# Saturday Quiz – May 28, 2011 – answers and discussion

Question 1:

A sovereign national government has to raise tax revenue to allow it to fulfill its political mandate.
Assume that the national accounts of a nation is reveal that its external surplus is equivalent to 2 per cent of GDP and the private domestic sector is saving overall 3 per cent of GDP. We would also observe:: (a) A budget deficit equal to 1 per cent of GDP. (b) A budget surplus equal to 1 per cent of GDP. (c) A budget deficit equal to 5 per cent of GDP. (d) A budget surplus equal to 5 per cent of GDP.
The answer is Option (a) – A budget deficit equal to 1 per cent of GDP. This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances. Refreshing the balances (again) – we know that from an accounting sense, if the external sector overall is in deficit, then it is impossible for both the private domestic sector and government sector to run surpluses. One of those two has to also be in deficit to satisfy the accounting rules. The important point is to understand what behaviour and economic adjustments drive these outcomes. So here is the accounting (again). 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. 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 what economic behaviour might lead to the outcome specified in the question? The following graph shows three situations where the external sector is in surplus of 2 per cent of GDP and the private domestic balance is in surplus of varying proportions of GDP (note I have written the budget balance as (T – G). In Period 1, the private domestic balance is in surplus (1 per cent of GDP) and the budget is also in surplus (1 per cent of GDP). The net injection to demand from the external sector (equivalent to 2 per cent of GDP) is sufficient to “fund” the private saving drain from expenditure without compromising economic growth. The growth in income would also allow the budget to be in surplus (via tax revenue). In Period 2, the rise in private domestic saving drains extra aggregate demand and necessitates a more expansionary position from the government (relative to Period 1), which in this case manifests as a balanced public budget,’ Period 3, relates to the data presented in the question – an external surplus of 2 per cent of GDP and private domestic saving equal to 3 per cent of GDP. Now the demand injection from the external sector is being more than offset by the demand drain from private domestic saving. The income adjustments that would occur in this economy would then push the budget into deficit of 1 per cent of GDP. The movements in income associated with the spending and revenue patterns will ensure these balances arise. The general rule is that the government budget deficit (surplus) will always equal the non-government surplus (deficit). So if there is an external surplus that is less than private domestic sector saving (a surplus) then there will always be a budget deficit. The higher the private saving is relative to the external surplus, the larger the deficit.
The following blogs may be of further interest to you: Question 3:
While bank lending is capital constrained a further constraint on excess lending would be created by regulators if a 100 per cent reserve ratio (that is, all loans had to be backed by reserves) was imposed.
The answer is False. In a “fractional reserve” banking system of the type the US runs (which is really one of the relics that remains from the gold standard/convertible currency era that ended in 1971), the banks have to retain a certain percentage (10 per cent currently in the US) of deposits as reserves with the central bank. You can read about the fractional reserve system from the Federal Point page maintained by the FRNY. Where confusion as to the role of reserve requirements begins is when you open a mainstream economics textbooks and “learn” that the fractional reserve requirements provide the capacity through which the private banks can create money. The whole myth about the money multiplier is embedded in this erroneous conceptualisation of banking operations. The FRNY educational material also perpetuates this myth. They say:
If the reserve requirement is 10%, for example, a bank that receives a \$100 deposit may lend out \$90 of that deposit. If the borrower then writes a check to someone who deposits the \$90, the bank receiving that deposit can lend out \$81. As the process continues, the banking system can expand the initial deposit of \$100 into a maximum of \$1,000 of money (\$100+\$90+81+\$72.90+…=\$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial \$100 deposit into a maximum of \$500 (\$100+\$80+\$64+\$51.20+…=\$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.
This is not an accurate description of the way the banking system actually operates and the FRNY (for example) clearly knows their representation is stylised and inaccurate. Later in the same document they they qualify their depiction to the point of rendering the last paragraph irrelevant. After some minor technical points about which deposits count to the requirements, they say this:
Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.
Recipients of income support provided by the national government are living off the hard work of those who pay income taxes.
The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound and what is unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance … Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money,” etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability …
Mainstream advocacy of fiscal rules that are divorced from a functional context clearly do not make much sense even though their use dominates public policy these days. It may be that a budget surplus is necessary at some point in time – for example, if net exports are very strong and fiscal policy has to contract spending to take the inflationary pressures out of the economy. This will be a rare situation but in those cases I would as a proponent of MMT advocate fiscal surpluses. Lerner outlined three fundamental rules of functional finance in his 1941 (and later 1951) works.
• The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
• By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
• If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the budget, or limiting the national debt, so much the worse for these principles. The government press shall print any money that may be needed to carry out rules 1 and 2.
So in an operational sense, taxation serves to reduce the spending capacity of the non-government sector to ensure that there is non-inflationary space for government to deliver public services. It doesn’t fund anything. You might like to read these blogs for further information: Premium Question 5:
Assume the current public debt to GDP ratio is 100 per cent and that the nominal interest rate and the inflation rate remain constant and zero. Under these circumstances it is impossible to reduce a public debt to GDP ratio, using an austerity package if the rise in the primary surplus to GDP ratio is always exactly offset by negative GDP growth rate of the same percentage value.
The answer is True. First, some background. 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 rise when there are deficits. Rising deficits usually mean 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. However, 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 (dream) land, 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 corrected 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 not 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 to act as if it is). 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 1Deficit spending 101 – Part 2Deficit 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. They 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. The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time as long as economic growth is strong enough. Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses. But it is also true that an austerity package which damages real growth can also reduce the public debt ratio. That is the focus of this question which assumes:
• Current public debt to GDP ratio is 100 per cent = 1.
• Nominal interest rate (i) and the inflation rate (p) remain constant and zero, which means the real interest rate (r = i – p) = 0.
The following Table shows three cases:
• Case A – primary budget surplus to GDP ratio exceeds the negative GDP growth rate.
• Case B – primary budget to GDP ratio is equal to the negative GDP growth rate.
• Case C – primary budget to GDP ratio is less than the negative GDP growth rate.
The case in question is Case B. In Case A, the primary budget surplus to GDP ratio (2 per cent – note it is presented as a negative figure given that the budget balance is presented as [G – T]) exceeds the negative GDP growth rate (-1 per cent). In this case, the debt ratio falls by the difference (given the real interest rate is zero).
As long as the primary surplus as a per cent of GDP is exactly equal to the negative GDP growth rate (Case B), there can be no reduction in the public debt ratio. This is because what is being added proportionately to the numerator of the ratio is also being added to the denominator. Under Case C where the primary budget surplus is 2 per cent and the contraction in real GDP is 3 percent for the debt ratio rises by the difference. How likely is it that Case A would occur in the real world when the government was pursuing such a fiscal path? Answer: unlikely. First, fiscal austerity will probably push the GDP growth rate further into negative territory which, other things equal, pushes the public debt ratio up. Why? The budget balance is endogenous (that is, depends on private activity levels) because of the importance of the automatic stabilisers. As GDP contracts, tax revenue falls and welfare outlays rise. It is highly likely that the government would not succeed in achieving a budget surplus under these circumstances. So as GDP growth declines further, the automatic stabilisers will push the balance result towards (and into after a time) deficit, which, given the borrowing rules that governments volunatarily enforce on themselves, also pushed the public debt ratio up. So austerity packages, quite apart from their highly destructive impacts on real standards of living and social standards, typically fail to reduce public debt ratios and usually increase them. So even if you were a conservative and erroneously believed that high public debt ratios were the devil’s work, it would be foolish (counter-productive) to impose fiscal austerity on a nation as a way of addressing your paranoia. Better to grit your teeth and advocate higher deficits and higher real GDP growth. That strategy would also be the only one advocated by MMT.]]>

