Saturday Quiz – March 26, 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:

Modern Monetary Theory tells us that a sovereign national government can run deficits without issuing debt. But the debt issuance allows the government to drain demand (private spending capacity) so that the public spending has more non-inflationary room to work within.

The answer is False.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

They claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

  • Building bank reserves does not increase the ability of the banks to lend.
  • The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
  • Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

You may wish to read the following blogs for more information:

Question 2:

Workers can enjoy a stable share of GDP over time if they secure wage increases in line with the growth in their contribution to production.

The answer is False.

The share the workers get of GDP (National Income) is called the “wage share”. Their contribution to production is labour productivity.

The wage share in nominal GDP is expressed as the total wage bill as a percentage of nominal GDP. Economists differentiate between nominal GDP ($GDP), which is total output produced at market prices and real GDP (GDP), which is the actual physical equivalent of the nominal GDP. We will come back to that distinction soon.

To compute the wage share we need to consider total labour costs in production and the flow of production ($GDP) each period.

Employment (L) is a stock and is measured in persons (averaged over some period like a month or a quarter or a year.

The wage bill is a flow and is the product of total employment (L) and the average wage (w) prevailing at any point in time. Stocks (L) become flows if it is multiplied by a flow variable (W). So the wage bill is the total labour costs in production per period.

So the wage bill = W.L

The wage share is just the total labour costs expressed as a proportion of $GDP – (W.L)/$GDP in nominal terms, usually expressed as a percentage. We can actually break this down further.

Labour productivity (LP) is the units of real GDP per person employed per period. Using the symbols already defined this can be written as:


so it tells us what real output (GDP) each labour unit that is added to production produces on average.

We can also define another term that is regularly used in the media – the real wage – which is the purchasing power equivalent on the nominal wage that workers get paid each period. To compute the real wage we need to consider two variables: (a) the nominal wage (W) and the aggregate price level (P).

We might consider the aggregate price level to be measured by the consumer price index (CPI) although there are huge debates about that. But in a sense, this macroeconomic price level doesn’t exist but represents some abstract measure of the general movement in all prices in the economy.

Macroeconomics is hard to learn because it involves these abstract variables that are never observed – like the price level, like “the interest rate” etc. They are just stylisations of the general tendency of all the different prices and interest rates.

Now the nominal wage (W) – that is paid by employers to workers is determined in the labour market – by the contract of employment between the worker and the employer. The price level (P) is determined in the goods market – by the interaction of total supply of output and aggregate demand for that output although there are complex models of firm price setting that use cost-plus mark-up formulas with demand just determining volume sold. We shouldn’t get into those debates here.

The inflation rate is just the continuous growth in the price level (P). A once-off adjustment in the price level is not considered by economists to constitute inflation.

So the real wage (w) tells us what volume of real goods and services the nominal wage (W) will be able to command and is obviously influenced by the level of W and the price level. For a given W, the lower is P the greater the purchasing power of the nominal wage and so the higher is the real wage (w).

We write the real wage (w) as W/P. So if W = 10 and P = 1, then the real wage (w) = 10 meaning that the current wage will buy 10 units of real output. If P rose to 2 then w = 5, meaning the real wage was now cut by one-half.

Nominal GDP ($GDP) can be written as P.GDP, where the P values the real physical output.

Now if you put of these concepts together you get an interesting framework. To help you follow the logic here are the terms developed and be careful not to confuse $GDP (nominal) with GDP (real):

  • Wage share = (W.L)/$GDP
  • Nominal GDP: $GDP = P.GDP
  • Labour productivity: LP = GDP/L
  • Real wage: w = W/P

By substituting the expression for Nominal GDP into the wage share measure we get:

Wage share = (W.L)/P.GDP

In this area of economics, we often look for alternative way to write this expression – it maintains the equivalence (that is, obeys all the rules of algebra) but presents the expression (in this case the wage share) in a different “view”.

So we can write as an equivalent:

Wage share – (W/P).(L/GDP)

Now if you note that (L/GDP) is the inverse (reciprocal) of the labour productivity term (GDP/L). We can use another rule of algebra (reversing the invert and multiply rule) to rewrite this expression again in a more interpretable fashion.

So an equivalent but more convenient measure of the wage share is:

Wage share = (W/P)/(GDP/L) – that is, the real wage (W/P) divided by labour productivity (GDP/L).

