Saturday Quiz – June 12, 2010 – answers and discussion

Here are the answers with discussion for yesterday’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:

In a fiat monetary system (for example, US or Australia) with an on-going external deficit, if you desire the domestic private sector to reduce its overall debt levels without employment losses, then you have to support the national government continually increasing the budget deficit in line with the private de-leveraging process.

The answer is Maybe.

For the domestic private sector (households and firms) to reduce their overall levels of debt they have to net save overall. The behavioural implications of this accounting result would manifest as reduced consumption or investment, which, in turn, would reduce overall aggregate demand.

The normal inventory-cycle view of what happens next goes like this. Output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.

The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.

Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms lay-off workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.

At that point, the economy is heading for a recession.

So the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur. While the question suggests that this intervention would come from an expanding public deficit, it could come from an expansion in net exports.

It is possible that at the same time that the households and firms are reducing their consumption in an attempt to lift the saving ratio, net exports boom. A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).

So it is possible that the public budget balance could actually go towards surplus and the private domestic sector increase its saving ratio if net exports were strong enough.

The important point is that the three sectors add to demand in their own ways. Total GDP and employment are dependent on aggregate demand. Variations in aggregate demand thus cause variations in output (GDP), incomes and employment. But a variation in spending in one sector can be made up via offsetting changes in the other sectors.

So the best answer is maybe.

The following blogs may be of further interest to you:

Question 2:

Sovereign funds do not store budget surpluses as national savings. They just account for assets that the government has bought in the same way that the property records of, say, the public schools and hospitals record holdings of other public assets accumulated through government spending.

The answer is True.

From the perspective of Modern Monetary Theory (MMT) the national 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 by purchasing assets in financial markets 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. In rejecting the notion that public surpluses create a cache of money that can be spent later we note that Government spends by crediting an account held by the commercial banks at the central bank. There is no revenue constraint. Government cheques don’t bounce! Additionally, taxation consists of debiting an account held by the commercial banks at the central bank. The funds debited are “accounted for” but don’t actually “go anywhere” and “accumulate”.

Thus is makes no sense to say that a sovereign government is saving in its own currency. Saving is an act that revenue-constrained households do to enhance their future consumption opportunities. The sacrifice of consumption now provides more funds in the future (via compounding). But the government doesn’t have to sacrifice spending now to spend in the future.

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 the mis-perceptions about sovereign funds is the false analogy mainstream macroeconomics draws between private household budgets and the government budget. 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.

However, trying to squeeze the economy to generate these mythical “pools of funds” which are then allocated to the sovereign fund as if they exist is very damaging. You can think of this in two stages.

First, the national government spends less than it taxes and this leads to ever decreasing levels of net private savings (unless there is a strong positive net exports response). The private deficits are manifest in the public surpluses and increasingly leverage the private sector. The deteriorating private debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity.

Second, while that process is going on, the Federal Government is actually spending an equivalent amount that it is draining from the private sector (through tax revenues) in the financial and broader asset markets (domestic and abroad) buying up speculative assets including shares and real estate.

Accordingly, creating a sovereign fund amounts to the government competing in the private equity market to fuel speculation in financial assets and distort allocations of capital.

However, as you can see from pulling it apart, this behaviour has been grossly misrepresented as providing “future savings”. Say the sovereign government ran a $15 billion surplus in the last financial year. It could then purchase that amount of financial assets in the domestic and international capital markets. But from an accounting perspective the Government would no longer have run that surplus because the $15 billion would be recorded as spending and the budget would break even.

In these situations, the public debate should be focused on whether this is the best use of public funds. It would be hard to justify this sort of spending when basic infrastructure provision and employment creation has been ignored for many years by neo-liberal governments.

So all we are talking about is a different portfolio of assets.

The following blog may be of further interest to you:

Question 3:

The massive build-up of Chinese holdings of US government debt has allowed US citizens to enjoy a higher material standard of living at the expense of the residents of China.

The answer is True.

I detected some angst from the comments about this question. My understanding of the concerns is that in a distributional some might benefit while others will not therefore the answer should be maybe. But we are doing macroeconomics in this blog (mostly) and so we are dealing with aggregates and so the distributional questions, while very important, are abstracted from.

