Saturday Quiz – January 15, 2011 – 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:

A coordinated fiscal austerity plan across all nations (aiming to run budget surpluses) would not be possible without impairing growth because it is likely that the private domestic sector in some countries will desire to save overall.

The answer is False.

The question has one true statement in it which if not considered in relation to the rationale for the true statement would lead one to answer True. But the rationale presented in the question is false and so the overall question is false.

The true statement is that “it is impossible for all governments (in all nations) to run public surpluses without impairing growth”. The false rationale then is that the reason the first statement is true is “because it is likely that the private domestic sector in some countries will desire to save overall”.

The question thus tests a knowledge of the sectoral balances and their interactions, the behavioural relationships that generate the flows which are summarised by decomposing the national accounts into these balances, and the constraints that is placed on the behaviour within the three sectors that is evident in the requirement that the balances must add up to zero as a matter of accounting.

Once again, here are the sectoral balances approach to the national accounts.

We can view the basic income-expenditure model in macroeconomics in 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).

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

Equating these two perspectives we get:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero. The sectoral balances derived are:

• The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
• The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
• The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.

A simplification is to add (I – S) + (X – M) and call it the non-government sector. Then you get the basic result that the government balance equals exactly $-for-$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances). This is also a basic rule derived from the national accounts and has to apply at all times.

So you might have been thinking that because the private domestic sector desired to save, then the government would have to be in deficit and hence the answer was true. But, of-course, the private domestic sector is only one part of the non-government sector – the other being the external sector.

Most countries currently run external deficits. This means that if the government sector is in surplus the private domestic sector has to be in deficit.

However, some countries have to run external surpluses if there is at least one country running an external deficit. That country can depending on the relative magnitudes of the external balance and private domestic balance, run a public surplus while maintaining strong economic growth. For example, Norway.

In this case an increasing desire to save by the private domestic sector in the face of fiscal drag coming from the budget surplus can be offset by a rising external surplus with growth unimpaired. So the decline in domestic spending is compensated for by a rise in net export income.

So it becomes obvious why the rationale is false and the overall answer to the question is false.

It is impossible for all governments (in all nations) to run public surpluses without impairing growth because not all nations can run external surpluses. For nations running external deficits (the majority), public surpluses have to be associated (given the underlying behaviour that generates these aggregates) with private domestic deficits.

These deficits can keep spending going for a time but the increasing indebtedness ultimately unwinds and households and firms (whoever is carrying the debt) start to reduce their spending growth to try to manage the debt exposure. The consequence is a widening spending gap which pushes the economy into recession and, ultimately, pushes the budget into deficit via the automatic stabilisers.

So you can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus. Clearly not every country can adopt this strategy given that the external positions net out to zero themselves across all trading nations. So for every external surplus recorded there has to be equal deficits spread across other nations.

You might like to read the following blogs for more discussion:

• Stock-flow consistent macro models
• Barnaby, better to walk before we run
• Norway and sectoral balances
• The OECD is at it again!

Question 2:

The government can always support private domestic sector saving in nominal terms by increasing the budget deficit and stimulating aggregate demand and national income.

The answer is False.

This answer should be read as a complement to the discussion in Question 1 as it also can be considered in terms of the sectoral balances.

If the external balance is zero (that is, net exports equal zero) the there is a one-to-one correspondence between the government balance and the private domestic sector balance such that, for example, a 2 per cent budget deficit must be associated with a 2 per cent private domestic sector balance surplus.

So in this circumstance the answer would be true.

But things get complicated when we introduce positive or negative external balances. Then a 2 per cent budget deficit might be associated with a 3 per cent external deficit and so the private domestic sector balance will be in deficit.

So the answer is only true if the budget deficit is larger (as a percent of GDP) than the external balance and growing faster.

Question 3:

The ratio of the “stock of money” and bank reserves has fallen dramatically in the US in recent years. This is best understood in terms of the tightly constrained credit markets due to recession.

