Saturday Quiz – July 16, 2011 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you work out why you missed a question or three! If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of modern monetary theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

Question 1:

A rising household saving ratio combined with an external deficit that is draining aggregate demand, doesn’t necessarily mean that the budget deficit has to rise to maintain current output growth.

The answer is True.

This question tests one’s basic understanding of the sectoral balances that can be derived from the National Accounts. The secret to getting the correct answer is to realise that the household saving ratio is not the overall sectoral balance for the private domestic sector.

In other words, if you just compared the household saving ratio with the external deficit and the budget balance you would be leaving an essential component of the private domestic balance out – private capital formation (investment).

To understand that, in macroeconomics we have a way of looking at the national accounts (the expenditure and income data) which allows us to highlight the various sectors – the government sector and the non-government sector (and the important sub-sectors within the non-government sector).

So we start by focusing on the final expenditure components of consumption (C), investment (I), government spending (G), and net exports (exports minus imports) (NX).

The basic aggregate demand equation in terms of the sources of spending is:

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).

In terms of the uses that national income (GDP) can be put too, we say:

GDP = C + S + T

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

So if we equate these two ideas sources of GDP and uses of GDP, we get:

C + S + T = C + I + G + (X – M)

Which we then can simplify by cancelling out the C from both sides and re-arranging (shifting things around but still satisfying the rules of algebra) into what we call the sectoral balances view of the national accounts.

There are three sectoral balances derived – the Budget Deficit (G – T), the Current Account balance (X – M) and the private domestic balance (S – I).

These balances are usually expressed as a per cent of GDP but we just keep them in $ values here:

(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.

You can then manipulate these balances to tell stories about what is going on in a country.

For example, when an external deficit (X – M < 0) and a public surplus (G - T < 0) coincide, there must be a private deficit. So if X = 10 and M = 20, X - M = -10 (a current account deficit). Also if G = 20 and T = 30, G - T = -10 (a budget surplus). So the right-hand side of the sectoral balances equation will equal (20 - 30) + (10 - 20) = -20. As a matter of accounting then (S - I) = -20 which means that the domestic private sector is spending more than they are earning because I > S by 20 (whatever $ units we like). So the fiscal drag from the public sector is coinciding with an influx of net savings from the external sector. 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. It is an unsustainable growth path.

So if a nation usually has a current account deficit (X – M < 0) then if the private domestic sector is to net save (S - I) > 0, then the public budget deficit has to be large enough to offset the current account deficit. Say, (X – M) = -20 (as above). Then a balanced budget (G – T = 0) will force the domestic private sector to spend more than they are earning (S – I) = -20. But a government deficit of 25 (for example, G = 55 and T = 30) will give a right-hand solution of (55 – 30) + (10 – 20) = 15. The domestic private sector can net save.

So by only focusing on the household saving ratio in the question, I was only referring to one component of the private domestic balance. Clearly in the case of the question, if private investment is strong enough to offset the household desire to increase saving (and withdraw from consumption) then no spending gap arises.

In the present situation in most countries, households have reduced the growth in consumption (as they have tried to repair overindebted balance sheets) at the same time that private investment has fallen dramatically.

As a consequence a major spending gap emerged that could only be filled in the short- to medium-term by government deficits if output growth was to remain intact. The reality is that the budget deficits were not large enough and so income adjustments (negative) occurred and this brought the sectoral balances in line at lower levels of economic activity.

The following blogs may be of further interest to you:

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

Question 2:

In the February Labour Force data for Australia released last Thursday, we learned that employment grew by only 400 in net terms during the month of February. Other highlights were that unemployment rose by 10,700 and that the labour force participation rate fell by 0.1 per cent indicating a rise in the proportion leaving the labour force. Taken together this data tells you that:

The answer is The labour force grew faster than employment but not as fast the working age population.

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.

The system of priority rules are applied such that labour force activities take precedence over non-labour force activities and working or having a job (employment) takes precedence over looking for work (unemployment). Also, as with most statistical measurements of activity, employment in the informal sectors, or black-market economy, is outside the scope of activity measures.

Paid activities take precedence over unpaid activities such that for example ‘persons who were keeping house’ as used in Australia, on an unpaid basis are classified as not in the labour force while those who receive pay for this activity are in the labour force as employed.

Similarly persons who undertake unpaid voluntary work are not in the labour force, even though their activities may be similar to those undertaken by the employed. The category of ‘permanently unable to work’ as used in Australia also means a classification as not in the labour force even though there is evidence to suggest that increasing ‘disability’ rates in some countries merely reflect an attempt to disguise the unemployment problem.