First, China can only do what the Americans and everyone else it trades with allow them to do. They cannot sell a penny’s worth of output in USD and therefore accumulate the USD which they then use to buy US treasury bonds if the US citizens didn’t buy their stuff.

Presumably, people buy imported goods made in China instead of locally-made goods (which are more expensive) because they perceive it is their best interests to do so.

I find these “freedom” campaigns curiously contradictory. They hate government involvement in the economy yet propose complex regulative structures (for example, tariffs) which would increase government control on resource allocation and, not to mention it, force citizens (against their will) to purchase goods and services they reject in an open comparison (on price and whatever other characteristics).

Many economists do not fully understand how to interpret the balance of payments in a fiat monetary system. For example, most will associate the rise in the current account deficit (exports less than imports plus net invisibles) with an outflow of capital. They then argue that the only way the US (if we use it as an example) can counter this is if US financial institutions borrow from abroad.

They then assume that this is a problem because it means, allegedly, that the US nation is “living beyond its means”. It it true that the higher the level of US foreign debt, the more its economy becomes linked to changing conditions in international credit markets. But the way this situation is usually constructed is dubious.

First, exports are a cost – a nation has to give something real to foreigners that it we could use domestically – so there is an opportunity cost involved in exports.

Second, imports are a benefit – they represent foreigners giving a nation something real that they could use themselves but which the local economy will benefit from having. The opportunity cost is all theirs!

So, on balance, if a nation can persuade foreigners to send more ships filled with things than it has to send in return (net export deficit) then that is a net benefit to the local economy. I am abstracting from all the arguments (valid mostly!) that says we cannot measure welfare in a material way. I know all the arguments that support that position and largely agree with them.

So how can we have a situation where foreigners are giving up more real things than they get from the local economy (in a macroeconommic sense)? The answer lies in the fact that the local nation’s current account deficit “finances” the desire of foreigners to accumulate net financial claims denominated in $AUDs. Think about that carefully. The standard conception is exactly the opposite – that the foreigners finance the local economy’s profligate spending patterns.

In fact, the local trade deficit allows the foreigners to accumulate these financial assets (claims on the local economy). The local economy gains in real terms – more ships full coming in than leave! – and foreigners achieve their desired financial portfolio. So in general that seems like a good outcome for all.

The problem is that if the foreigners change their desire to accumulate financial assets in the local currency then they will become unwilling to allow the “real terms of trade” (ships going and coming with real things) to remain in the local nation’s favour. Then the local econmy has to adjust its export and import behaviour accordingly. If this transition is sudden then some disruptions can occur. In general, these adjustments are not sudden.

So if you understand this then you will be able to appreciate the following juxtaposition:

Neo-liberal myth: US consumers have to borrow $billions from foreigners to keep consuming.

MMT reality: US consumers are funding $billions in foreign savings (accumulation of $US-denominated financial assets by foreigners).

Here is a transactional account of how this works which starts off with a US citizen buying a Chinese product.

  • US citizen buys a nice little Chinese car.
  • If the US consumer pays cash, then his/her bank account is debited and the Chinese car dealer’s account is credited – this has the impact of increasing foreign savings of US dollar-denominated financial assets. Total deposits in the US banking system, so far, are unchanged.
  • If the US consumer takes out a loan to buy the car, then his/her bank’s balance sheet now records the loan as an asset and creates a deposit (the loan) on the liability side. When the US consumer then hands the cheque over to the car dealer (representing the Chinese firm – ignore intervening transactions) the Chinese car company has a new asset (bank deposit) and my loan boosts overall bank deposits (loans create deposits). Foreign savings in US dollars rise by the amount of the loan.
  • So the trade deficit (1 car in this case) results from the Chinese car firm’s desire to net save US dollar-denominated financial assets and sell goods and services to the US in order to get those assets – it is the only way they can accumulate financial assets in a foreign currency.

What if the Chinese car company then decided to buy US Government debt instead of holding the US dollar-denominated bank deposits?

Some more accounting transactions would occur.

