Saturday Quiz – August 27, 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:

Which scenario represents a more expansionary outcome:

(a) A budget deficit equivalent to 5 per cent of GDP (including the impact of automatic stabilisers equivalent to 3 per cent of GDP).

(b) A budget deficit equivalent to 3 per cent of GDP.

(c) You cannot tell because you do not know the decomposition between the cyclical and structural components in Option (B)

The answer is Option (a).

The question probes an understanding of the forces (components) that drive the budget balance that is reported by government agencies at various points in time and how to correctly interpret a budget balance.

In outright terms, a budget deficit that is equivalent to 5 per cent of GDP is more expansionary than a budget deficit outcome that is equivalent to 3 per cent of GDP irrespective of the cyclical and structural components.

In that sense, the question lured you into thinking that only the discretionary component (the actual policy settings) were of interest. In that context, Option (c) would have been the correct answer.

To see the why Option (a) is the best answer we have to explore the issue of decomposing the observed budget balance into the discretionary (now called structural) and cyclical components. The latter component is driven by the automatic stabilisers that are in-built into the budget process.

The federal (or national) government budget balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. It is a simple matter of accounting with no theory involved. However, the budget balance is used by all and sundry to indicate the fiscal stance of the government.

So if the budget is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit we say the fiscal impact expansionary (adding net spending).

Further, a rising deficit (falling surplus) is often considered to be reflecting an expansionary policy stance and vice versa. What we know is that a rising deficit may, in fact, indicate a contractionary fiscal stance – which, in turn, creates such income losses that the automatic stabilisers start driving the budget back towards (or into) deficit.

So the complication is that we cannot conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty clearly relates to the operation of the automatic stabilisers.

To see this, the most simple model of the budget balance we might think of can be written as:

Budget Balance = Revenue – Spending.

Budget Balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)

We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the budget balance are the so-called automatic stabilisers.

In other words, without any discretionary policy changes, the budget balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the budget balance moves towards deficit (or an increasing deficit). When the economy is stronger – tax revenue rises and welfare payments fall and the budget balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.

So just because the budget goes into deficit or the deficit increases as a proportion of GDP doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.

To overcome this uncertainty, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. The Full Employment Budget Balance was a hypothetical construct of the budget balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.

So a full employment budget would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity. If the budget was in surplus at full capacity, then we would conclude that the discretionary structure of the budget was contractionary and vice versa if the budget was in deficit at full capacity.

The calculation of the structural deficit spawned a bit of an industry in the past with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.

Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s. All of them had issues but like all empirical work – it was a dirty science – relying on assumptions and simplifications. But that is the nature of the applied economist’s life.

As I explain in the blogs cited below, the measurement issues have a long history and current techniques and frameworks based on the concept of the Non-
Accelerating Inflation Rate of Unemployment (the NAIRU) bias the resulting analysis such that actual discretionary positions which are contractionary are seen as being less so and expansionary positions are seen as being more expansionary.

The result is that modern depictions of the structural deficit systematically understate the degree of discretionary contraction coming from fiscal policy.

So the data provided by the question unambiguously points to Option (a) being the more expansionary impact – made up of a discretionary (structural) deficit of 2 per cent and a cyclical impact of 3 per cent. The cyclical impact is still expansionary – lower tax revenue and higher welfare payments.

Option (b) might in fact signal a higher structural deficit which would indicate a more expansionary fiscal intent from government but it could also indicate a large automatic stabiliser (cyclical) component.

You might like to read these blogs for further information:

Question 2:

When the government matches an increase in deficit spending with debt issued to the private sector, the growth in aggregate demand is less than would be the case if the government didn’t borrow.

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.

The textbook argument claims 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 3:

Fiscal austerity (manifesting as a budget surplus) will not to damage economic growth if the external balance is in surplus.

The answer is False.

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.

Consider the following Table which depicts three cases – two that define a state of macroeconomic equilibrium (where aggregate demand equals income and firms have no incentive to change output) and one (Case 2) where the economy is in a disequilibrium state and income changes would occur.