The following diagram shows the complete breakdown of the categories used by the statisticians in this context. The yellow boxes are relevant for this question.

So the Working Age Population (WAP) is usually defined as those persons aged between 15 and 65 years of age or increasing those persons above 15 years of age (recognising that official retirement ages are now being abandoned in many countries).

As you can see from the diagram the WAP is then split into two categories: (a) the Labour Force (LF) and; (b) Not in the Labour Force – and this divisision is based on activity tests (being in paid employed or actively seeking and being willing to work).

The Labour Force Participation Rate is the percentage of the WAP that are active. So if the participation rate is 65 per cent it means that 65 per cent of those persons above the age of 15 are actively engaged in the labour market (either employed or unemployed).

You can also see that the Labour Force is divided into employment and unemployment. Most nations use the standard demarcation rule that if you have worked for one or more hours a week during the survey week you are classified as being employed.

If you are not working but indicate you are actively seeking work and are willing to currently work then you are considered to be unemployed. If you are not working and indicate either you are not actively seeking work or are not willing to work currently then you are considered to be Not in the Labour Force.

So you get the category of hidden unemployed who are willing to work but have given up looking because there are no jobs available. The statistician counts them as being outside the labour force even though they would accept a job immediately if offered.

The question gave you information about employment, unemployment and the labour force participation rate and you had to deduce the rest based on your understanding.

In terms of the Diagram the following formulas link the yellow boxes:

Labour Force = Employment + Unemployment = Labour Force Participation Rate times the Working Age Population

It follows that the Working Age Population is derived as Labour Force divided by the Labour Force Participation Rate (appropriately scaled in percentage point units).

So if both Employment and Unemployment is growing then you can conclude that the Labour Force is growing by the sum of the extra Employment and Unemployment expressed as a percentage of the previous Labour Force.

The Labour Force can grow in one of four ways:

• Working Age Population growing with the labour force participation rate constant;
• Working Age Population growing and offsetting a falling labour force participation rate;
• Working Age Population constant and the labour force participation rate rising;
• Working Age Population falling but being offset by a rising labour force participation rate.

So in our case, if the Participation Rate is falling then the proportion of the Working Age Population that is entering the Labour Force is falling. So for the Labour Force to be growing the Working Age Population has to be growing faster than the Labour Force.

Now consider the following Table which shows the Australian labour force aggregates for January and February 2010 (the same that were used in the question).

So the correct answer is as above.

Of the second option:

The working age population grew faster than employment and offset the decline in the labour force arising from the drop in the participation rate.

Clearly impossible if both employment and unemployment both rose.

And of the third option:

The labour force grew faster than employment but you cannot tell what happened to the working age population from the information provided.

Clearly you can tell what happened to the working age population by deduction.

The following blog may be of further interest to you:

• Being beguiled by labour force data

Question 3:

If the European Monetary Union (Eurozone) relaxed the budget restrictions on national governments that are applicable under the Stability and Growth Pact (3 per cent deficit to GDP ratios and 60 per cent public debt to GDP ratios) then the current solvency risk facing several EMU members would be resolved.

The answer is False.

Linking of solvency risk and the Stability and Growth Pact is false.

The Stability and Growth Pact which is summarised as imposing a rule on EMU member countries that their budget deficits cannot exceed 3 per cent of GDP rule and their public debt to GDP ratio cannot exceed 60 per cent. In the links provided below you will find extensive analysis of the nonsensical nature of these rules.

The SGP was designed to place nationally-determined fiscal policy in a straitjacket to avoid the problems that would arise if some runaway member states might follow a reckless spending policy, which in its turn would force the ECB to increase its interest rates. Germany, in particular, wanted fiscal constraints put on countries like Italy and Spain to prevent reckless government spending which could damage compliant countries through higher ECB interest rates.

In a 2006 book I published with Joan Muysken and Tom Van Veen – Growth and cohesion in the European Union: The Impact of Macroeconomic Policy – we showed that it is widely recognised that these figures were highly arbitrary and were without any solid theoretical foundation or internal consistency.

The current crisis is just the last straw in the myth that the SGP would provide a platform for stability and growth in the EMU. In my 2008 book (published just before the crisis) with Joan Muysken – Full Employment abandoned – we provided evidence to support the thesis that the SGP failed on both counts – it had provided neither stability nor growth. The crisis has echoed that claim very loudly.