  • The Chinese company would put in an order for the bonds which would transfer the bank deposit into the hands of the central bank (Federal Reserve) who is selling the bond (ignore the specifics of which particular account in the Government is relevant) and in return hand over a bit of paper called a bond to the Chinese car maker’s lawyers or representative.
  • The US Government’s foreign debt rises by that amount.
  • But this merely means that the US Government promises, on maturity of the bond, to credit the Chinese car firm’s bank account (add reserves to the commercial bank the car firm deals with) with the face value of the bond plus interest and debit some account at the central bank (or whatever specific accounting structure deals with bond sales and purchases).

If you understand all of that then you will clearly understand that this merely amounts to substituting a non-interest bearing reserve balance for an interest-bearing Government bond. That transaction can never present any problems of solvency for a sovereign government.

The US consumers get all the real goods and services and the Chinese have bits of paper.

The following blogs may be of further interest to you:

Question 4:

Short-term interest rates are set by the central bank while the fiscal strategy manifests in tax and spending decisions by the government. Whereas the private sector cannot directly influence the interest rate target being set it can determine the size of the budget deficit at any point in time.

The answer is True.

So 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 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.

Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.

Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.

In other words, the natinal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.

However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.

The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.

The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.

However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.

So the private sector cannot directly influence the central bank’s capacity to set interest rates. Clearly the central bank considers developments in the private sector but that is a different matter.

However, the private sector does ultimately determine the budget balance associated with fiscal policy.

The budget balance has two conceptual components. First, the part that is associated with the chosen (discretionary) fiscal stance of the government independent of cyclical factors. So this component is chosen by the government.

Second, the cyclical component which refer to the automatic stabilisers that 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 budget 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 cyclical component is not insignificant and if the swings in private spending are significant then there will be significant swings in the budget balance. The importance of this component is that the government cannot reliably target a particular deficit outcome with any certainty. This is why adherence to fiscal rules are fraught and normally lead to pro-cyclical fiscal policy which is usually undesirable, especially when the economy is in recession.

While the short-term interest rate is exogenously set by the central bank, economists consider the budget outcome to be endogenous – that is, it is determined by private spending (saving) decisions. The government can set its discretionary net spending at some target to target a particular budget deficit outcome but it cannot control private spending fluctuations which will ultimately determine the final actual budget balance.

So the best answer is true.

The following blogs may be of further interest to you:

Question 5:

If employment growth matches the pace of growth in the civilian population (people above 15 years of age) then the economy will experience a constant unemployment rate as long as participation rates do not change.

The answer is True.

The Civilian Population is shorthand for the working age population and can be defined as all people between 15 and 65 years of age or persons above 15 years of age, depending on rules governing retirement. The working age population is then decomposed within the Labour Force Framework (used to collect and disseminate labour force data) into two categories: (a) the Labour Force; and (b) Not in the Labour Force. This demarcation is based on activity principles (willingness, availability and seeking work or being in work).

The participation rate is defined as the proportion of the working age population that is in the labour force. So if the working age population was 1000 and the participation rate was 65 per cent, then the labour force would be 650 persons. So the labour force can vary for two reasons: (a) growth in the working age population – demographic trends; and (b) changes in the participation rate.

The labour force is decomposed into employment and unemployment. To be employed you typically only have to work one hour in the survey week. To be unemployed you have to affirm that you are available, willing and seeking employment if you are not working one hour or more in the survey week. Otherwise, you will be classified as not being in the labour force.

So the hidden unemployed are those who give up looking for work (they become discouraged) yet are willing and available to work. They are classified by the statistician as being not in the labour force. But if they were offered a job today they would immediately accept it and so are in no functional way different from the unemployed.

When economic growth wanes, participation rates typically fall as the hidden unemployed exit the labour force. This cyclical phenomenon acts to reduce the official unemployment rate.

So clearly, the working age population is a much larger aggregate than the labour force and, in turn, employment. Clearly if the participation rate is constant then the labour force will grow at the same rate as the civilian population. And if employment grows at that rate too then while the gap between the labour force and employment will increase in absolute terms (which means that unemployment will be rising), that gap in percentage terms will be constant (that is the unemployment rate will be constant).