Note that in the equilibrium cases, the (S – I) = (G – T) + (X – M) whereas in the disequilibrium case (S – I) > (G – T) + (X – M) meaning that aggregate demand is falling and a spending gap is opening up. Firms respond to that gap by decreasing output and income and this brings about an adjustment in the balances until they are back in equality.

So in Case 1, assume that the private domestic sector desires to save 2 per cent of GDP overall (spend less than they earn) and the external sector is running a surplus equal to 4 per cent of GDP.

In that case, aggregate demand will be unchanged if the government runs a surplus of 2 per cent of GDP (noting a negative sign on the government balance means T > G).

In this situation, the surplus does not undermine economic growth because the injections into the spending stream (NX) are exactly offset by the leakages in the form of the private saving and the budget surplus. This is the Norwegian situation.

In Case 2, we hypothesise that the private domestic sector now wants to save 6 per cent of GDP and they translate this intention into action by cutting back consumption (and perhaps investment) spending.

Clearly, aggregate demand now falls by 4 per cent of GDP and if the government tried to maintain that surplus of 2 per cent of GDP, the spending gap would start driving GDP downwards.

The falling income would not only reduce the capacity of the private sector to save but would also push the budget balance towards deficit via the automatic stabilisers. It would also push the external surplus up as imports fell. Eventually the income adjustments would restore the balances but with lower GDP overall.

So Case 2 is a not a position of rest – or steady growth. It is one where the government sector (for a given net exports position) is undermining the changing intentions of the private sector to increase their overall saving.

In Case 3, you see the result of the government sector accommodating that rising desire to save by the private sector by running a deficit of 2 per cent of GDP.

So the injections into the spending stream are 4 per cent from NX and 2 per cent from the deficit which exactly offset the desire of the private sector to save 6 per cent of GDP. At that point, the system would be in rest.

This is a highly stylised example and you could tell a myriad of stories that would be different in description but none that could alter the basic point.

If the drain on spending outweighs the injections into the spending stream then GDP falls (or growth is reduced).

So even though an external surplus is being run, the desired budget balance still depends on the saving desires of the private domestic sector. Under some situations, these desires could require a deficit even with an external surplus.

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

Question 4:

If the central bank regulated that banks have to hold reserve equivalent to their outstanding loans this would restrict lending.

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.

In other words, the required reserves play no role in the credit creation process.

The actual operations of the monetary system are described in this way. Banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. 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).

These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. 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”.

At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

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.

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 reserve requirements that might be in place at any point in time do not provide the central bank with a capacity to control the money supply.

So would it matter if reserve requirements were 100 per cent? In this blog – 100-percent reserve banking and state banks – I discuss the concept of a 100 per cent reserve system which is favoured by many conservatives who believe that the fractional reserve credit creation process is inevitably inflationary.

There are clearly an array of configurations of a 100 per cent reserve system in terms of what might count as reserves. For example, the system might require the reserves to be kept as gold. In the old “Giro” or “100 percent reserve” banking system which operated by people depositing “specie” (gold or silver) which then gave them access to bank notes issued up to the value of the assets deposited. Bank notes were then issued in a fixed rate against the specie and so the money supply could not increase without new specie being discovered.

Another option might be that all reserves should be in the form of government bonds, which would be virtually identical (in the sense of “fiat creations”) to the present system of central bank reserves.

While all these issues are interesting to explore in their own right, the question does not relate to these system requirements of this type. It was obvious that the question maintained a role for central bank (which would be unnecessary in a 100-per cent reserve system based on gold, for example.

It is also assumed that the reserves are of the form of current current central bank reserves with the only change being they should equal 100 per cent of deposits.

We also avoid complications like what deposits have to be backed by reserves and assume all deposits have to so backed.

In the current system, the the central bank ensures there are enough reserves to meet the needs generated by commercial bank deposit growth (that is, lending). As noted above, the required reserve ratio has no direct influence on credit growth. So it wouldn’t matter if the required reserves were 10 per cent, 0 per cent or 100 per cent.

In a fiat currency system, commercial banks require no reserves to expand credit. Even if the required reserves were 100 per cent, then with no other change in institutional structure or regulations, the central bank would still have to supply the reserves in line with deposit growth.