The rationale of controlling government debt and budget deficits were consistent with the rising neo-liberal orthodoxy that promoted inflation control as the macroeconomic policy priority and asserted the primacy of monetary policy (a narrow conception notwithstanding) over fiscal policy. Fiscal policy was forced by this inflation first ideology to become a passive actor on the macroeconomic stage.

But these rules, while ensuring that the EMU countries will have to live with high unemployment and depressed living standards (overall) for years to come, given the magnitude of the crisis and the austerity plans that have to be pursued to get the public ratios back in line with the SGP dictates, are not the reason that the EMU countries risk insolvency.

That risk arises from the fact that when they entered the EMU system, they ceded their currency sovereignty to the European Central Bank (ECB) which had several consequences. First, EMU member states now share a common monetary stance and cannot set interest rates independently. The former central banks – now called National Central Banks are completely embedded into the ECB-NCB system that defines the EMU.

Second, they no longer have separate exchange rates which means that trade imbalances have to be dealt with in monetary terms not in relative price changes.

Third, and most importantly, the member governments cannot create their own currency and as a consequence can run out of Euros! So imagine there was a bank run occuring in Australia, while the situation would signal mass frenzy, the Australian government has the infinite capacity to guarantee all deposits denominated in $AUD should it choose to do so. If the superannuation industry collapsed in Australia, the Australian government could just guarantee all retirement incomes denominated in $AUD should it choose to do so. The same goes for any sovereign government (including the US and the UK).

But an EMU member government could not do this and their banking or public pension systems could become insolvent.

Further, it could reach a situation where it did not have enough Euros available (via taxation revenue or borrowing) to repay its debt commitments (either retire existing debt on maturity or service interest payments). In that sense, the government itself would become insolvent.

A sovereign government such as Australia or the US could never find itself in that sort of situation – they are never in risk of insolvency.

So the source of the solvency risk problem is not the fiscal rules that the EMU nations have placed on themselves but the fact they have ceded currency sovereignty.

The following blogs may be of further interest to you:

• Euro zone’s self-imposed meltdown
• A Greek tragedy …
• España se está muriendo
• Exiting the Euro?
• Doomed from the start
• Europe – bailout or exit?
• Not the EMF … anything but the EMF!

Question 4:

The Greek crisis could significantly ease its current crisis if it improved its capacity to tax its higher income earning groups.

The answer is True.

The Greek government effectively is like a state in a federal system where the central bank determines the interest rate (which may or may not be appropriate for the conditions in the particular sub-region in the system) and issues currency.

The state-federal analogy is a bit stretched when it comes to the Eurozone (EMU) because federal systems always have a national fiscal capacity which provides the capacity to redistribute spending across regions to meet specific demands. For ideological reasons (conservative economic beliefs), the EMU deliberately did not incorporate such a capacity into its system which is a glaring weakness that is now being exposed in the current crisis.

The Greek government is bound by the same rules that bound natinos when there was a gold standard and currencies were convertible. In this case there is only one currency which is not issued by the Greek government.

Under the gold standard as applied domestically, existing gold reserves controlled the domestic money supply. Given gold was in finite supply at the time, it was considered linking the money supply to the quantity of gold available, would provide a stable monetary system.

Shifts in a nation’s gold reserves reflected (largely) trade relationships and deficit nations had to ship gold to surplus nations (as all trade imbalances were reconciled via gold shipments).

Gold reserves restricted the expansion of bank reserves and the supply of high powered money (Government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.

As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.

So a nation with an external deficit was faced with the prospect of persistent domestic recession as they had to shrink the money supply when they lost gold.

The concept of (and the term) monetisation comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money. The process was that the government would order some gold and sign a cheque for the delivery. This cheque is deposited by the miner in their bank. The bank then would exchange this cheque with the central bank in return for added reserves. The central bank then accounts for this by reducing the government account at the bank. So the government’s loss is the commercial banks reserve gain.

The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance.

As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.

With the move away from the strict gold standard and to US-dollar convertibility, the monetary system which prevailed in the Post World War 2 period up until its collapse in 1971, little changed.

Monetary policy had to defend the currency parity agreed by the nations and so an external deficit country had to endure money supply contractions and domestic recession. Fiscal policy had to ensure it did not compromise the external parity by generating income growth that would drive imports faster than exports. It was a balancing game and for most nations biased towards sluggish domestic conditions.