The following Table simulates a simple labour market. You can see that while unemployment rises steadily over time the unemployment rate is constant. So as long as employment growth is equal to the growth in the underlying population and the participation rate doesn’t change, the unemployment rate will be constant although more people will be unemployed.

Understanding these aggregates is very important because as we saw in the week just past, the Labour Force data released by the Australian Bureau of Statistics on Thursday has been incorrectly represented in almost all the media coverage. While employment growth was keeping pace with the underlying population the participation rate fell and so the unemployment rate fell. The media focused on the link between the positive employment growth and the declining unemployment and concluded our economy was booming. The reality was very different.

The following blog may be of further interest to you:

This Post Has 34 Comments

  1. I still maintain my opinion from yesterday the best answer to question 4 is Maybe. Consider the situation where Australia’s government decides whether or not to buy some fighter planes from America. The deficit will be a few billion dollars higher if they do than if they don’t. Therefore it is not something the private sector has control over at
    that point in time, so the statement can not be true in that instance.

    Yes, I understand that the government cannot control the deficit. But that is not what the question asked.

  2. My understanding of the concerns is that in a distributional some might benefit while others will not therefore the answer should be maybe. But we are doing macroeconomics in this blog (mostly) and so we are dealing with aggregates and so the distributional questions, while very important, are abstracted from.

    [emphasis added]

    Those of us with “angst” are only asking that you either

    1) Aggregate using a reasonable social welfare function, in which case the answer to the question is ambiguous. SWF is also part of macro.

    2) Modify the language. You can simply say “increases aggregate consumption over that period” without the feel-good language that suggests that this is a “benefit”, or that we “enjoy” the additional consumption — these terms suggest that the change is desirable, and in order to claim that, you need a social welfare function.

  3. Hi Bill,

    I’d like to raise the same issue raised by RSJ but in a different way.

    I have no issue with the transactions that you detailed about import purchases. However, I think that the external sector is important when considering full employment, at least for some countries such as the US, where the exchange rate refuses to devalue because market forces keep the dollar strong.

    There is of course no solvency issue involved, when the Federal Reserve has the powers to set the yield curve to whatever values it wants. However, more that an issue with solvency or any financial constraint, its more about the limitations of fiscal policy. With the production capacity of the United States, price rise is not a worry if the Obama government provides a much higher fiscal expansion than what it has (I guess lot of it was simply automatic stabilizers acting via reduced tax payments and non-voluntary).

    In the transactions you have mentioned, the rest of the world simply purchases Treasury securities with the proceeds from exports. There are other transactions possible because of the dollar accumulation. The table L.107 of the Z.1 accounts of the US gives some details. The exporters, for example can purchase equities, corporate bonds and mortgaged backed securities. This leads to income outflow to foreigners in the form of dividend and coupon payments. If the foreigners hadn’t held the securities, the flows would have been to the domestic financial and the household sector and would have added to aggregate demand.

    While an expansionary fiscal stance leads to an increase in aggregate demand, a further expansion is more dilutive in nature – it just leads to the widening of the current account. While the current account is widening, foreigners are accumulating financial assets not just Treasury securities. While debt/gdp ratios move to what mainstream economists called “unsustainable levels”, the claims by foreigners on various sectors of the US, not just the government may rise at an even faster rate, and it is indeed unsustainable.

    One may argue that the exchange rate may finally take care of this, but it may happen with a very high time lag.

    While one may argue that not all countries can be in a surplus simultaneously, there can be some scenarios where countries growing at a much higher rate than the developed countries can enjoy imports to some levels. A coordinated action where China is expanding helped by a good fiscal policy can ease some pressure on the US, for example.

    Also, there are distributional issues – even if a country runs a JG, there can be a scenario in which expansionary fiscal policy leads to more people moving into the buffer stock rather than moving out because the imports continue to grow putting strains on aggregate demand. It may not be useful for citizens earning higher than the minimum wage levels set by the buffer stock, because it wouldn’t be possible for them to work at those wages.