### This Post Has 8 Comments

1. Well, it’s not that clear what 100% reserves is actually meaning. If it would mean that deposits would have to be fully backed by reserves or treasury bonds, lending could not exceed the actual stock of bank capital, and would thus be severly constraint. (Of course, the CB could still lend more reserves, but it would do so without securities – assuming that all other bank assets would be considered of inferior quality – thus no reserves) So, the central bank would actually have to break the rules…

2. Fed Up says:

“Loans create deposits which are then backed by reserves after the fact.”

“Loans create deposits …”

I want to rephrase that from a medium of exchange standpoint. The “central bank credo” is that all new medium of exchange (demand deposits) has/have to have a loan attached. That means it has to be borrowed into existance with an interest rate attached, repayment terms attached, and brings something from the future to the present.

“which are then backed by reserves after the fact.”

I disagree with that. It seems to me that the central bank reserves can be after the fact, during the fact, or before the fact. Notice the timing difference. In the USA right now, it is before the fact. They are hoping for more private debt.

3. Fed Up says:

“They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”.

And, “The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.”

Can the fed just lower the reserve requirement or find a way to lower the effective reserve requirement (sweeps accounts)?

4. Fed Up says:

“If the reserve requirement is 10%, for example, a bank that receives a \$100 deposit may lend out \$90 of that deposit. If the borrower then writes a check to someone who deposits the \$90, the bank receiving that deposit can lend out \$81. As the process continues, the banking system can expand the initial deposit of \$100 into a maximum of \$1,000 of money (\$100+\$90+81+\$72.90+…=\$1,000).”

I agree with bill that the demand deposits are NOT lended out. There is no demand deposit(s) multiplier.

However, if the reserve requirement is 10%, enforced, and the fed allows the fed funds rate to rise, would that mean the maximum amount of debt that can be created is a factor of 10?

5. Fed Up says:

“What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).”

Does the value of the collateral matter here too?

6. stone says:

Good Habit “Well, it’s not that clear what 100% reserves is actually meaning.”

If the proposal is to prevent “bank style” money creation so as to avoid credit cycles, then apparently “equity only banking” is the understood terminology. Under such an equity only system, loans would have to be funded by the loan company selling bonds or issuing shares. Deposits would be kept in a giro bank that would not be able to make loans. In effect such a system would do away with banks as we know them as well as any requirement for a central bank. To my mind the financial inovation of the current banking system is an attempt to wriggle around the potential strangle hold that money holders would otherwise exert. Howerever the banking system has created a whole new set of problems of its own especially the need for the gov to guarentee depositors which leads to reckless lending, asset bubbles and exorbitant banking profits. To my mind a better solution would be to combine an equity only system with a whole-scale wealth redistribution (via an asset tax and citizens dividend) so that the “money holders” meant everyone. The danger of “money holders” having a strangle hold is only an issue if wealth is concentrated.

7. Stone “would do away with banks as we know them as well as any requirement for a central bank”

Well, there should still be a Central Bank as clearing house for interbank payments, and as the issuer of curre bncy (Unless there would be a monopolistic bank, but then there are no constraints at all anymore) But certainly – as long as private sector debt can serve as a collateral for the CB to lend bankreserves, there can’t be no meaningful claim that loans are 100 % backed by reserves – they would then back each other, so that we have circular money creation, and no 100 % reserves.

8. John Armour says:

“Recipients of income support provided by the national government are living off the hard work of those who pay income taxes.”

I knew that question was a trap, but I still walked into it.

I’m waiting now for “the government is wasting taxpayer’s money”.

True of course…chick, chick, bang !