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Saturday Quiz – May 22, 2010

Welcome to the billy blog Saturday quiz. The quiz tests whether you have been paying attention over the last seven days. See how you go with the following five questions. Your results are only known to you and no records are retained.

1. Estonia and Latvia both run currency boards which requires that the nation have sufficient foreign reserves to match the outstanding central bank liabilities (reserves and cash outstanding). This system ensures 100 per cent convertibility but is highly deflationary unless the country runs external surpluses.

2. From the perspective of Modern Monetary Theory (MMT), mass unemployment can arise from workers demanding too high a nominal wage in relation to the inflation rate.

3. A Eurozone nation that runs a persistent current account deficit cannot sustain rising living standards over time given that the ECB chooses to maintain rigid control of the inflation rate.

4. A sovereign national government can run a balanced budget over the business cycle (peak to peak) as long as it accepts that after all the spending adjustments are exhausted that the private domestic balance will mirror the external balance. That means a country running an external deficit will have an increasingly indebted private domestic sector.

5. If nominal wages keep pace with inflation which is accelerating at the same rate as labour productivity is growing then there is no shift in the wage share in GDP.

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    This Post Has 6 Comments
    1. Bill, are you sure that the correct answer for Q3 is “Unlikely”? It is somewhat confusing for my non-English mind. My first intention was “Most likely” but since this is not an option I went for “True” and that seems wrong.

    2. Dear Sergei

      I think unlikely is the correct answer. Unlikely means not impossible but improbably. I will explain tomorrow.

      best wishes

    3. Bill,
      In the spirit of debate and to test my understanding of what I’ve been reading here, I posted the following question on Bruce Bartlett’s blog, Capital Gains and Games. Following it is his response. It is obvious that I really don’t fully understand the mechanics of MMT, but the response admits that the Fed can print money as it sees fit while the political branch, the Treasury is restricted by statute to “not monitize debt”. That was a clarification for me.

      The response avoids the issue of lack of demand preventing inflation and simply states that monitizing debt injects cash into the system, which because this guy thinks M. Friedman was on to something is by definition inflationary. But as that cash would go to former bond holders who would likely not spend it but reinvest in something. Thus it would not create demand as I imagine it and thus not be inflationary.

      The response also points to the 70s stagflation as evidence that inflation can coincide with underutilization of capacity. I’ve always credited stagflation with wage contracts that include “cost of living increases”, escalation clauses in purchasing agreements and collective bargaining’s wage and benefit growth, all of which have been in deep recession for my adult lifetime in North America.

      It seems to me if the MMT argument is to be won it needs to take on the old belief system directly which Ed Harrison has done tentatively at a theoretical level in his blog while Marshal Aurbach has been very good at the applied level in his policy positions. So my question to you is why is monitizing the debt, or for that matter the federal budget itself not inflationary? Is it simply a matter of how the money is spent and thus of policy as to whether it becomes inflationary or not?


      If bond market vigilantes strike, as I perhaps mistakenly understand it, they would do so by NOT purchasing bonds at a treasury auction. If that were to happen, the interest rate offered for those bonds would be raised until a buyer could be found.

      Also as I understand, maybe wrongly again, there is a statute that prevents the Treasury itself from purchasing treasuries, or maybe it is simply that that would be spending money and would first require authorization from Congress. So suppose Congress, seeing the run on the dollar, lifts the restriction and authorizes the expenditure and the Treasury purchases treasuries until it stabilizes them at the interest rate desired by the Fed.

      It seems to me this would have two immediate effects, first to push the interest rate to the level desired by policy makers and second to soak up liquidity on the larger market because the treasures once repurchased by the Treasury simply cease to exist and are no longer capital for use to underwrite the extension of credit in the private markets.

      Other more knowledgable folks I’ve tried this question on have said such purchases would be inflationary and bring up Weimar and Zimbabwe, but in both of those instances excesses in the money supply were washing over crippling collapses in productive capacity. In the case of Weimar, France had just occupied the Rhur Valley wiping out German industrial capacity. In Zimbabwe, the issuer of the currency had also expropriated the agricultural base of the economy, industrial farms, and parceled them off as political payoff to people incompetent to use them. So in both cases extra money was chasing radically diminished capacity.