    While I understand that for the US, a huge fiscal action is required, but something needs to be done about the external sector as well and the currency too. In some sense, a stable debt/gdp is a good indicator. While I understand that there is nothing called “high” public debt/gdp ratios, a return to a stable value is good. For example, a coordinated action by all nations, can take the public debt/gdp ratios at a high but stable level.

  4. Further to my comment . . .

    When I use phrases like “limitation”, I really don’t mean it in the sense used by Barro or even Krugman etc. My use of such phrases is just to highlight a few things, when on the other hand, I fully support your ideas such as Job Guarantee, for which there is no limitation or constraint.

  5. Off Topic: Bill,

    At least here we’re ready to rock the boat. We’ve stocked up Fosters, bought some funny Aussie hats and look forward to celebrate a crushing defeat of Germany. Hope that helps! There’s also no shortage of German enemy combatant fans here, because their children are flooding our free-for-all no numerus clausus university system. Knowing you’re not so much interested in soccer but very much in economic papers you might want to check out the Goldman Sachs World Cup Edition 2010:

    The only thing I’ll miss once Goldman Sachsd disappears from earth is their world cup edition. Of course they always hedge their bids and never ever predict a winner. Which seems logical to me given that most of their models know only one winner: GS. Good luck tonight! Cheers, Stephan

  6. I still hold that Q 4 should be false. The private sector can “influence” the size of budget deficits, but only the public sector can determine the actual size of budget deficits at any point in time. That’s what austerity, deficit terrorism, and democratic repression / retardation is all about.

  7. Greg,

    The deficit is endogenous and the policy is partly exogenous. The government sets G and t – the government spending and the tax rates, and the private sector determines the total taxes paid. The confusion arises because the total taxes paid depends on the tax rates, but more importantly it depends on economic activity. The government announces the policy typically at the beginning of the fiscal year and it simply has no control on the total taxes paid. Believing that governments determine the deficit is equivalent to believing that the government can predict the future and has perfect foresight.

    It is not inconsistent with the fact that government can go into austerity. Being less austere would mean increasing G and/or decreasing t.

    So austerity and no-control are not really inconsistent with each other.

  8. Dear Greg

    You said:

    That’s what austerity, deficit terrorism, and democratic repression / retardation is all about.

    And that is why the goal of their actions – the budget balance – will typically rise as they implement austerity – contrary to their hopes. Ultimately, if the government scorches the private sector enough – that is, drive enough firms broke – they will reduce the deficit – but they will never control it.

    Budget outcomes are endogenous. This doesn’t mean the government doesn’t have discretion over its budget parameters.

    best wishes

  9. Dear Stephan at 11:41

    I might … just a bit … and only for a short while … become a soccer fan this Monday morning (EAST).

    best wishes

  10. Hello Ramanan.

    Government may not be able to “predict the future” nor have “perfect foresight”, but “government sets G and t” and has the ability to enforce t. With modern and broad data collection ability, I disagree that government “has no control on the total taxes paid”.

    If government can set spending, set tax policy and enforce the collection of taxes, I don’t understand why you feel that government has no control over taxes paid.

    Since tax revenue is merely a mathematical function of government spending (not a source of funds) government can always affect changes in taxes paid by changes in government spending (assuming no changes in international trade activity.)

  11. Hi Greg,

    So you agree that the government sets the tax rates but the disagreement is on total taxes paid in $$$s. My point is not merely on the enforcement. During a period, say one fiscal year, many things happen. Consumers are talking decisions on spending, producers are talking decisions on investment in fixed capital and inventories, wages, hiring etc. The total taxes paid depends directly on the demand, which is not directly controlled by the government. Of course governments can increase demand, I understand, but the private sector is taking its own decisions.

    In your argument, you are implicitly assuming that incomes are fixed. This is not the case. If consumers and producers have increased confidence, it leads to higher economic activity and hence incomes and hence taxes. If they lack animal spirits, the activity will be low and the government has no control on the total quantity of taxes. It is effectively a price setter and a quantity taker. (price as in the tax rate).

    So you may be implicitly assuming that incomes are fixed, but they wary. Before the recession started incomes were higher and now they are lower. Since total taxes are proportional to the incomes, it varies by economic activity.