The answer is True.

It has been demonstrated beyond doubt that there is no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”.

You will note that in MMT there is very little spoken about the money supply. In an endogenous money world there is very little meaning in the aggregate.

The mainstream theory of money and monetary policy asserts that the money supply (volume) is determined exogenously by the central bank. That is, they have the capacity to set this volume independent of the market. The monetarist portfolio approach claims that the money supply will reflect the central bank injection of high-powered (base) money and the preferences of private agents to hold that money. This is the so-called money multiplier.

So the central bank is alleged to exploit this multiplier (based on private portfolio preferences for cash and the reserve ratio of banks) and manipulate its control over base money to control the money supply.

To some extent these ideas were a residual of the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.

The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

A leading contributor to the endogeneous money literature is Canadian Marc Lavoie. In his 1984 article (‘The endogeneous flow of credit and the Post Keynesian theory of money’, Journal of Economic Issues, 18, 771-797) he wrote(page 774):

When entrepreneurs determine the effective demand, they must plan the level of production, prices, distributed dividends, and the average wage rate. Any production in a modern or in an “entrepreneur” economy is of a monetary nature and must involve some monetary outlays. When production is at a stationary level, it can be assumed that firms have at their disposal sufficient cash to finance their outlays. This working capital, in the aggregate, constitutes credits that have never been repaid. When firms want to increase their outlays, however, they clearly have to obtain extended credit lines or else additional loans from the banks. These flows of credit then reappear as deposits on the liability side of the balance sheets of banks when firms use these loans to remunerate their factors of production.

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.

Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans.

The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

So a declining ratio of some money stock measure to bank reserves is best explained by the fact that credit creation is being constrained by some factor – such as a recession.

You might like to read these blogs for further information:

• Lost in a macroeconomics textbook again
• Lending is capital- not reserve-constrained
• Oh no … Bernanke is loose and those greenbacks are everywhere
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• 100-percent reserve banking and state banks
• Money multiplier and other myths

Question 4:

The higher the tax revenue, the more the government can spend in real terms.

The answer is True.

The answer is straight-forwardly true once you understand the role that taxation plays in a fiat monetary system.

Clearly, I was tempting the reader to follow a logic such that – Modern Monetary Theory (MMT) shows that taxpayers do fund anything and sovereign governments are never revenue-constrained because they are the monopoly issuers of the currency in use. Therefore, the government can spend whatever it likes irrespective of the level of taxation. Therefore the answer is false.

But, that logic while correct for the most part ignores the underlying role of taxation.

In a fiat monetary system the currency has no intrinsic worth. Further the government has no intrinsic financial constraint. Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. The starting point of this new understanding is that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

In this way, it is clear that the imposition of taxes creates unemployment (people seeking paid work) in the non-government sector and allows a transfer of real goods and services from the non-government to the government sector, which in turn, facilitates the government’s economic and social program.

The crucial point is that the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. Accordingly, government spending provides the paid work which eliminates the unemployment created by the taxes.

This train of logic also explains why mass unemployment arises. It is the introduction of State Money (government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. For aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages).

Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account, but doesn’t desire to spend all it earns, other things equal. As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

The purpose of State Money is for the government to move real resources from private to public domain. It does so by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets). From the previous paragraph it is also clear that if the Government doesn’t spend enough to cover taxes and desire to save the manifestation of this deficiency will be unemployment.

Keynesians have used the term demand-deficient unemployment. In our conception, the basis of this deficiency is at all times inadequate net government spending, given the private spending decisions in force at any particular time.

Accordingly, the concept of fiscal sustainability does not entertain notions that the continuous deficits required to finance non-government net saving desires in the currency of issue will ultimately require high taxes. Taxes in the future might be higher or lower or unchanged. These movements have nothing to do with “funding” government spending.

To understand how taxes are used to attenuate demand please read this blog – Functional finance and modern monetary theory.

