level and so there would have been a significant cyclical component being reflected in the fiscal balance.
Given the federal fiscal balance in June 2008 was in surplus the Treasury would have classified this as mildly contractionary whereas in fact the Commonwealth government was running a highly contractionary fiscal position which was preventing the economy from generating a greater number of jobs.
The following blog posts may be of further interest to you:
- The dreaded NAIRU is still about!
- Structural deficits – the great con job!
- Structural deficits and automatic stabilisers
- Another economics department to close
Central bank balance sheet management aimed at controlling the yields on public debt at all maturities may not have much impact on the term structure during periods of high inflation.
The answer is True.
I was going to use the term ‘economic impact’ but decided against that because it might be misleading given that it would require a discussion of what an economic impact actually is. I consider an economic impact has to involve a discussion of the real economy rather than just the financial dimensions.
In that context you would then have had to consider two things: (a) the impact on private interest rates; and (b) whether interest rates matter for aggregate demand. And in a simple dichotomous choice (true/false) that becomes somewhat problematic.
I chose the alternative ‘impact on the term structure’ because it didn’t require any consideration of the real economy but only the impact on private interest rates.
The ‘term structure’ of interest rates, in general, refers to the relationship between fixed-income securities (public and private) of different maturities. Sometimes commentators will confine the concept to public bonds but that would be apparent from the context. Usually, the term structure takes into account public and private bonds/paper.
The yield curve is a graphical depiction of the term structure – so that the interest rates on bonds are graphed against their maturities (or terms).
The term structure of interest rates provides financial markets with a indication of likely movements in interest rates and expectations of the state of the economy.
If the term structure is normal such that short-term rates are lower than long-term rates fixed-income investors form the view that economic growth will be normal. Given this is associated with an expectation of some stable inflation over the medium- to longer-term, long maturity assets have higher yields to compensate for the risk.
Short-term assets are less prone to inflation risk because holders are repaid sooner.
When the term structure starts to flatten, fixed-income markets consider this to be a transition phase with short-term rates on the rise and long-term rates falling or stable. This usually occurs late in a growth cycle and accompanies the tightening of monetary policy as the central bank seeks to reduce inflationary expectations.
Finally, if a flat terms structure inverts, the short-rates are higher than the long-rates. This results after a period of central bank tightening which leads the financial markets to form the view that interest rates will decline in the future with longer-term yields being lower. When interest rates decrease, bond prices rise and yields fall.
The investment mentality is tricky in these situations because even though yields on long-term bonds are expected to fall investors will still purchase assets at those maturities because they anticipate a major slowdown (following the central bank tightening) and so want to get what yields they can in an environment of overall declining yields and sluggish economic growth.
So the term structure is conditioned in part by the inflationary expectations that are held in the private sector.
It is without doubt that the central bank can manipulate the yield curve at all maturities to determine yields on public bonds. If they want to guarantee a particular yield on say a 30-year government bond then all they have to do is stand ready to purchase (or sell) the volume that is required to stabilise the price of the bond consistent with that yield.
Remember bond prices and yields are inverse. A person who buys a fixed-income bond for $100 with a coupon (return) of 10 per cent will expect $10 per year while they hold the bond. If demand rises for this bond in secondary markets and pushes the price up to say $120, then the fixed coupon (10 per cent on $100 = $10) delivers a lower yield.
Now it is possible that a strategy to fix yields on public bonds at all maturities would require the central bank to own all the debt (or most of it). This would occur if the targeted yields were not consistent with the private market expectations about future values of the short-term interest rate.
If the private markets considered that the central bank would stark hiking rates then they would decline to buy at the fixed (controlled) yield because they would expect long-term bond prices to fall overall and yields to rise.
So given the current monetary policy emphasis on controlling inflation, in a period of high inflation, private markets would hold the view that the yields on fixed income assets would rise and so the central bank would have to purchase all the issue to hit its targeted yield.
In this case, while the central bank could via large-scale purchases control the yield on the particular asset, it is likely that the yield on that asset would become dislocated from the term structure (if they were only controlling one maturity) and private rates or private rates (if they were controlling all public bond yields).
So the private and public interest rate structure could become separated. While some would say this would mean that the central bank loses the ability to influence private spending via monetary policy changes, the reality is that the economic consequences of such a situation would be unclear and depend on other factors such as expectations of future movements in aggregate demand, to name one important influence.
That is enough for today!
(c) Copyright 2020 William Mitchell. All Rights Reserved.