I won’t show this but I could also express this in growth terms such that if the growth in the real wage equals labour productivity growth the wage share is constant. The algebra is simple but we have done enough of that already.

That journey might have seemed difficult to non-economists (or those not well-versed in algebra) but it produces a very easy to understand formula for the wage share.

Two other points to note. The wage share is also equivalent to the real unit labour cost (RULC) measures that Treasuries and central banks use to describe trends in costs within the economy. Please read my blog – Saturday Quiz – May 15, 2010 – answers and discussion – for more discussion on this point.

So it becomes obvious that the correct statement is that the real wage has to keep pace with productivity growth for the wage share to remain constant. If the nominal wage (W) and the price level (P) are growing at the pace the real wage is constant. And if the real wage is growing at the same rate as labour productivity, then both terms in the wage share ratio are equal and so the wage share is constant.

The wage share was constant for a long time during the Post Second World period and this constancy was so marked that Kaldor (the Cambridge economist) termed it one of the great “stylised” facts. So real wages grew in line with productivity growth which was the source of increasing living standards for workers.

The productivity growth provided the “room” in the distribution system for workers to enjoy a greater command over real production and thus higher living standards without threatening inflation.

Since the mid-1980s, the neo-liberal assault on workers’ rights (trade union attacks; deregulation; privatisation; persistently high unemployment) has seen this nexus between real wages and labour productivity growth broken. So while real wages have been stagnant or growing modestly, this growth has been dwarfed by labour productivity growth.

The following blogs may be of further interest to you:

Question 3:

The ratio of the “stock of money” (currency plus demand deposits) to bank reserves has fallen dramatically in the US in recent years. This tells us that the money multiplier is not constant.

The answer is False.

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:

Question 4:

The level of tax revenue has no bearing on the real spending capacity of a sovereign government.

The answer is False.

The answer is false but not for the reasons the mainstream economics textbooks would suggest – that is, that taxation revenue finances government spending.

To understand this we need to explore the role that taxation plays in a fiat monetary system and to note that the question talks about real spending capacity (the capacity to purchase real goods and services) rather than nominal spending capacity (the capacity to spend dollars).

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 falsity 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 following blogs may be of further interest to you:

Premium Question 5:

The government and the private domestic sectors cannot simultaneously reduce their debt levels (under current public sector debt-issuance arrangements)

The answer is False.

For the answer to be false we need to find a situation where the government and private domestic sectors can run surpluses simultaneously and thus run down debt levels.

So this is a question about the sectoral balances – the government budget 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. The balances reflect the underlying economic behaviour in each sector which is interdependent – given this is a macroeconomic system we are considering.

To refresh your memory the 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).

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.

You can also write this as:

(S – I) + (T – G) = (X – M)

Which gives an easier interpretation (especially in relation to this question).

The sectoral balances derived are:

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

Using this version of the sectoral balance framework:

(S – I) + (T – G) = (X – M)

So the domestic balance (left-hand side) – which is the sum of the private domestic sector and the government sector equals the external balance.

For the left-hand side of the equation to be positive (that is, in surplus overall) and the individual sectoral components to be in surplus overall, the right-hand side has to be positive (that is, an external surplus) and of sufficient magnitude.

This is also a basic rule derived from the national accounts and has to apply at all times.

The following graph and accompanying table shows a 8-period sequence where for the first four years the nation is running an external deficit (2 per cent of GDP) and for the last four year the external sector is in surplus (2 per cent of GDP).

For the question to be true we should never see the government surplus (T – G > 0) and the private domestic surplus (S – I > 0) simultaneously occurring – which in the terms of the graph will be the green and navy bars being above the zero line together.

You see that in the first four periods that never occurs which tells you that when there is an external deficit (X – M < 0) the private domestic and government sectors cannot simultaneously run surpluses, no matter how hard they might try. The income adjustments will always force one or both of the sectors into deficit.

The sum of the private domestic surplus and government surplus has to equal the external surplus. So that condition defines the situations when the private domestic sector and the government sector can simultaneously pay back debt.

It is only in Period 5 that we see the condition satisfied (see red circle).

That is because the private and government balances (both surpluses) exactly equal the external surplus.

If the private domestic sector tried to push for higher saving overall (say in Period 6), national income would fall (because overall spending fell) and the government surplus would vanish as the automatic stabilisers responded with lower tax revenue and higher welfare payments.

