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The Weekend Quiz – February 27-28, 2021 – 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:

When a nation is generating large external surpluses, it can create more space for non-inflationary spending in the future if the government runs fiscal surpluses and accumulates them in a sovereign fund.

The answer is False.

The public finances of a country such as Australia – which issues its own currency and floats it on foreign exchange markets are not reliant at all on the dynamics of our industrial structure. To think otherwise reveals a basis misunderstanding which is sourced in the notion that such a government has to raise revenue before it can spend.

So it is often considered that a mining boom, for example (as in the Australian case) which drives strong growth in national income and generates considerable growth in tax revenue is a boost for the government and provides them with “savings” that can be stored away and used for the future when economic growth was not strong. Nothing could be further from the truth.

The fundamental principles that arise in a fiat monetary system are as follows:

  • The central bank sets the short-term interest rate based on its policy aspirations.
  • Government spending capacity is independent of taxation revenue. The non-government sector cannot pay taxes until the government has spent.
  • Government spending capacity is independent of borrowing which the latter best thought of as coming after spending.
  • Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
  • Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about “crowding out”.
  • The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.
  • Government debt-issuance is a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

These principles apply to all sovereign, currency-issuing governments irrespective of industry structure. Industry structure is important for some things (crucially so) but not in delineating “public finance regimes”.

The mistake lies in thinking that such a government is revenue-constrained and that a booming mining sector delivers more revenue and thus gives the government more spending capacity. Nothing could be further from the truth irrespective of the rhetoric that politicians use to relate their fiscal decisions to us and/or the institutional arrangements that they have put in place which make it look as if they are raising money to re-spend it! These things are veils to disguise the true capacity of a sovereign government in a fiat monetary system.

In the midst of the erroneous intergenerational (ageing population) debate, which is being used by conservatives all around the world as a political tool to justify moving to fiscal surpluses, the notion arises that governments will not be able to honour their liabilities to pensions, health etc unless drastic action is taken.

Hence the hype and spin moved into overdrive to tell us how the establishment of sovereign funds. The financial markets love the creation of sovereign funds because they know there will be more largesse for them to speculate with at the expense of public spending. Corporate welfare is always attractive to the top end of town while they draft reports and lobby governments to get rid of the Welfare state, by which they mean the pitiful amounts we provide to sustain at minimal levels the most disadvantaged among us.

Anyway, the claim is that the creation of these sovereign funds create the fiscal room to fund the so-called future liabilities. Clearly this is nonsense. A sovereign government’s ability to make timely payment of its own currency is never numerically constrained. So it would always be able to fund the pension liabilities, for example, when they arose without compromising its other spending ambitions.

The creation of sovereign funds basically involve the government becoming a financial asset speculator. So national governments start gambling in the World’s bourses usually at the same time as millions of their citizens do not have enough work.

The logic surrounding sovereign funds is also blurred. If one was to challenge a government which was building a sovereign fund but still had unmet social need (and perhaps persistent labour underutilisation) the conservative reaction would be that there was no fiscal room to do any more than they are doing. Yet when they create the sovereign fund the government spends in the form of purchases of financial assets.

So we have a situation where the elected national government prefers to buy financial assets instead of buying all the labour that is left idle by the private market. They prefer to hold bits of paper than putting all this labour to work to develop communities and restore our natural environment.

An understanding of modern monetary theory will tell you that all the efforts to create sovereign funds are totally unnecessary. Whether the fund gained or lost makes no fundamental difference to the underlying capacity of the national government to fund all of its future liabilities.

A sovereign government’s ability to make timely payment of its own currency is never numerically constrained by revenues from taxing and/or borrowing. Therefore the creation of a sovereign fund in no way enhances the government’s ability to meet future obligations. In fact, the entire concept of government pre-funding an unfunded liability in its currency of issue has no application whatsoever in the context of a flexible exchange rate and the modern monetary system.

The misconception that “public saving” is required to fund future public expenditure is often rehearsed in the financial media.

First, running fiscal surpluses does not create national savings. There is no meaning that can be applied to a sovereign government “saving its own currency”. It is one of those whacko mainstream macroeconomics ideas that appear to be intuitive but have no application to a fiat currency system.

In rejecting the notion that public surpluses create a cache of money that can be spent later we note that governments spend by crediting bank accounts. There is no revenue constraint. Government cheques don’t bounce! Additionally, taxation consists of debiting an account at an RBA member bank. The funds debited are “accounted for” but don’t actually “go anywhere” and “accumulate”.

The concept of pre-funding future liabilities does apply to fixed exchange rate regimes, as sufficient reserves must be held to facilitate guaranteed conversion features of the currency. It also applies to non-government users of a currency. Their ability to spend is a function of their revenues and reserves of that currency.

So at the heart of all this nonsense is the false analogy neo-liberals draw between private household budgets and the government fiscal position. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.

You might have thought the answer was perhaps true because it would depend on whether the economy was already at full employment and what the desired saving plans of the private domestic sector was. However, the question mentioned the future not the present. In the absence of the statement about creating more fiscal space in the future, then it is possible (depending on the private domestic balance) that the government would have to run surpluses to ensure nominal aggregate spending was not outstripping the real capacity of the economy to absorb it.

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

Question 3:

When output gaps are based on the concept of the NAIRU (Non-Accelerating-Inflation-Rate-of-Unemployment), the estimates produced will usually lead one to conclude that a government’s discretionary fiscal position is more expansionary than it actually is.

The answer is True.

The implicit estimates of potential GDP that are produced by central banks, treasuries and other bodies like the OECD are typically too pessimistic.

The reason is that they typically use the NAIRU to compute the “full capacity” or potential level of output which is then used as a benchmark to compare actual output against. The reason? To determine whether there is a positive output gap (actual output below potential output) or a negative output gap (actual output above potential output).