So to make the point clear – the taxes do not fund the spending. They free up space for the spending to occur in a non-inflationary environment.

You might say that this only applies at full employment where there are no free resources and so taxation has to take those resources off the non-government sector in order for the government to spend more. That would also be a true statement.

But it doesn’t negate the overall truth of the main proposition.

Further, you might say that governments can spend whenever they like. That is also true but if it just kept spending the growth in nominal demand would outstrip real capacity and inflation would certainly result. So in that regard, this would not be a sensible strategy and is excluded as a reasonable proposition. Moreover, it would not be able to expand its real spending (which requires output to rise).

The point is that the statement is never false.

The following blogs may be of further interest to you:

• A modern monetary theory lullaby
• Functional finance and modern monetary theory
• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3

Premium Question 5:

A sovereign national government cannot generate full employment without taxation.

The answer is True.

First, to clear the ground we state clearly that a sovereign government is the monopoly issuer of the currency and is never revenue-constrained. So it never has to “obey” the constraints that the private sector always has to obey.

The foundation of many mainstream macroeconomic arguments is the fallacious analogy they draw between the budget of a household/corporation and the government budget. However, there is no parallel between the household (for example) which is clearly revenue-constrained because it uses the currency in issue and the national government, which is the issuer of that same currency.

The choice (and constraint) sets facing a household and a sovereign government are not alike in any way, except that both can only buy what is available for sale. After that point, there is no similarity or analogy that can be exploited.

Of-course, the evolution in the 1960s of the literature on the so-called government budget constraint (GBC), was part of a deliberate strategy to argue that the microeconomic constraint facing the individual applied to a national government as well. Accordingly, they claimed that while the individual had to “finance” its spending and choose between competing spending opportunities, the same constraints applied to the national government. This provided the conservatives who hated public activity and were advocating small government, with the ammunition it needed.

So the government can always spend if there are goods and services available for purchase, which may include idle labour resources. This is not the same thing as saying the government can always spend without concern for other dimensions in the aggregate economy.

For example, if the economy was at full capacity and the government tried to undertake a major nation building exercise then it might hit inflationary problems – it would have to compete at market prices for resources and bid them away from their existing uses.

In those circumstances, the government may – if it thought it was politically reasonable to build the infrastructure – quell demand for those resources elsewhere – that is, create some unemployment. How? By increasing taxes.

So to answer the question correctly, you need to understand the role that taxes play in a fiat currency system.

In a fiat monetary system the currency has no intrinsic worth. Further the government has no intrinsic financial constraint. Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. The starting point of this new understanding is that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

In this way, it is clear that the imposition of taxes creates unemployment (people seeking paid work) in the non-government sector and allows a transfer of real goods and services from the non-government to the government sector, which in turn, facilitates the government’s economic and social program.

The crucial point is that the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. Accordingly, government spending provides the paid work which eliminates the unemployment created by the taxes.

So it is now possible to see why mass unemployment arises. It is the introduction of State Money (government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages).

Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account, but doesn’t desire to spend all it earns, other things equal. As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

The purpose of State Money is for the government to move real resources from private to public domain. It does so by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets). From the previous paragraph it is also clear that if the Government doesn’t spend enough to cover taxes and desire to save the manifestation of this deficiency will be unemployment.

Keynesians have used the term demand-deficient unemployment. In our conception, the basis of this deficiency is at all times inadequate net government spending, given the private spending decisions in force at any particular time.

So the answer should now be obvious. If the economy is to remain at full employment the government has to command private resources. Taxation is the vehicle that a sovereign government uses to “free up resources” so that it can use them itself. But taxation has nothing to do with “funding” of the government spending.

To understand how taxes are used to attenuate demand please read this blog – Functional finance and modern monetary theory.

The following blogs may be of further interest to you:

• The budget deficits will increase taxation!
• Will we really pay higher taxes?
• A modern monetary theory lullaby
• Functional finance and modern monetary theory
• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3