Now I noted that the central bank might be able to influence the behaviour of banks by imposing a penalty on the provision of reserves. It certainly can do that. As a monopolist, the central bank can set the price and supply whatever volume is required to the commercial banks.

But the price it sets will have implications for its ability to maintain the current policy interest rate which we consider in Question 3.

The central bank maintains its policy rate via open market operations. What really happens when an open market purchase (for example) is made is that the central bank adds reserves to the banking system. This will drive the interest rate down if the new reserve position is above the minimum desired by the banks. If the central bank wants to maintain control of the interest rate then it has to eliminate any efforts by the commercial banks in the overnight interbank market to eliminate excess reserves.

One way it can do this is by selling bonds back to the banks. The same would work in reverse if it was to try to contract the money supply (a la money multiplier logic) by selling government bonds.

The point is that the central bank cannot control the money supply in this way (or any other way) except to price the reserves at a level that might temper bank lending.

So if it set a price of reserves above the current policy rate (as a penalty) then the policy rate would lose traction.

The fact is that it is endogenous changes in the money supply (driven by bank credit creation) that lead to changes in the monetary base (as the central bank adds or subtracts reserves to ensure the “price” of reserves is maintained at its policy-desired level). Exactly the opposite to that depicted in the mainstream money multiplier model.

The other fact is that the money supply is endogenously generated by the horizontal credit (leveraging) activities conducted by banks, firms, investors etc – the central bank is not involved at this level of activity.

You might like to read these blogs for further information:

Question 5 – Premium question

In the context of population ageing, the fact that a sovereign government is never financially constrained means that it can always provide first-class health care to its citizens.

The answer is False.

Does the dependency ratio matter? It surely does but not in the way that is usually assumed.

The standard dependency ratio is normally defined as 100*(population 0-15 years) + (population over 65 years) all divided by the (population between 15-64 years). Historically, people retired after 64 years and so this was considered reasonable. The working age population (15-64 year olds) then were seen to be supporting the young and the old.

The aged dependency ratio is calculated as:

100*Number of persons over 65 years of age divided by the number of persons of working age (15-65 years).

The child dependency ratio is calculated as:

100*Number of persons under 15 years of age divided by the number of persons of working age (15-65 years).

The total dependency ratio is the sum of the two. You can clearly manipulate the “retirement age” and add workers older than 65 into the denominator and subtract them from the numerator.

If we want to actually understand the changes in active workers relative to inactive persons (measured by not producing national income) over time then the raw computations are inadequate.

Then you have to consider the so-called effective dependency ratio which is the ratio of economically active workers to inactive persons, where activity is defined in relation to paid work. So like all measures that count people in terms of so-called gainful employment they ignore major productive activity like housework and child-rearing. The latter omission understates the female contribution to economic growth.

Given those biases, the effective dependency ratio recognises that not everyone of working age (15-64 or whatever) are actually producing. There are many people in this age group who are also “dependent”. For example, full-time students, house parents, sick or disabled, the hidden unemployed, and early retirees fit this description.

I would also include the unemployed and the underemployed in this category although the statistician counts them as being economically active.

If we then consider the way the neo-liberal era has allowed mass unemployment to persist and rising underemployment to occur you get a different picture of the dependency ratios.

The reason that mainstream economists believe the dependency ratio is important is typically based on false notions of the government budget constraint.

So a rising dependency ratio suggests that there will be a reduced tax base and hence an increasing fiscal crisis given that public spending is alleged to rise as the ratio rises as well.

So if the ratio of economically inactive rises compared to economically active, then the economically active will have to pay much higher taxes to support the increased spending. So an increasing dependency ratio is meant to blow the deficit out and lead to escalating debt.

These myths have also encouraged the rise of the financial planning industry and private superannuation funds which blew up during the recent crisis losing millions for older workers and retirees. The less funding that is channelled into the hands of the investment banks the better is a good general rule.

But all of these claims are not in the slightest bit true and should be rejected out of hand.

So the predominant debate is that a fiscal crisis is emerging and that we have to make people work longer despite this being very biased against the lower-skilled workers who physically are unable to work hard into later life.

We are also encouraged to increase our immigration levels to lower the age composition of the population and expand the tax base. Further, we are told relentlessly that the government will be unable to afford to provide the quality and quantity of the services that we have become used too.