    Lets say that the government wants to target a taxes to $2T in a fiscal year. During the fiscal year, it sees that it may not meet its target. So it increases the tax rate. This in turn, puts a downward pressure on economic activity, since it leads to a lower disposable income and hence less spending. So the government may not manage to meet its target. The government may see this and increase tax rates to even higher levels. This leads to a further decrease in economic activity and lesser tax collection in $$$s.

    You can probably start to form such stories to appreciate this point.

  12. Greg @4:59 … saw your comment after submitting mine @5:02. I guess we are on the same page now.

  13. Greg: “I still hold that Q 4 should be false. The private sector can “influence” the size of budget deficits, but only the public sector can determine the actual size of budget deficits at any point in time. That’s what austerity, deficit terrorism, and democratic repression / retardation is all about.”

    Bill Mitchell: “And that is why the goal of their actions – the budget balance – will typically rise as they implement austerity – contrary to their hopes. Ultimately, if the government scorches the private sector enough – that is, drive enough firms broke – they will reduce the deficit – but they will never control it.

    “Budget outcomes are endogenous. This doesn’t mean the government doesn’t have discretion over its budget parameters.”

    Wait! You’re both wrong! 😉

    There is a false dichotomy here. Either the government determines the deficit or the private sector does. The right answer is none of the above. The system is interdependent, neither is in control. 🙂

  14. Min (and Bill and Greg) – If either does nothing then the other is in control. Therefore the correct answer should be Maybe.

  15. Min and Aidan,

    I give you two numbers a and b. You choose a number c multiply it with b and subtract the result from a.

    So I give you a and b and you tell me [a – (b x c )]

    Do I have a control on the number you gave me ?

  16. Bill,

    “I might … just a bit … and only for a short while …” Hmmm … guess your interest in soccer was very short. About 4 minutes? 4:0. Depressing. Always the same story. It takes at least half a tournament before the heros come along and eliminate the German squad. But I’m amazed how cool Australian fans are. You need some nerves to ignore someone yelling “Deutschland, Deutschland” in your face after 3:0 and to stop the face-2-face screaming after 4:0 without further comment with a bloody German nose. Respect!

  17. Ramanan @ 20:54

    I like the argument that RSJ makes but I miss your interpretation of it. So if the currency is strong and government is constantly injecting funds into economy or exporters/foreigners get an ever increasing share of fiscal stimulus and purchase private sector assets then the domestic private sector can easily choose to purchase foreign assets such as China or Brazil ETF and get income associated with those assets. Will it then short-circuit your argument?

  18. Sergei,

    When exporters sell products to the US, they earn in dollars and they can chose to invest in other assets such as equities or corporate bonds which earns income. Else they may sell it to their banks which may sell it to its central bank.

    US investors can bid up stock prices in Brazil but in the end, the US is a debtor nation. If you refer to the US flow of funds, L.107, you can see the position of the rest of the world.

    Your argument is as if the US household can purchase all assets in the world. Surely thats not the case!

    Lets see how it works. You exchange $100 at a Brazilian bank which works in the US. The Brazilian bank increases your deposits at its Brazil branch by R$200 assuming 1R$=0.5$ and in exchange has $100 extra at US Bank. You buy stocks worth R$200 and the Brazilian bank buys some asset in the US, such as Treasury security which was sacrificed by you.

    If you manage to earn more than the Brazilian bank, thats great but it would indeed take huge bets from US households to be earning like this. Unfortunately thats not what the data shows and you can see that from the US Flow of Funds.

    Your solution is however feasible. According to Ben Bernanke in his famous speech on the supposed “saving glut” he had to say this