Periods 7 and 8 show what happens when the private domestic sector runs deficits with an external surplus. The combination of the external surplus and the private domestic deficit adding to demand drives the automatic stabilisers to push the government budget into further surplus as economic activity is high. But this growth scenario is unsustainable because it implies an increasing level of indebtedness overall for the private domestic sector which has finite limits. Eventually, that sector will seek to stabilise its balance sheet (which means households and firms will start to save overall). That would reduce domestic income and the budget would move back into deficit (or a smaller surplus) depending on the size of the external surplus.

So what is the economics that underpin these different situations?

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 cost 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.

Only when the government budget deficit supports aggregate demand at income levels which permit the private sector to save out of that income will the latter achieve its desired outcome. At this point, income and employment growth are maximised and private debt levels will be stable.

The following blogs may be of further interest to you:

This Post Has 39 Comments

  1. Regarding question 5, one thing I am having trouble getting my head around with sectoral balances is that when most people think about private sector debt, aren’t we talking about transactions between private sector agents that just net out to zero in aggregate? For example, if a household reduces its debt level by paying down a mortgage or defaulting on it, that is just a transaction between the household and the business sector. Isn’t it true that this doesn’t require any change in the overall private sector balance?

    What kind of debt are we talking about when we say that the private domestic sector reducing its debt level by running a surplus? I am a little confused about this point.

  2. Question 3 should be true.
    If you define the money multiplier as m=MS/MB, then the fact that it has fallen proves it is not constant.

  3. Dear MamMoTh (at 2011/03/27 at 7:06)

    It would have to exist before it can be variable or constant. Question 3 is definitely false in a modern monetary economy with an endogenous money supply and central banks providing reserves on demand.

    best wishes

  4. The question is how it can be possible for both the government and the private sector to run surpluses at the same time – i.e. spend less than they take in. The political context for this is the apparent mystery of how people (like Americans) can go ever more deeply into debt at the same time their government is doing the same. The answers are opposite but symmetrical. Americans’ public and private debts were able to increase only because of the enormous external trade deficit matched the two combined. In question five the pattern is repeated on the surplus side of the line.

    James Galbraith explains this in a very non-technical way in “The Predator State.” He calls the sectoral balances “a fundamental truth of macroeconomics as important as it is poorly understood.” When you wrap your head around this, a huge mass of vague anti-foreign ideology falls away. You are ready to see that imports are real benefits and exports are real costs. You don’t particularly care what China does or doesn’t do. Either we get imports from them that we don’t have to pay for in real terms or they import more from us instead, which creates jobs. The crucial MMT follow-on is that, should they *not* import more from us, and if the domestic private sector continues to net-save, the government *must* increase spending to reduce unemployment and prevent a collapse of aggregate demand.

  5. Dear Bill, m=MS/MB it’s a definition of a ratio.
    It comes into existence as soon as you define it, as you did in previous quizzes.

  6. “The question is how it can be possible for both the government and the private sector to run surpluses at the same time – i.e. spend less than they take in.”

    No. The question is how they can “reduce their debt levels”. The government does need to run a surplus to reduce its debt level, but that is not true of the private sector. The private sector is in debt to itself, not to the government.

  7. Bill,
    Thanks for Q1, I get it. I have a further question if you or anyone happen to have the answer:

    When the Central Bank receives the reserves in exchange for the bonds that have been auctioned, do we consider these reserves “stored” or do they cease to exist? and, are the reserves actually “transferred” to a Treasury account, or is there just an “empty” accounting entry?

    Sorry my question is a bit clumsy.

    Kind Regards

  8. Max —

    I’m not sure why this matters: “The private sector is in debt to itself, not to the government.” In our present financial situation the private sector is in a balance sheet recession. In the aggregate it has unsustainable debt levels. Accordingly, it must save (in aggregate, the private sector must take in more money than it spends) so it can rebuild its balance sheet. So either aggregate demand falls or the government goes into deficit.


  9. Max, Rotten Apple,
    I think the clue was in Q3:

    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.

    I understand it (or not) like this:

    Although the private sector owes the money to the banks (which happen to be in the private sector), they can find the money needed to pay the interest back if there is “Net Bank Lending” going on, where each period the banks are lending more money than they are receiving in repayments, thus expanding the “stock of money”.

    As there is little net bank lending at the moment, and as NBL is unsustainable as a strategy for growth anyway, that leaves the government deficit to provide the funds to help the private sector to pay its interest on these loans to the bank, especially after the credit binge we have just had.

