Here are the answers with discussion for this Weekend’s Quiz. The information provided should help you work out why you missed a question or three! If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of Modern…
As long as employment growth keeps pace with labour force growth, unemployment will not rise.The answer is False. If you didn’t get this correct then it is likely you lack an understanding of the labour force framework which is used by all national statistical offices. The labour force framework is the foundation for cross-country comparisons of labour market data. The framework is made operational through the International Labour Organization (ILO) and its International Conference of Labour Statisticians (ICLS). These conferences and expert meetings develop the guidelines or norms for implementing the labour force framework and generating the national labour force data. The rules contained within the labour force framework generally have the following features:
- an activity principle, which is used to classify the population into one of the three basic categories in the labour force framework;
- a set of priority rules, which ensure that each person is classified into only one of the three basic categories in the labour force framework; and
- a short reference period to reflect the labour supply situation at a specified moment in time.
When a government issues debt it creates more non-inflationary space for itself to spend than if it spent without issuing debt.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.
- Why history matters
- Building bank reserves will not expand credit
- Building bank reserves is not inflationary
- The complacent students sit and listen to some of that
- Saturday Quiz – February 27, 2010 – answers and discussion
The non-government sector is wealthier when the government matches it deficit with new debt issues.The answer is False. This answer is complementary to that provided for Question 1 and relies on the same understanding of reserve operations. So within a fiat monetary system we need to understand the banking operations that occur when governments spend and issue debt. That understanding allows us to appreciate 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 as explained in the answer to Question 1. But at this stage, M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. In other words, budget 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. You may wish to read the following blogs for more information:
- Why history matters
- Building bank reserves will not expand credit
- Building bank reserves is not inflationary
- The complacent students sit and listen to some of that
- Saturday Quiz – February 27, 2010 – answers and discussion
If net exports are running at 2 per cent of GDP, and the private domestic sector overall is saving an equivalent of 3 per cent of GDP, the government must: (a) Be running a surplus equal to 1 per cent of GDP. (b) Be running a surplus equal to 5 per cent of GDP. (c) Be running a deficit equal to 1 per cent of GDP. (d) Be running a deficit equal to 1 per cent of GDP.The answer is Option C Be running a deficit equal to 1 per cent of GDP. This question tests your knowledge of the sectoral balances that are derived from the National Accounts. First, you need to understand the basic relationship between the sectoral flows and the balances that are derived from them. The flows are derived from the National Accounting relationship between aggregate spending and income. So: (1) Y = C + I + G + (X – M) where Y is GDP (income), C is consumption spending, I is investment spending, G is government spending, X is exports and M is imports (so X – M = net exports). Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses: (2) Y = C + S + T where S is total saving and T is total taxation (the other variables are as previously defined). You than then bring the two perspectives together (because they are both just “views” of Y) to write: (3) C + S + T = Y = C + I + G + (X – M) You can then drop the C (common on both sides) and you get: (4) S + T = I + G + (X – M) Then you can convert this into the familiar sectoral balances accounting relations which allow us to understand the influence of fiscal policy over private sector indebtedness. So we can re-arrange Equation (4) to get the accounting identity for the three sectoral balances – private domestic, government budget and external: (S – I) = (G – T) + (X – M) The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents. Another way of saying this is that total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents. All these relationships (equations) hold as a matter of accounting and not matters of opinion. Thus, when an external deficit (X – M < 0) and public surplus (G – T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process. Second, you then have to appreciate the relative sizes of these balances to answer the question correctly. The rule is that the sectoral balances have to sum to zero. So if we write the condition above as: (S – 1) – (G – T) – (X – M) = 0 And substitute the values of the question we get: 3 – (G – T) – 2 = 0 We can solve this for (G – T) as (G – T) = 3 – 2 = 1 Given the construction (G – T) a positive number (1) is a deficit. The outcome is depicted in the following graph. This tells us that even if the external sector is growing strongly and is in surplus there may still be a need for public deficits. This will occur if the private domestic sector seek to save at a proportion of GDP higher than the external surplus. The economics of this situation might be something like this. The external surplus would be adding to overall aggregate demand (the injection from exports exceeds the drain from imports). However, if the drain from private sector spending (S > I) is greater than the external injection then the only way output and income can remain constant is if the government is in deficit. National income adjustments would occur if the private domestic sector tried to push for higher saving overall – income would fall (because overall spending fell) and the government would be pushed into deficit whether it liked it or not via falling revenue and rising welfare payments. You may wish to read the following blogs for more information:
- Back to basics – aggregate demand drives output
- Stock-flow consistent macro models
- Norway and sectoral balances
- The OECD is at it again!