However, all of these remedies miss the point overall. It is not a financial crisis that beckons but a real one. Dependency ratios matter because they tell us how many workers will be available to produce real goods and services at any point in time. So we can make projections about real GDP growth for given projections about productivity once we have an idea of these underlying dependency ratios.

Clearly we want to be sure that the projected real needs of the population are capable of being met with the likely available resources.

So the only question we need to ask about the future population trends relate to whether there will be enough real resources available to provide aged-care, etc at a desirable level in the future? However, that is never the way the debate is framed. The worry is always that public outlays will rise because more real resources will be required “in the public sector” than previously.

However these outlays are irrelevant from a financial point of view. The government can purchase anything that is for sale in the currency it issues at any time. There is never a question that the government cannot afford to buy something that is available.

It is the availability that is the issue. As long as these real resources are available there will be no problem. In this context, the type of policy strategy that is being driven by these myths will probably undermine the future productivity and provision of real goods and services in the future.

It is clear that the goal should be to maintain efficient and effective medical care systems. Clearly the real health care system matters by which I mean the resources that are employed to deliver the health care services and the research that is done by universities and elsewhere to improve our future health prospects. So real facilities and real know how define the essence of an effective health care system.

Further, productivity growth comes from research and development and in Australia the private sector has an abysmal track record in this area. Typically they are parasites on the public research system which is concentrated in the universities and public research centres (for example, CSIRO).

Unfortunately, tackling the problems of the distant future in terms of current “monetary” considerations which have led to the conclusion that fiscal austerity is needed today to prepare us for the future will actually undermine our future.

The irony is that the pursuit of budget austerity leads governments to target public education almost universally as one of the first expenditures that are reduced.

Most importantly, maximising employment and output in each period is a necessary condition for long-term growth. The emphasis in mainstream integeneration debate that we have to lift labour force participation by older workers is sound but contrary to current government policies which reduces job opportunities for older male workers by refusing to deal with the rising unemployment.

Anything that has a positive impact on the dependency ratio is desirable and the best thing for that is ensuring that there is a job available for all those who desire to work.

Further encouraging increased casualisation and allowing underemployment to rise is not a sensible strategy for the future. The incentive to invest in one’s human capital is reduced if people expect to have part-time work opportunities increasingly made available to them.

But all these issues are really about political choices rather than government finances. The ability of government to provide necessary goods and services to the non-government sector, in particular, those goods that the private sector may under-provide is independent of government finance.

Any attempt to link the two via fiscal policy “discipline:, will not increase per capita GDP growth in the longer term. The reality is that fiscal drag that accompanies such “discipline” reduces growth in aggregate demand and private disposable incomes, which can be measured by the foregone output that results.

Clearly surpluses help control inflation because they act as a deflationary force relying on sustained excess capacity and unemployment to keep prices under control. This type of fiscal “discipline” is also claimed to increase national savings but this equals reduced non-government savings, which arguably is the relevant measure to focus upon.

So even though the government is not financially constrained it might adopt a policy platform that undermines productivity growth and leaves the economy short of real productive resources at a time in the future when they will be needed to fulfill its socio-economic program.

You might like to read this blogs for further information:

This Post Has 25 Comments

  1. Bill et al,
    Aside: I note that Wikipedia has been substancially updated with MMT (look up ‘Chartalism’ on Wikipedia) and includes very recent criticisms. This entry (under sub heading Criticism) caught my eye due to last weeks quiz:

    Murphy also criticises MMT on the basis that savings in the form of government bonds are not net assets for the private sector as a whole, since the bond will only be redeemed after the government “raises the necessary funds from the same group of Taxpayers in the future”.[18] In response to this, MMT authors point out that the repayment of bonds does not necessarily have to occur from taxes; a central bank attempting to hold an interest rate target must necessarily purchase government bonds. These purchases occur through the creation of currency, rather than taxation.

    MMT’s response to the criticism lacks the point that it is the budget deficit that adds to NFA, not the corresponding bond sales, and that like all government spending, the interest payments adds NFA to the private sector too. (Hopefully I am right about that).

    Either way, I think MMT proponents (rather than amateurs like me) should look at this carefully and suggest corrections, in order to prevent further misrepresentations. There have been quite alot of changes to the page on ‘Job Guarantee’ as well.

  2. bill, would you be willing to discuss my “in the present” vs. “in the future” argument about Q2? I assume that the gov’t budget is set up to pay both interest and principal so that the gov’t bond is paid off at maturity (meaning no rollover risk). Thanks!

  3. I think the answer to question 4 is ‘true’.

    Banks are capital constrained, and hence so is the system as a whole. As you say if the system
    as a whole is short reserves these can be injected by selling bonds to the CB. If reserve requirements
    were 100% this would require either a lot more capital or a lot more borrowing of fed funds.

    Either one would lower banks returns and they would obviously increase rates, and so likely reduced credit

  4. Rallying against the money multiplier seems like misdirected effort to me: both the money multiplier and the description favored by MMT have basically the same underlying accounting. (Do MMT’ers realize this ?).

    Its wrong to say that the MMT paradigm is ‘better’ because it’s more literally accurate – we rarely judge models like that:
    quantum mechanics may be more ‘accurate’ then Newtonian mechanics, but the latter is easier to use and hence more appropriate for everyday scales.

    Likewise here, one should prefer the paradigm which is easier to use correctly.
    This depends on the problem. Sometimes MMT is good, but the money multiplier
    has some conceptual advantages – for example it has embedded in it the fact that banks cannot
    create loans without limit but are constrained by capital.

  5. mpr

    Actually, the “money multiplier” is not constrained by capital.

    It is, in its fictitious form, constrained by deposits and the reserve requirement, if there is one.

    Are you sure you’re not confusing assets with capital ?

  6. John, you are right that from inside the money multiplier paradigm the constraint is deposits.
    But my comment was not written inside that paradigm (I should have been more explicit about this).

    In other words, if you are thinking about the money multiplier you say “ah there is a constraint on
    bank lending” (deposits). But the accounting underlying the two paradigms is essentially the same
    (I can spell this out of necessary) at least in the aggregate across the banking system as a whole.
    Therefore you can translate what this constraint means from one language to the other, and you
    find it corresponds to banks being capital constrained. (In a system where the required loan/capital
    ratio is equal to the ratio in the money multiplier).

    Why not just use the more “correct” description involving capital ? Well bank capital is more abstract than deposits
    and certainly less familiar to most people. If I’m right about Q4, for example, this shows that this constraint is not quite as easy to think about in the MMT paradigm.

  7. I must confess to being a bit confused at this point mpr.
    I sense that you’re trying to find common threads in the way both systems are constrained as a way of promoting better understanding ?
    And if by “corresponds to banks being capital constrained” you mean that the sum of the money multiplier progression equals the capital ratio (for the same common ratio) then I’d certainly agree. At least on the arithmetic.
    But if we were to leave it there, I think there are some valuable insights we’d be missing out on by not taking things a bit further, for example, the endogeneity of the money supply. Think how much muddle-headed policy had its roots in the exogenous version.
    I don’t feel by the way that this stuff has anything uniquely to do with MMT. It just happens to get a fair bit of discussion on MMT sites.
    My apologies if I’ve misunderstood you, and please don’t hesitate to “spell it out” if you think it might help.
    Still learning, and happy to keep doing so !

  8. CharlesJ
    That Wikipedia entry does need looking at.
    2nd paragraph under Vertical Transactions.
    “In order for the government to spend, it sells government bonds on the open market.”
    Any idea who wrote it?

  9. I got question 5 correct but now I’m not sure if I got it correct for the right or wrong reasons. My thinking did not touch dependency ratios but I did call it as False because it depends on the real resources available and there may not be any or many.

  10. Q5 cost me a max.
    It seems to hinge on the definition of “can” in the question but hey!
    “Its ok with me”
    Award yourself an extra half point if you can name the actor, director and film that quote is taken from.

  11. I actually got question four correct, but now I’m second-guessing.

    Okay, let’s say that there’s a 100% reserve requirement. Now, this will mean that at the end of a given accounting period banks will have to borrow much more reserves on the interbank lending market. This rush for reserves will cause interest-rates to climb.