    I am still trying to refine my understanding though, so others can probably explain it better.

    Kind Regards

  10. dehbach, I agree but that makes the question an empirical one rather than an accounting (true by definition) one.

  11. CharlesJ says:
    When the Central Bank receives the reserves ……….

    My understanding is that, because it is a vertical transaction, they cease to exist and, because the government is not revenue constrained, any idea of a liability is meaningless.

  12. CharlesJ

    To add to Andy’s comment, you’re correct that the reserve liabilities disappear on the central bank’s balance sheet, and are replaced by a CB treasury account liability.

    Basically, it’s just a relabelling of liabilities on the CB balance sheet, reserves->treasury deposits. There’s no contraction of the CB balance sheet, unlike the case when the CB sells treasuries from it’s own portfolio for interest rate management.

  13. I think Max has a point – there seems to be a hidden assumption that retirement of private sector debt requires private sector surpluses. I suspect that this is true, but only because of interest payments.

    If you borrow from a bank, although the initial balance sheet transaction is NFA neutral, you essentially commit to an ongoing transfer of your NFA to the bank in the form of interest payments, over the lifetime of the loan. The bank absorbs more NFA from its borrowers than it returns, and given a finite amount of non-bank NFA, this process must be unstable and lead to defaults, unless further injections of NFA to the non-bank private sector are given, in the form of govt deficits or external surpluses.

    At least, that’s how it seems to me.

  14. I ‘ve got a question regarding question 5.
    Your description of the sectoral balance gives the impression that each part is rather independent of the other. I would argue that, especially the current accounts deficit is (except maybe for fuel and food imports) an outcome of the government’s and private sector’s desire to spend. If they are determined to net save and are ready to be very elastic on their expenses. imports will surely take a big hit. Moreover, domestic producers will lose revenue and will probably try to compensate by selling their products abroad (even at lower prices). That will add to export income and drive the external trade deficit down. That can be multiplied by government taxation (for instance large tax increases on car sales, etc).

    Does the above sound logical? I always wondered if the current accounts deficit has a dynamic of it’s own, or if it’s just the outcome of the private + government sector’s actions (assuming Rest of the World always wants to net save in the country’s currency).

  15. Paradigm Shift, “The bank absorbs more NFA from its borrowers than it returns”-

    If the bank is not growing, then wouldn’t it just recycle those interest payments out as pay to employees or dividends to shareholders? I can see that an expanding bank would retain them to build up bank capital.

  16. Stone, yes, I’m assuming the bank is retaining earnings and growing its equity. If it recycled 100% of its interest income as interest payments to depositors, expenses, dividends, etc then the bank would not be a net sink of NFA.

  17. Andy, ParadignShift,
    Thanks for the reply, I’m guessing under MMT any transfer of liability to the treasury account should be considered administrative only or a left over from Bretton Woods perhaps.

    ParadigmShift, Stone,
    Perhaps it is not the interest but the principle instead. When banks net-lend year on year, they are issuing more principle than they are returning to the central bank (or do they get to keep the principle as well?). During a balance sheet recession, the private sector needs the funds to pay back this principle, but the net-bank-lending has stalled, and a budget deficit is required.

    Kind Regards

  18. ParadigmShift, Stone,
    To correct what I have just written:

    Perhaps it is not the interest but the principle instead. When banks net-lend year on year, they are issuing more principle than than is being paid back, (or do they get to keep the principle as well?). When the principle is paid back, that amount of NFA no longer exists in the private sector.

    During a balance sheet recession, the private sector needs the funds to pay back this principle, but the net-bank-lending has stalled, and there are less NFA existing in the private sector, and a budget deficit is required.

  19. Max —

    Its true by accounting identity because of the sectoral balances. Or I misunderstand your question.


  20. Rotten Apple & Max,

    You’re leaving out the external sector. The private sector might for instance be reducing external debt. Having three sectors makes things more complicated (allows things to be more complicated…)

  21. “m=MS/MB it’s a definition of a ratio. It comes into existence as soon as you define it”


  22. “Its true by accounting identity because of the sectoral balances.”

    I disagree. Private sector debt can expand or contract independently of a sectoral surplus/deficit.

    In fact, this “surplus = less debt” logic is almost backwards. A private sector surplus is more consistent with increasing debt than decreasing. More savings enables more debt!

  23. CharlesJ “During a balance sheet recession, the private sector needs the funds to pay back this principle, but the net-bank-lending has stalled, and there are less NFA existing in the private sector, and a budget deficit is required.”