These measurements are then used to decompose the actual fiscal outcome at any point in time into structural and cyclical fiscal balances. The fiscal components are adjusted to what they would be at the potential or full capacity level of output.

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 outcome 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 position into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

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.

As you can see, the estimation of the benchmark is thus a crucial component in the decomposition of the fiscal outcome and the interpretation we place on the fiscal policy stance.

If the benchmark (potential output) is estimated to be below what it truly is, then a sluggish economy will be closer to potential than if you used the true full employment level of output. Under these circumstances, one would conclude that the fiscal stance was more expansionary than it truly was.

This is very important because the political pressures may then lead to discretionary cut backs to “reign in the structural deficit” even though it is highly possible that at that point in time, the structural component is actually in surplus and therefore constraining growth.

The mainstream methodology involved in estimating potential output almost always uses some notion of a NAIRU which itself is unobserved. The NAIRU estimates produced by various agencies (OECD, IMF etc) always inflate the true full employment unemployment rate and completely ignore underemployment, which has risen sharply over the last 20 years.

The point is that by reducing the potential GDP estimates (by inflating the estimate of full employment unemployment) the structural deficits always contain some cyclical component and suggest that the discreationary policy choice is more expansionary than what it truly is when calibrated against a more meaningful potential GDP measure.

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

Question 4:

A nation can run a external deficit accompanied by a government sector surplus, which is of a larger proportion to GDP than the external balance), while the private domestic sector is spending less than they are earning.

The answer is False.

This is a question about the sectoral balances – the government fiscal balance, the external balance and the private domestic balance – that have to always add to zero because they are derived as an accounting identity from the national accounts.

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 (CAB). 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.

The following Table represents two options in percent of GDP terms.

Sectoral Balance Interpretation of Result Case A Case B
External Balance (X – M) Deficit is negative -2 -2
Fiscal Balance (G – T) Deficit is positive -2 -3
Private Domestic Balance (S – I) Deficit is negative -4 -5

The first set of possibilities (Case A) show that the external deficit is exactly offset by the government sector surplus and under those circumstances the domestic sector cane only be spending less than they are earn (that is, net saving (overall) is negative).

You can see that the private domestic sector balance is negative (that is, the sector is spending more than they are earning – Investment is greater than Saving – and has to be equal to 4 per cent of GDP.

Case B – the scenario in the question – shows that the nation is running an external deficit (2 per cent of GDP) but the government sector surplus is larger (3 per cent of GDP).

Under these circumstances, the private domestic deficit rises to 5 per cent of GDP to satisfy the accounting rule that the balances sum to zero.

So what is the economic rationale for this result?

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

The external deficit also means that foreigners are increasing financial claims denominated in the local currency. Given that exports represent a real costs and imports a real benefit, the motivation for a nation running a net exports surplus (the exporting nation in this case) must be to accumulate financial claims (assets) denominated in the currency of the nation running the external deficit.

A fiscal surplus also means the government is spending less than it is “earning” and that puts a drag on aggregate demand and constrains the ability of the economy to grow.

In these circumstances, for income to be stable, the private domestic sector has to spend more than they earn.

You can see this by going back to the aggregate demand relations above. For those who like simple algebra we can manipulate the aggregate demand model to see this more clearly.

Y = GDP = C + I + G + (X – M)

which says that the total national income (Y or GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

So if the G is spending less than it is “earning” and the external sector is adding less income (X) than it is absorbing spending (M), then the other spending components must be greater than total income

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

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.

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    This Post Has 3 Comments
    1. Question 1
      Prof. Mitchell how does Norway fit in this case given that: a) has the largest sovereign fund in the world in excess of 1 trillion dollars, b) government budget surpluses at least 5% annually, c) unemployment rate considerably less than 4%, d) inflation rate much below 2% annually, e) private domestic saving about 6% of GDP, f) annual average growth rate of 3%, g) one of the highest external surplus,
      h) extremely high tax rates, i)perhaps the best welfare state in the world, j) abundant natural resources, k) highly educated work force, l) the happiest country in the world, and the list goes on.
      So how else could Norway have spent all these oil revenues that started flowing in the country since the North Sea oil discoveries in the late 1970s?

    2. Is it correct to say that government bond issues sterilize deficits in the sense that (like taxes) they remove money from circulation, thereby removing a major source of inflationary pressure from the economy (in addition to their other functions as explained by MMT)?

      The non-government sector obtains new net financial assets in the form of government debt which must be saved rather than spent on goods and services.

      So an increase in (gross) government spending increases aggregate spending, while an increase in net government spending (the “deficit”) increases saving rather than spending.

      I’m asking because there seems to be growing talk in some circles about a possible resurgence of inflation, partly due to mounting government deficits in many countries.

    3. I think the answer to my own question is no, after re-reading some of Bill’s articles. (My confusion stems from an effort to learn about economics by reading both old books on economics and MMT).

      Mainstream economics has used the woolly concept of “money in circulation” to build theories of liquidity (as a prerequisite for economic growth) and inflation/deflation. But MMT regards spending flows (aggregate demand) as the key to economic growth and inflation and the stock of currency and bank deposits at any given time (“money in circulation”) is just a residual in this process.

      From this perspective, money which isn’t spent is saved and savings represent a leakage from the income-expenditure stream. Whether or not they’re held in bank deposits or government bonds doesn’t affect the income-spending flows at the heart of MMT analysis.

      As Bill said recently, when the government issues bonds to match a “deficit”, that borrowing “has no impact on the inflation propensity inherent in the (original) spending”. So the question of “sterilizing” deficits doesn’t arise.

      At least, I think that’s right.

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