    Now, the central bank will have to accommodate this unless they want the interest-rates to spiral out of control (as the demand for reserves is so inelastic). So, if I understand correctly, that’s the first thing that will happen in response to a 100% reserve requirement.

    Bill points out that under such circumstances some banks may be required to borrow at the discount window. I think he’s correct, as if the above were to happen it would all be a bit of a mess. But borrowing at the discount window is more expensive than borrowing at the Fed funds rate and so loanable funds will become that much more expensive. In a certain sense, this more expensive loan rate will, in fact, restrict lending to a degree. No?

  12. John,

    Here is what I mean by the accounting being the same: start with the multiplier paradigm: A bank has (somehow either as a deposit, cash …) $100. It creates a $90 loan and puts the rest in reserves.

    Once the $90 is redeposited (and in MMT this is one step – the creation of a loan/deposit), then $90 of the original $100 becomes completely notional. If the bank didn’t have the $100 it could borrow it, and then immediately pay it back
    (“after” the redeposit) without changing anything, except that it does have to come up with the $10 in reserves.

    But now we’re basically back at the MMT paradigm: the bank creates the $90 loan/deposit and needs to come up with $10 in reserves. In MMT it can borrow these from other banks, but this is of course not possible on aggregate. On aggregate either these reserves already exist or it has to sell a $10 bond to the CB.

    That $10 is what I’m thinking of as the capital. Actually that isn’t correct; its only correct if the bank funds itself entirely through capital. In practice it can fund itself in a variety of ways including … deposits ! But funding through deposits is exactly what the multiplier describes.

    So it seems to me that the fallacy of the multiplier consists of it claiming that banks can only fund themselves through deposits. That isn’t so, but one shouldn’t forget that they need to fund themselves somehow – capital, debt …
    Coming back to Q 4, increasing reserves to 100% would certainly mean a lot more funding costs.

    Part of the endogenous/exogenous debate seems like semantics to me: lending is determined by demand at a particular interest rate, but that interest rate is effected by policy. If you change policy (e.g increase reserves to 100%) so that the rate changes, the demand changes and the amount of money creation changes. Is that endogenous or exogenous ?

  13. “A bank has (somehow either as a deposit, cash …) $100. ”

    It can’t have that somehow. It has to have that as a result (direct or indirect) of a vertical transaction. That ‘have it somehow’ is the reason we also end up with the ‘government borrows’ idea as well. You have to follow it back.

    In other words when a bank gets initial capital is has to have $100 in the capital account (which is a liability same as a customer deposit) and $100 in bank reserves. Bank capital is just an infinite customer time deposit with a variable interest rate.

  14. ” In a certain sense, this more expensive loan rate will, in fact, restrict lending to a degree. No?”

    But that again is a price not quantity target. It doesn’t matter if the reserve requirement is 100% or 0%, the lending criteria takes account of the price at the discount window as a factor (along with the risk of having to use it) not the amount of reserves in existence.

    The demand for money at the currency price is always satisfied by the banks up to their capital ratio whatever the reserve level – because they know they can rely on the discount window as a backstop. Just knowing that means they rarely have to because they can usually just pay interest to some other private bank who has too many reserves.

  15. @ Neil

    The question Bill asked was whether it would ‘restrict lending’. So, I figure even if it does this indirectly through some roundabout mechanism, it still has to be taken into account.

    You’re right in saying that the lending criteria takes into account the existence of the discount window. You’re also right in saying that this criteria depends upon the possibility of using the discount window. And that’s where my point comes in.

    To reiterate: when reserve requirements are bumped up to 100% — which means that banks have to hold 10x more reserves than they currently have to — the demand for spare reserves on the interbank lending market is going to go up (presumably by about tenfold as well).

    Now, if the central bank wants to maintain it’s targeted interest-rate it’s going to have to respond to this by supplying the reserves needed in exchange for bonds and the like held in the private sector.

    But I anticipate that such a large shift in policy will create something of a mess and — as Bill himself said — this will increase usage of the discount window. This increased usage will then, as you said above, be included in the lending criteria of an loans made. Because this lending from the discount window will be at the penalty rate, the price of making a loan will also — in the aggregate — increase.