    Does that pre-suppose that banks expand indefinately? I guess the alternative is for the loans to be written off cutting into bank equity.

  24. vimothy, of course I should have added MB not 0.
    so do you agree with me that the answer should be True?
    (not that it matters much, just to check whether i am alone on this one since everybody is discussing question 5).

  25. Dear Vimothy (at 2011/03/28 at 3:08) and MamMoTh (at 2011/03/28 at 8:16)

    You can define a ratio in any way you want and in that sense it exists.

    The question was not about mathematics but rather about economics. The conceptualisation of the banking system and credit creation etc and the relationship between the monetary base and broader aggregates as described by the “money multiplier” is false and therefore doesn’t exist.

    The correct conceptualisation is to consider the relationship as a divisor where the base responds to the aggregate not the other way around.

    best wishes

  26. “”More savings enables more debt!” How so?”

    If debt increases disproportionally to savings, that is a recipe for a financial crisis. Savings must increase alongside debt to maintain a margin for error.

  27. Bill, the question was not about the mainstream conceptualisation of the banking system which we know is wrong.
    But about whether the changes in the ratio m=MS/MB in recent years proved m not to be constant.
    Hence I think the answer should be trivially true.
    You will not convince me of the opposite, nor will I convince you that it should be true.

  28. Bill, I view the multiplier as an identity and not a behavioural relationship (though not necessarily a particularly helpful identity)–it is equally right to view it from either perspective as long as you remember that it doesn’t tell you about causality or provide you as a policy maker with something you can exploit.

    MamMoTh, I would say that Q3 is true, yes.

  29. Max says:

    If debt increases disproportionally to savings, that is a recipe for a financial crisis. Savings must increase alongside debt to maintain a margin for error.

    That’s false because savings don’t equate to ability to service debt.

  30. “That’s false because savings don’t equate to ability to service debt.”

    You don’t think more savings would have been helpful in 2008?

  31. Bill –

    Proving the Money Multiplier is not constant is actually a very important part of proving that it’s a useless measure. It’s all very well disproving things in theory, but the theory isn’t much use unless the data concurs.

    Therefore the real answer to question 3 is True.

  32. CharlesJ

    I think I see what you’re saying, but horizontal bank lending activities don’t directly affect the NFA of the private sector, they only shift it around within the sector as interest is paid. Loan repayment won’t reduce private sector NFA, to the extent that it is a horizontal activity.

    I’m still trying to figure out whether and why the private sector as a whole needs to net save in order to reduce its debt. This would be true of an individual with no prior savings and no realisable assets, but it’s not obvious to me that this generalises to the private sector (bank+nonbank) as a whole. I need to mull that over some more, I think.

  33. ParadigmShift – I agree. That was the point of my original comment above. It would be nice to see Bill address this at some point.

    There always seems to be an unspoken assumption that the private sector as a whole needs to net save in order to reduce its debt levels, and this does seem to follow from the accounting identity, but I have never heard anybody in the MMT camp explain how this actually works when private sector debt repayment simply involves a shuffling around of assets between the household and financial sectors. Presumably this activity all nets out to zero and does not affect the private sector’s NFAs.

    Perhaps, as Agog says above, it has something to do with the interaction with the foreign sector? Or is there something else we are missing?

  34. ParadigmShift,
    Assume for simplicity that all bank loans have 0% interest. The when the loan is created, the stock of money in the private sector increases by the same amount. As the loan is paid back, the stock of money reduces. Where there is interest on the loan, this is just moved around the private sector, but the principal of the loan adds to the stock of money when the loan is created, and reduces the stock of money as it is paid back.

  35. CharlesJ

    Quite right, I was really just pointing out that changes in money supply don’t necessarily parallel changes in NFA, so that even though loan repayment reduces the money supply, it doesn’t reduce private sector NFA.

  36. Rotten Apple

    I’m with you, it seems that there’s a blog post waiting to be written should Bill find the time. I’ve long been confused on this point, and I’ve never really seen it fleshed out in a way that makes sense in the way that other aspects of MMT do. I would think that the result would not depend on the existence of an external sector, and should also be true in a closed economy, “without loss of generality” as mathematicians would say. It seems that the implication is that the private sector can generate debt all by itself, but cannot reduce those debt levels without interacting with the govt sector. This doesn’t make sense to me, but maybe I’m drawing the wrong conclusions.

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