      In the US, with industrial utilization at something less than 80%, I think, and unemployment, depending on how you count it between 9% and 15% it does not seem to me we are any where close to a capacity constraint. In addition, over two trillion of new “money” was created when the Fed started to soak up all the toxics in our private banks two years ago and it has resulted in the lowest inflation since 1964 (according to the Times yesterday).

      It seems to me that this is because all of that money was siphoned immediately into the financial economy and thus isolated on balance sheets around the world outside of the productive economy. This seems to imply that it is not a question of how much money is out there, but how much is circulating and at what velocity that causes inflation and that if the Treasury began to purchase treasuries it would in fact reduce the amount of money out there without taking it from the real economy.

      Damage to the real economy could come from a credit squeeze resultant from the Treasury purchase of treasuries, but that would seem to me to create demand for treasuries that would be self correcting as it would create demand for government paper at the rate the government wants for it.

      If this is true then the government can both control the interest rate and mop up liquidity at the same time.


      Well, the Treasury certainly can redeem its own bonds. That’s purchasing Treasuries.

      It is prohibited from monetizing its debt by issuing cash to pay for it. It has to use funds obtained from taxes or borrowing or selling off assets to buy Treasuries — not from “printing money”.

      You mean “desired by the Treasury” (and the politicians in power). The Fed can buy and sell what it pleases to hit the target interest rates it desires, printing as much money as it wants to do so. But it is supposed to be independent of the politicians (ahem).

      The Treasury can buy Treasuries as it pleases too, so long as it doesn’t print money to do so. There’s no problem with it lowering interest rates that way, by buying back its bonds.

      *But* if we are talking about the big-deficit years projected to come, then it is going to be *selling* a whole lot more bonds than it buys on net. So that’s the end of that idea.

      Now if you are suggesting “lift the restriction” to let the Treasury “print money” to use in buying back the bonds it issues to finance a deficit, then after covering a deficit of $X by issuing $X of bonds and then buying $X of bonds for money that it just newly created, obviously the net is simply “no change” in bonds issued (it isn’t buying any at all on net) while it covers the deficit by issuing $X of new money to pay the govt’s bills.

      That $X is base money spent into the economy, and through the bank deposit money multiplier it will become $2x or $3x added to the money supply. Adding $3x to the money supply to buy $X of wages/goods = “inflation” … which does not reduce interest rates!

      Other more knowledgable folks I’ve tried this question on have said such purchases would be inflationary and bring up Weimar and Zimbabwe

      Yup. For perspective, in 2008 (the last year with normal numbers before the financial crisis) the monetary base was $800 billion. Say you decide to “monetize” a $600 billion deficit, you increase the money base by 75% right there … then apply the money multiplier … and off on the Road to Weimar we go!

      Minor point: Nobody is talking about inflation in the US today (we wish!) but at some future date when presumably the current economic weakness will be long past.

      Major point: It’s totally bogus to think an economy can’t have inflation with underutilized resources. That idea was definitively refuted for the US during the long stagflation of the “oil crisis” years — inflation in double digits with unemployment topping near 11%.

      And there’s a whole lot more data from world history than that. As Friedman said, “serious inflation is always and everywhere a monetary phenomenon”. Every economy has finite capacity. Increase the money supply compared to that capacity by 50%, 100%, 200% … every year, and what do you expect to happen to prices? MV = PQ is pretty much definitional.

      Rising inflation can by itself cause under-utilization of capacity by destroying economic relationships. Zimbabwe had plenty of unused capacity during its economic collapse to a fraction of its former self amid hyperinflation. More all the time! If you can create hyperinflation amid all those unused resources, you can create it anywhere.

    4. 4 out of 5, made my day :-),
      i have had it before but this time without guessing on some question. And I’ll guess “true” on question no1 is closer to “maybe” than “false”.

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