- Barnaby, better to walk before we run
- Saturday Quiz – June 19, 2010 – answers and discussion
Fiscal austerity programs (which try to create primary budget surpluses) are likely to thwart the chances of a government reducing its public debt as a proportion of GDP because they are likely to reduce real GDP growth which, then drives the budget deficit up via the automatic stabilisers.The answer is False. While Modern Monetary Theory (MMT) places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue, the mainstream debate is dominated by the concept. The unnecessary practice of fiat currency-issuing governments of issuing public debt $-for-$ to match public net spending (deficits) ensures that the debt levels will always rise when there are deficits. But the rising debt levels do not necessarily have to rise at the same rate as GDP grows. The question is about the debt ratio not the level of debt per se. Rising deficits often are associated with declining economic activity (especially if there is no evidence of accelerating inflation) which suggests that the debt/GDP ratio may be rising because the denominator is also likely to be falling or rising below trend. Further, historical experience tells us that when economic growth resumes after a major recession, during which the public debt ratio can rise sharply, the latter always declines again. It is this endogenous nature of the ratio that suggests it is far more important to focus on the underlying economic problems which the public debt ratio just mirrors. Mainstream economics starts with the flawed analogy between the household and the sovereign government such that any excess in government spending over taxation receipts has to be “financed” in two ways: (a) by borrowing from the public; and/or (b) by “printing money”. Neither characterisation is remotely representative of what happens in the real world in terms of the operations that define transactions between the government and non-government sector. Further, the basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure. However, in mainstream thinking, the framework for analysing these so-called “financing” choices is called the government budget constraint (GBC). The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as: Which you can read in English as saying that Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable. However, this is merely an accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been correctly added and subtracted. So in terms of MMT, the previous equation is just an ex post accounting identity that has to be true by definition and has no real economic importance. But for the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves and act as if it is a financial constraint). Further, in mainstream economics, money creation is erroneously depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money. This is called debt monetisation and you can find out why this is typically not a viable option for a central bank by reading the Deficits 101 suite – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3. Anyway, the mainstream claims that if governments increase the money growth rate (they erroneously call this “printing money”) the extra spending will cause accelerating inflation because there will be “too much money chasing too few goods”! Of-course, we know that proposition to be generally preposterous because economies that are constrained by deficient demand (defined as demand below the full employment level) respond to nominal demand increases by expanding real output rather than prices. There is an extensive literature pointing to this result. So when governments are expanding deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases. But not to be daunted by the “facts”, the mainstream claim that because inflation is inevitable if “printing money” occurs, it is unwise to use this option to “finance” net public spending. Hence they say as a better (but still poor) solution, governments should use debt issuance to “finance” their deficits. Thy also claim this is a poor option because in the short-term it is alleged to increase interest rates and in the longer-term is results in higher future tax rates because the debt has to be “paid back”. Neither proposition bears scrutiny – you can read these blogs – Will we really pay higher taxes? and Will we really pay higher interest rates? – for further discussion on these points. The mainstream textbooks are full of elaborate models of debt pay-back, debt stabilisation etc which all claim (falsely) to “prove” that the legacy of past deficits is higher debt and to stabilise the debt, the government must eliminate the deficit which means it must then run a primary surplus equal to interest payments on the existing debt. A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue. The standard mainstream framework, which even the so-called progressives (deficit-doves) use, focuses on the ratio of debt to GDP rather than the level of debt per se. The following equation captures the approach: So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP. The real interest rate is the difference between the nominal interest rate and the inflation rate. This standard mainstream framework is used to highlight the dangers of running deficits. But even progressives (not me) use it in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn. Many mainstream economists and a fair number of so-called progressive economists say that governments should as some point in the business cycle run primary surpluses (taxation revenue in excess of non-interest government spending) to start reducing the debt ratio back to “safe” territory. Almost all the media commentators that you read on this topic take it for granted that the only way to reduce the public debt ratio is to run primary surpluses. That is what the whole “credible exit strategy” rhetoric is about and what is driving the austerity push around the world at present. The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time. So it is clear that the public debt ratio can fall even if there is an on-going budget deficit if the real GDP growth rate is strong enough. This is win-win way to reduce the public debt ratio. But the question is analysing the situation where the government is desiring to run primary budget surpluses. Consider the following Table which captures the variations possible in the question. In Year 1, the B/Y(-1) = 1 (that is, the public debt ratio at the start of the period is 100 per cent). The (-1) just signals the value inherited in the current period. We have already assumed that the inflation rate and the nominal interest rate are constant and zero, which means that the real interest rate is also zero and constant. So the r term in the model is 0 throughout our stylised simulation. This is not to dissimilar to the situation at present in many countries. In Year 1, there is zero real GDP growth and the Primary Budget Balance is also zero. Under these circumstances, the debt ratio is stable. Now in Year 2, the fiscal austerity program begins and assume for the sake of discussion that it doesn’t dent real GDP growth. In reality, a major fiscal contraction is likely to push real GDP growth into the negative (that is, promote a recession). But for the sake of the logic we assume that nominal GDP growth is 1 per cent in Year 2, which means that real GDP growth is also 1 per cent given that all the nominal growth is real (zero inflation). We assume that the government succeeds in pushing the Primary Budget Surplus to 1 per cent of GDP. This is the mainstream nirvana – the public debt ratio falls by 2 per cent as a consequence. In Year 3, we see that the Primary Budget Surplus remains positive (0.5 per cent of GDP) but is now below the positive real GDP growth rate. In this case the public debt ratio still falls. In Year 4, real GDP growth contracts (0.5 per cent) and the Primary Budget Surplus remains positive (1 per cent of GDP). In this case the public debt ratio still falls which makes the proposition in the question false. So if you have zero real interest rates, then even in a recession, the public debt ratio can still fall and the government run a budget surplus as long as Primary Surplus is greater in absolute value to the negative real GDP growth rate. Of-course, this logic is just arithmetic based on the relationship between the flows and stocks involved. In reality, it would be hard for the government to run a primary surplus under these conditions given the automatic stabilisers would be undermining that aim. In Year 5, the real GDP growth rate is negative 1.5 per cent and the Primary Budget Surplus remains positive at 1 per cent of GDP. In this case the public debt ratio rises. The best way to reduce the public debt ratio is to stop issuing debt. A sovereign government doesn’t have to issue debt if the central bank is happy to keep its target interest rate at zero or pay interest on excess reserves. The discussion also demonstrates why tightening monetary policy makes it harder for the government to reduce the public debt ratio – which, of-course, is one of the more subtle mainstream ways to force the government to run surpluses. The following blog may be of further interest to you: