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.
When a currency-issuing government voluntarily constrains itself to borrow from the private sector to cover its deficit spending, it logically reduces the funds available for private investment expenditure.
The answer is False.
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.
However, the notion of opportunity cost relies on the assumption that all available resources are fully utilised.
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.
If the economy is already at full capacity, then 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.
However, the question is focusing on the concept of financial crowding out which is a centrepiece of mainstream macroeconomics textbooks. This concept has nothing to do with “real crowding out” of the type noted in the opening paragraphs.
The financial crowding out assertion is a central plank in the mainstream economics attack on government fiscal intervention. 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 blog posts will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit 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.
Additionally, credit-worthy private borrowers can usually access credit from the banking system. Banks lend independent of their reserve position so government debt issuance does not impede this liquidity creation.
The following blog posts may be of further interest to you:
- When a huge pack of lies is barely enough
- Saturday Quiz – April 17, 2010 – answers and discussion
- Building bank reserves will not expand credit
- Building bank reserves is not inflationary – for further discussion
- Building bank reserves is not inflationary – for further discussion
An increasing fiscal deficit tells us nothing about the government’s policy intentions.
The answer is that True.
The actual fiscal deficit outcome that is reported in the press and by Treasury departments is not a pure measure of the fiscal policy stance adopted by the government at any point in time. As a result, a straightforward interpretation of
Economists conceptualise the actual fiscal outcome as being the sum of two components: (a) a discretionary component – that is, the actual fiscal stance intended by the government; and (b) a cyclical component reflecting the sensitivity of certain fiscal items (tax revenue based on activity and welfare payments to name the most sensitive) to changes in the level of activity.
The former component is now called the “structural deficit” and the latter component is sometimes referred to as the automatic stabilisers.
The structural deficit thus conceptually reflects the chosen (discretionary) fiscal stance of the government independent of cyclical factors.
The cyclical factors refer to the automatic stabilisers which operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.
In times of economic decline, the automatic stabilisers work in the opposite direction and push the fiscal balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).
The problem is then how to determine whether the chosen discretionary fiscal stance is adding to demand (expansionary) or reducing demand (contractionary). It is a problem because a government could be run a contractionary policy by choice but the automatic stabilisers are so strong that the fiscal balance goes into deficit which might lead people to think the “government” is expanding the economy.
So just because the fiscal balance goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.
To overcome this ambiguity, economists decided to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.
As a result, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. As I have noted in previous blog posts, the change in nomenclature here is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.
The Full Employment Budget Balance was a hypothetical construction of the fiscal balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the fiscal position (and the underlying fiscal parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.
This framework allowed economists to decompose the actual fiscal balance into (in modern terminology) the structural (discretionary) and cyclical fiscal balances with these unseen fiscal components being adjusted to what they would be at the potential or full capacity level of output.
The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal outcome and it arises because the economy is deviating from its potential.
So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the fiscal balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.
If the fiscal position is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual fiscal outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently.
So you could have a downturn which drives the fiscal balance into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.
The question then relates to how the “potential” or benchmark level of output is to be measured. The calculation of the structural deficit spawned a bit of an industry among the profession raising lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.
Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s.
As the neo-liberal resurgence gained traction in the 1970s and beyond and governments abandoned their commitment to full employment , the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blog posts – The dreaded NAIRU is still about and Redefing full employment … again!.
The NAIRU became a central plank in the front-line attack on the use of discretionary fiscal policy by governments. It was argued, erroneously, that full employment did not mean the state where there were enough jobs to satisfy the preferences of the available workforce. Instead full employment occurred when the unemployment rate was at the level where inflation was stable.
The estimated NAIRU (it is not observed) became the standard measure of full capacity utilisation. If the economy is running an unemployment equal to the estimated NAIRU then mainstream economists concluded that the economy is at full capacity. Of-course, they kept changing their estimates of the NAIRU which were in turn accompanied by huge standard errors. These error bands in the estimates meant their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.
Typically, the NAIRU estimates are much higher than any acceptable level of full employment and therefore full capacity. The change of the the name from Full Employment Budget Balance to Structural Balance was to avoid the connotations of the past where full capacity arose when there were enough jobs for all those who wanted to work at the current wage levels.
Now you will only read about structural balances which are benchmarked using the NAIRU or some derivation of it – which is, in turn, estimated using very spurious models. This allows them to compute the tax and spending that would occur at this so-called full employment point. But it severely underestimates the tax revenue and overestimates the spending because typically the estimated NAIRU always exceeds a reasonable (non-neo-liberal) definition of full employment.
So the estimates of structural deficits provided by all the international agencies and treasuries etc all conclude that the structural balance is more in deficit (less in surplus) than it actually is – that is, bias the representation of fiscal expansion upwards.
As a result, they systematically understate the degree of discretionary contraction coming from fiscal policy.
The only qualification is if the NAIRU measurement actually represented full employment. Then this source of bias would disappear.
Why all this matters is because, as an example, the Australian government thinks we are close to full employment now (according to Treasury NAIRU estimates) when there is 5.2 per cent unemployment and 7.5 per cent underemployment (and about 1.5 per cent of hidden unemployment). As a result of them thinking this, they consider the structural deficit estimates are indicating too much fiscal expansion is still in the system and so they are cutting back.
Whereas, if we computed the correct structural balance it is likely that the Federal fiscal deficit even though it expanded in both discretionary and cyclical terms during the crisis is still too contractionary.
The following blog posts may be of further interest to you:
- A modern monetary theory lullaby
- Saturday Quiz – April 24, 2010 – answers and discussion
- The dreaded NAIRU is still about!
- Structural deficits – the great con job!
- Structural deficits and automatic stabilisers
- Another economics department to close
The crucial difference between a monetary system based on the convertible currency backed by gold and a fiat currency monetary is that under the former system:
(a) excessive national government spending led to inflation.
(b) the national government had to issue debt to cover spending above taxation.
(c) the national government could not use net spending to achieve full employment.
The correct (best) answer is – that under the former system, the national government had to issue debt to cover spending above taxation.
Under the convertible currency backed by gold (which was the way the Bretton Woods system operated) the paper money issued by a central bank was proportional to the stock of gold held (the proportion being the defined price of gold to the base currency). A currency’s value was expressed in terms of a specified unit of gold and there was convertibility which allowed a person to swap the paper money for the relevant amount of gold. A parity was fixed and central banks agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance.
Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate).
In the early gold standard arrangements (prior to Bretton Woods), gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries.
This inflow of gold would allow the governments in surplus nations to expand the money supply (issue more notes) because they now had more gold to back the currency. This expansion was in strict proportion to the set value of the local currency in terms of grains of gold. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline.
From the perspective of an external deficit nation, the loss of gold reserves forced their government to withdraw paper currency which was deflationary – rising unemployment and falling output and prices. The latter improved the competitiveness of their economy which also helped resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.
The proponents of the gold standard focus on the way it prevents the government from issuing paper currency as a means of stimulating their economies. Under the gold standard, the government could not expand base money if the economy was in trade deficit. It was considered that the gold standard acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balance. The domestic economy however was forced to make the adjustments to the trade imbalances.
Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade). Variations in the gold production levels also influenced the price levels of countries.
After World War 2, the IMF was created to supercede the gold standard and the so-called gold exchange standard emerged. Convertibility to gold was abandoned and replaced by convertibility into the US dollar, reflecting the dominance of the US in world trade (and the fact that they won the war!). This new system was built on the agreement that the US government would convert a USD into gold at $USD35 per ounce of gold. This provided the nominal anchor for the exchange rate system.
The Bretton Woods System was introduced in 1946 and created the fixed exchange rates system. Governments could now sell gold to the United States treasury at the price of $USD35 per ounce. So now a country would build up US dollar reserves and if they were running a trade deficit they could swap their own currency for US dollars (drawing from their reserves) and then for their own currency and stimulate the economy (to increase imports and reduce the trade deficit).
The fixed exchange rate system however rendered fiscal policy relatively restricted because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).
This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $US dollar reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.
So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion.
Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.
Whichever system we want to talk off – pure gold standard or USD-convertible system backed by gold – the constraints on government were obvious.