That is why the system collapsed and was replaced by the fiat monetary system.

But in signing up for the EMU, all member governments reinstated the constraints that were imposed (voluntarily by the system of currency convertibility).

All Greek government spending has to be financed. That can come from taxation or debt-issuance. However, in the current crisis, the bond markets are exacting premium rates (above the benchmark German bond rate) from the Greek government which is further straining their public finances.

It is known that the system of tax collection is fairly inefficient in Greece for various reasons that are not germane to our interests here and for which I am not qualified to speak anyway. So it follows that when a government is revenue-constrained as all the EMU nations are – anything that improves the efficiency of the tax collection process will reduce their need to issue debt (into a hostile market) and ease the fiscal pressures they are facing.

The following blogs may be of further interest to you:

• Euro zone’s self-imposed meltdown
• A Greek tragedy …
• España se está muriendo
• Exiting the Euro?
• Doomed from the start
• Europe – bailout or exit?
• Not the EMF … anything but the EMF!

Premium Question 5:

Mainstream economists have argued that the large scale quantitative easing conducted by central banks in recent years – so-called printing money – would be inflationary. They base their predictions on the Quantity Theory of Money which links the growth of the money stock to the inflation rate (too much money chasing too few goods). The fact that inflation has not accelerated sharply indicates that this mainstream economic theory should be discarded.

The answer is False.

The question requires you to: (a) understand the Quantity Theory of Money; and (b) understand the impact of quantitative easing in relation to Quantity Theory of Money.

The short reason the answer is false is that quantitative easing has not increased the aggregates that drive the alleged causality in the Quantity Theory of Money – that is, the various estimates of the “money supply”.

The Quantity Theory of Money which in symbols is MV = PQ but means that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and Q is always at full employment as a result of market adjustments.

Yes, in applying this theory they deny the existence of unemployment. The more reasonable mainstream economists (who probably have kids who cannot get a job at present) admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.

In general, the Monetarists (the most recent group to revive the Quantity Theory of Money) claim that with V and Q fixed, then changes in M cause changes in P – which is the basic Monetarist claim that expanding the money supply is inflationary. They say that excess monetary growth creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).

One of the contributions of Keynes was to show the Quantity Theory of Money could not be correct. He observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed. There is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will re

The mainstream have related the current non-standard monetary policy efforts – the so-called quantitative easing – to the Quantity Theory of Money and predicted hyperinflation will arise.

So it is the modern belief in the Quantity Theory of Money is behind the hysteria about the level of bank reserves at present – it has to be inflationary they say because there is all this money lying around and it will flood the economy.

Textbook like that of Mankiw mislead their students into thinking that there is a direct relationship between the monetary base and the money supply. They claim that the central bank “controls the money supply by buying and selling government bonds in open-market operations” and that the private banks then create multiples of the base via credit-creation.

Students are familiar with the pages of textbook space wasted on explaining the erroneous concept of the money multiplier where a banks are alleged to “loan out some of its reserves and create money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations. Please read my blog – Money multiplier and other myths – for more discussion on this point.

The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the central bank does not have the capacity to control the money supply. We have regularly traversed this point. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

So when we talk about quantitative easing, we must first understand that it requires the short-term interest rate to be at zero or close to it. Otherwise, the central bank would not be able to maintain control of a positive interest rate target because the excess reserves would invoke a competitive process in the interbank market which would effectively drive the interest rate down.

Quantitative easing then involves the central bank buying assets from the private sector – government bonds and high quality corporate debt. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserves. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.

For the monetary aggregates (outside of base money) to increase, the banks would then have to increase their lending and create deposits. This is at the heart of the mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. The recent experience (and that of Japan in 2001) showed that quantitative easing does not succeed in doing this.

Should we be surprised. Definitely not. The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.

The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.

Those that claim that quantitative easing will expose the economy to uncontrollable inflation are just harking back to the old and flawed Quantity Theory of Money. This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase. Should quantitative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.

So the fact that large scale quantitative easing conducted by central banks in Japan in 2001 and now in the UK and the USA has not caused inflation does not provide a strong refutation of the mainstream Quantity Theory of Money because it has not impacted on the monetary aggregates.

The fact that is hasn’t is not surprising if you understand how the monetary system operates but it has certainly bedazzled the (easily dazzled) mainstream economists.

The following blogs may be of further interest to you:

• Money multiplier and other myths
• Islands in the sun
• Operation twist – then and now
• Quantitative easing 101
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary