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The Weekend Quiz – March 14-15, 2020 – 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:

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:

Question 2:

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:

Question 3:

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.

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    This Post Has 17 Comments
    1. I’m pleased to report a 4/4 result (only the second time I’ve managed a full-house). Though question 4 was always going to be easy, the answer is always to sack Christine Lagarde! Question 3 was tricky and I had to go back to the textbook to refresh some ideas before choosing an answer, with only 75% confidence.

    2. Good for you Ferdinand! I got tripped up with question 3 thinking that only the government bond market term structure was in question. Unbelievable how I love to hate the quiz but still love it…

    3. Another off topic post.
      Last week I was on another open discussion site.
      I saw the return of someone who had been absent for a long time. This person is a multi-hundred millionaire.
      About 2 years ago I asked this person if she/he thought MMT was true.
      The answer, basically, was no.

      So, I asked again. I pointed out all the central banks who had called for a more fiscal response to the next down turn.
      I pointed out the article by the Bank of Canada that Bill wrote about recently.
      I pointed out that Japan was proving that deficit spending did not cause inflation, let alone hyperinflation. And that a 236% ratio of debt the GDP didn’t cause interest rates to spike or even rise.
      I pointed out that England, then Great Britain, the the UK had had a national debt for 325 years now and had not need to pay it off, even when it lost its Empire.
      I ended with this, “So, can you embrace MMT now?”

      I got a reply quite rapidly. The entire reply was —
      “No. Covid-19 has never been a problem until now, but now it is. Assuming that something will never be a problem because it’s not a problem now is dangerous.”

      This is the “someday it will be a problem” argument.
      I had shown that there needed to be a mechanism to show how it would be a problem.
      The reply contained no mechanism. Just the claim that someday it** might be a problem.

      .** . “It” being using MMT and its JG program to help the mass of the people.

      This person is a liberal who gives lots and lots of money to further liberal political policies.
      Yet can’t grok that MMT and its JG is a better way to help the mass of the people of the world, and of the US.
      That currently the Right in the US uses MMT to pay for wars without a way to win them.
      And allow tax cuts for the 1%. Resulting in $1T deficits, even before the new crisis.
      But, not any money for the people, even in the coronavirus crisis. At least not yet that I know of.

    4. Steve, I am a trillionaire. You should listen to me. Well technically I’m not very wealthy outside my own mind at least. But you shouldn’t believe it and you certainly shouldn’t evaluate any arguments based on what you think a person’s wealth might be. A person’s wealth may give an indication about how likely they are happy with the way things are at this point in time. But even that is not sure.

    5. Jerry,
      I don’t get your point.
      It has been confirmed to my satisfaction that the person is very rich.
      But, I didn’t believe him or her, so the wealth didn’t sway me.
      I’m just relating a true story that might be of some interest.
      This idea that someday it *might* be a problem *somehow* seems like a very common thought.

    6. Dear Bill,

      I was at the Manchester meeting the other week, I was the guy on the right who was told to shut up, quite rightly! I thought the presentation you made was great. I was going to say hello but didn’t as you had other folk talking to you. Anyway I’m glad I took the opportunity of seeing you. I just heard the jazz artist Behki Mseleku on BBC Radio 6 and thought he should be introduced to your audience. No doubt he’s well known to you, but I’m afraid his name had passed me by!
      I was glad to see your video of the meeting with Noel Pearson, as I have little experience of the Indigenous peoples struggles in your country, or the fact that they showed, prior to the 60s, little of the woes they now undergo.

      Hope to see you in the UK again soon!

      Dave Kelley.

    7. Steve,
      Perhaps have a look at New Economic Perspectives dot org, with the two-part “MMT is a Political Problem”. Could explain your correspondent.

      Re Q4, it’s a deep theoretical point. Should they decide to fire Lagarde, or should they fire her without waiting for a decision? Very philosophical.

    8. Answer to question 1, sixth paragraph from bottom: Can anyone please explain what the following sentence means in plain English: “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.”

    9. Dear Non Economist (at 2020/03/16 at 3:20 pm)

      It means that:

      1. The nation as a whole has lower real income.

      2. The question is who will bear that loss – workers and/or capital – and in what proportion (that is, how will the loss be distributed).

      3. If the loss is shared so that neither workers and capital feel the need to protect their real incomes by pushing up prices and/or wage demands, then the loss is finite and inflation doesn’t result.

      best wishes

    10. My friends here,
      in the context of a polite discussion about MMT, how insulting is it to be asked if the Gov. can deficit spend $300T with a T to *give* $1M to every American adult? I.e., asked if this would be a problem.

    11. Steve, that’s not unusual at least for me. Just be careful how you respond. You cant control how others behave. You will get insulted, but you will be right.

    12. Jerry, et all,
      I found it especially insulting because I ended my last PM to him with this.

      “PS — I am with you if you are worried that 10 to 20 years down the road the mass of the people *will* get drunk on deficit spending and force the Gov. too do too much of it. This is why I have several times called for a Constitutional Amendment that limits deficit spending. Something like 3% of GDP plus the current account (deficit?). With an escape clause that with a 60% vote in both houses of Congress it can be raised to 10% of GDP + the CA deficit in an emergency for 1 year at a time.”

      Then the reply I got was the blast about $300T deficits.

      He asked me to please not message him ever again. So I will not reply.

      This strong area of resistance to MMT could be weakened if my suggestion were adopted by the core group of MMTers.

    13. Steve, what you said is NOT what MMT is about. If you stick with what Bill Mitchell says then you will always be on solid ground to defend your argument. If you are going to make up your own arguments- don’t call them MMT! Your 3% plus whatever? idea is not a defensible argument under many circumstances.

    14. Jerry,
      I NEVER said putting a limit on deficit spending was a part of MMT.
      I said that adding it by the core MMters group would reduce some resistance to MMT.
      And, of course, if the core group of MMters added it then it wold be part of MMT.

      I proposed 3% plus the balance of payments deficit as a starting point. I’m no expert so I just wanted the real experts to start there and improve it.
      Also, my post here and other places has included an escape system for additional deficits in an emergency.
      The current coronavirus crisis is obviously such an emergency.

    15. Look Steve- my advice is stick with what Mitchell says. God knows there is enough of it to quote from. Well there is a lot of it but I still want more :)

      That is my advice if you are arguing with someone else somewhere else- stick to what Bill says and you will always be the winner.

      Except for the quizzes- those answers should be open for discussion just because I get so many wrong and hate that. But once in a while I am right and Bill wasn’t. Never admits that though. So that is when I make arguments.

    16. Woohoo, getting 100% regularly now. Can I suggest a wee tweak to the discussion of Q.1. The defaulting nation, like Argentina, holds all the cards… only provided the USA is not going to launch a coup to install their neoliberal puppets who will impose austerity and pay the IMF their blood money.

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