    However, as I have argued today, some of the key reasons for the large U.S. current account deficit are external to the United States, implying that purely inward-looking policies are unlikely to resolve this issue. Thus a more direct approach is to help and encourage developing countries to re-enter international capital markets in their more natural role as borrowers, rather than as lenders. For example, developing countries could improve their investment climates by continuing to increase macroeconomic stability, strengthen property rights, reduce corruption, and remove barriers to the free flow of financial capital. Providing assistance to developing countries in strengthening their financial institutions–for example, by improving bank regulation and supervision and by increasing financial transparency–could lessen the risk of financial crises and thus increase both the willingness of those countries to accept capital inflows and the willingness of foreigners to invest there. Financial liberalization is a particularly attractive option, as it would help both to permit capital inflows to find the highest-return uses and, by easing borrowing constraints, to spur domestic consumption. Other changes will occur naturally over time. For example, the pace at which emerging-market countries are accumulating international reserves should slow as they increasingly perceive their reserves to be adequate and as they move toward more flexible exchange rates. The factors underlying the U.S. current account deficit are likely to unwind only gradually, however. Thus, we probably have little choice except to be patient as we work to create the conditions in which a greater share of global saving can be redirected away from the United States and toward the rest of the world–particularly the developing nations.

  19. You can still have behavior even if you do not have identified utility function and the first order conditions of optimization for each economic unit whether representative, overlapping or not! If you have dynamic account balances that are specified with feedback factors, then an impact upon the balances can induce a feedback path which a dynamic adgustment (behavior). You can look inside the “black box” with vertical and horizontal relations as long as you have identified a covariance structure for them. These are not equivalent methods but sufficient to produce behavioral parameters. In other words, you search for patterns and not individual behavior.

  20. Panayotis,

    Sorry couldn’t get you. Anything relevant to my comments ?

  21. You can qualify further behavior using another trick. You can calibrtae the rate of change in this dynamic structure mentioned in my previous comment as probability/frequency of occurrence for the relations you pattern. This calibration can include several terms such as a mean rate derived from a Poisson process, a random walk from a Brownian motion process and a random jump from an asymptotic hyperbolic function of a Pareto process. Notice that behavioral patterns of vertical/horizontal relations can be specified as a polynomial with a stationary or nonlinear series and a remainder term to capture thebounded operation from imperfection and friction that requires behavioral adjustment as danger upon decisions and as scarcity upon practices.

  22. Ramanan,

    I was not criticizing your comments but offering an alternative to behavioral specification as someone or more have argued that you needed utility functions to capture aggregated behavior in macro models.

  23. Ramanan, sorry, I still do not understand why being a debtor nation is detrimental to the people of this nation even if the government runs consistent budget deficits which can have certain distributional effects in favour of foreigners

  24. Sergei, slightly difficult with a small comment. Will come back to you on this.

  25. exporters/foreigners get an ever increasing share of fiscal stimulus and purchase private sector assets then the domestic private sector can easily choose to purchase foreign assets

    No, as current account + capital account = 0.

  26. Ramanan: “Min and Aidan,

    “I give you two numbers a and b. You choose a number c multiply it with b and subtract the result from a.

    “So I give you a and b and you tell me [a – (b x c )]

    “Do I have a control on the number you gave me ?”

    I say that neither sector has control. 🙂

  27. Dear All

    The question used to term “determine” rather than “control”.

    The fact is that once the discretionary fiscal settings are in place (they are exogenous – meaning they are set by the government), the resulting actual budget outcome is driven by non-government spending decisions. That is the sense that I used the term determine.

    Yes, if discretionary policy settings then change the budget outcome will change, but once set, the resulting outcome is determined by the non-government spending. The government cannot control or set the actual budget outcome.

    best wishes

  28. bill: “they are exogenous – meaning they are set by the government”

    But is the government outside the system?

  29. Referring to the deficit, both Ramanan and Bill have stated that, across the business cycle, it should follow some trend, and that counter-cyclical spending will force it to deviate from the trend. Perhaps we can better think then in terms of the private sector setting the counter-cyclical movements, but the government policy setting the trend.

    What then, do you believe the trend should be?

  30. @ RJS

    Maybe the general trend of the deficit (in real terms) should be proportional to population growth. IOW, each person’s share of the national wealth should remain roughly constant in real terms. (?)

  31. Bll –
    Nice try, but when you wrote question 4 you included the phrase at any point in time.

    Had you asked whether the private sector could determine the size of the surplus once the discretionary fiscal settings are in place then the answer would be true. But you didn’t.

Leave a Reply

Your email address will not be published. Required fields are marked *

Back To Top