The gold standard as applied domestically meant that existing gold reserves controlled the domestic money supply. Given gold was in finite supply (and no new discoveries had been made for years), it was considered to provide a stable monetary system. But when the supply of gold changed (a new field discovered) then this would create inflation.
So gold reserves restricted the expansion of bank reserves and the supply of high powered money (government currency). The central bank thus could not expand their liabilities beyond their gold reserves. In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.
As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.
The concept of (and the term) monetisation comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money. The process was that the government would order some gold and sign a cheque for the delivery. This cheque is deposited by the miner in their bank. The bank then would exchange this cheque with the central bank in return for added reserves. The central bank then accounts for this by reducing the government account at the bank. So the government’s loss is the commercial banks reserve gain.
The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance.
As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.
The move to fiat currencies fundamentally altered the way the monetary system operated even though the currency was still, say, the $AUD.
This system had two defining characteristics: (a) non-convertibility; and (b) flexible exchange rates.
First, under a fiat monetary system, “state money” has no intrinsic value. It is non-convertible. So for this otherwise “worthless” currency to be acceptable in exchange (buying and selling things) some motivation has to be introduced.
That motivation emerges because the sovereign government has the capacity to require its use to relinquish private tax obligations to the state. Under the gold standard and its derivatives money was always welcome as a means of exchange because it was convertible to gold which had a known and fixed value by agreement. This is a fundamental change.
Second, given the relationship between the commodity backing (gold) and the ability to spend is abandoned and that the Government is the monopoly issuer of the fiat currency in use (defined by the tax obligation) then the spending by this government is revenue independent. It can spend however much it likes subject to there being real goods and services available for sale. This is a dramatic change.
Irrespective of whether the government has been spending more than revenue (taxation and bond sales) or less, on any particular day the government has the same capacity to spend as it did yesterday. There is no such concept of the government being “out of money” or not being able to afford to fund a program. How much the national government spends is entirely of its own choosing. There are no financial restrictions on this capacity.
This is not to say there are no restrictions on government spending. There clearly are – the quantity of real goods and services available for sale including all the unemployed labour. Further, it is important to understand that while the national government issuing a fiat currency is not financially constrained its spending decisions (and taxation and borrowing decisions) impact on interest rates, economic growth, private investment, and price level movements.
We should never fall prey to the argument that the government has to get revenue from taxation or borrowing to “finance” its spending under a fiat currency system. It had to do this under a gold standard (or derivative system) but not under a fiat currency system. Most commentators fail to understand this difference and still apply the economics they learned at university which is fundamentally based on the gold standard/fixed exchange rate system.
Third, in a fiat currency system the government does not need to finance spending in which case the issuing of debt by the monetary authority or the treasury has to serve other purposes. Accordingly, it serves a interest-maintenance function by providing investors with an interest-bearing asset that drains the excess reserves in the banking system that result from deficit spending. If these reserves were not drained (that is, if the government did not borrow) then the spending would still occur but the overnight interest rate would plunge (due to competition by banks to rid themselves of the non-profitable reserves) and this may not be consistent with the stated intention of the central bank to maintain a particular target interest rate.
Importantly, the source of funds that investors use to buy the bonds is derived from the net government spending anyway (that is, spending above taxation). The private sector cannot buy bonds in the fiat currency unless the government has spent the same previously. This is a fundamental departure from the gold standard mechanisms where borrowing was necessary to fund government spending given the fixed money supply (fixed by gold stocks). Taxation and borrowing were intrinsically tied to the government’s management of its gold reserves.
So in a fiat currency system, government borrowing doesn’t fund its spending. It merely stops interbank competition which allows the central bank to defend its target interest rate.
The flexible exchange rate system means that monetary policy is freed from defending some fixed parity and thus fiscal policy can solely target the spending gap to maintain high levels of employment. The foreign adjustment is then accomplished by the daily variations in the exchange rate.
The following blog posts may be of further interest to you:
- Gold standard and fixed exchange rates – myths that still prevail
- Deficit spending 101 – Part 1
- Deficit spending 101 – Part 2
- Deficit spending 101 – Part 3
That is enough for today!
(c) Copyright 2020 William Mitchell. All Rights Reserved.