    All else being equal the increase in the price of loans should drive down the demand for loans and this should, in an extremely roundabout way (and only temporarily), restrict lending to some degree.

  16. @ Neil,
    “It can’t have that somehow. It has to have that as a result (direct or indirect) of a vertical transaction.”

    At the point you’re objecting to, I’m writing in terms of the multiplier paradigm, the goal
    being to show that this is not as far from MMT as one might think.

    So it rather misses the point for you to insist that at that very moment I should actually be thinking
    in terms of vertical/horizontal transactions; then they’d be nothing to compare.

  17. mpr, I suggest reading JKH’s comment here:

    It starts with:


    A thought provoking post, thanks. It prompted me to flesh out a model of my own. Apologies for the length of this “comment”; it will require someone to have an unusual level of interest in order to read it.

    I’ve responded to some of your points specifically near the end, but first here’s my model:


    Let the world consist of two banks, A and B, and a central bank CB.”

    It is a long comment but well worth reading.

  18. mpr, I also suggest this:

    JKH says:
    Tuesday, June 28, 2011 at 21:00

    “Fed Up,

    I assumed 10 in central bank reserves as a corrective modification to your starting balance sheet, as I already explained. It’s got nothing to do with a reserve “requirement”.

    Let’s start over.

    Suppose you create a new bank.

    You issue 10 in capital (shares).

    New investors pay for their shares that by writing cheques on their deposits at other banks.

    That brings central bank reserves into your bank (as settlement for the cheques). The role of reserves in this case is their use as settlement balances, not because of a “reserve requirement”.

    Your starting balance sheet is:

    10 central bank reserves

    10 capital

    At that point, you have no loans and no deposits.

    Suppose you buy t-bills from other banks to get an interest earning asset. That moves central bank reserves to other banks (settlement in payment for the t-bills) and your balance sheet is now:

    10 t bills

    10 capital

    You still have no loans and no deposits.

    T bills are considered “risk free”.

    That means all of your capital is excess to any requirement to support risk, because none of it is allocated to risk taking.

    Now you make 100 loans and credit your borrowers with 100 in their deposit accounts. (Loans create deposits.)

    Your balance sheet now is:

    10 t bills
    100 loans

    Liabilities and Capital:
    100 deposits
    10 capital

    Your capital now backstops the risk on 100 loans, and is considered fully allocated to risk.

    There’s a fundamental difference between liquidity management and capital management. In this case, the cash that was brought in with the initial capital issue ended up being invested in risk free treasury bills. But the primary purpose of the capital is to backstop the risk subsequently taken in the loans.

    As an alternative, you could sell the t bills and use the money to pay down 10 in deposits, in which case your balance sheet is:

    100 loans

    Liabilities and Capital
    90 deposits
    10 capital

    That’s a more conventional picture of how capital fits in vis a vis corresponding assets. But this version is only a variation of the first, because of liquidity management. The capital in either case is allocated to 100 loans for risk purposes.”

    I believe we assumed a 10% capital requirement.

  19. Philip Pilkington said: “But borrowing at the discount window is more expensive than borrowing at the Fed funds rate and so loanable funds will become that much more expensive. In a certain sense, this more expensive loan rate will, in fact, restrict lending to a degree. No?”

    If necessary, is there any reason the discount window rate can’t be made the same as the fed funds rate?

  20. Neil Wilson said: ‘Bank capital is just an infinite customer time deposit with a variable interest rate.”

    Aren’t time deposits supposed to be risk free, while bank capital is not risk free?

  21. Here is how it was explained to me.

    If there is a “run on the bank” and the loans continue to perform, that is a time maturity mismatch. That means the bank is illiquid.

    If there is a “run on the bank” and the loans don’t perform well enough, the bank is insolvent.

  22. Fed Up

    In normal non-banking business if you ain’t got the cash you’re bust no matter how good your sales pipeline. Cashflow kills businesses however ‘solvent’ their accounts.

    In a 100% reserve banking world you’re effectively trying to turn banks from the special ethereal like entities they are at the moment into a normal business that will simply die if it runs out of cash. The theory being that normal business constraints will get them to behave more appropriately.

    That’s one of the reasons the “100%’ers” are pretty opposed to maturity transformation.

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