Saturday Quiz – November 24, 2012 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you understand the reasoning behind the answers. 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 fiscal rule that forces governments to run budget surpluses each year would equally force the private sector to run deficits and accumulate increasing levels of indebtedness as a result.

The answer is False.

Note that this question begs the question as to how the government might succeed in running permanent surpluses. Whatever behavioural forces might lead to that outcome, the sectoral balances all have to sum to zero. Once you understand that, then deduction leads to the correct answer.

To refresh your memory the balances are derived as follows. The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.

From the sources perspective we write:

GDP = C + I + G + (X – M)

which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

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

Equating these two perspectives we get:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero. 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.

The first trick in the question is to appreciate that the private sector does not equal the non-government sector. So you cannot know what would happen to the private domestic sector balance if the government was running a surplus unless you also know what the external sector balance was.

The following Table shows a stylised business cycle with some simplifications. The economy is running a budget surplus in the first three periods (but declining) and then increasing deficits. Over the entire cycle the balanced budget rule would be achieved as the budget balances average to zero. So the deficits are covered by fully offsetting surpluses over the cycle.

The simplification is the constant external deficit (that is, no cyclical sensitivity) of 2 per cent of GDP over the entire cycle. You can then see what the private domestic balance is doing clearly. When the budget balance is in surplus, the private balance is in deficit. The larger the budget surplus the larger the private deficit for a given external deficit.

As the budget moves into deficit, the private domestic balance approaches balance and then finally in Period 6, the budget deficit is large enough (3 per cent of GDP) to offset the demand-draining external deficit (2 per cent of GDP) and so the private domestic sector can save overall. The budget deficits are underpinning spending and allowing income growth to be sufficient to generate savings greater than investment in the private domestic sector.

On average over the cycle, under these conditions (balanced public budget) the private domestic deficit exactly equals the external deficit. As a result, the private domestic sector will always be spending more than they earn (becoming increasingly indebted) if the government ran a balanced budget when their external sector was in deficit.

The private domestic sector overall can only save in these circumstances if the government runs a deficit. This conclusion also thus applies to nations running budget surpluses.

But if the external sector was in a surplus, and that surplus was larger than the budget surplus, then the private domestic sector would be spending less overall than its income and so would be able to save overall.

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:

If a government is running an austerity program and learns that the estimated output gap was smaller than they originally thought, then other things equal, the government’s discretionary fiscal austerity would have to be intensified to balance the structural budget.

The answer is True.

The “other things equal” qualifier refers to other information that is necessary to compute structural budget balances, such as, the fiscal sensitivity to the output gap. The question is thus seeking a comparison between a true output gap and one that is biased downwards and how that influences the estimation of the structural budget balance.

We are seeing the use of the term “structural deficit” more often in the public debate as the weak recovery ensues and the talk has turned to credible “exit” plans for fiscal policy.

The mainstream position that budgets should be balanced or in surplus (and that the deficits being experienced at present will need to be “paid” for by offsetting surpluses then leads commentators to conclude that any estimated structural deficit is a problem. I will briefly come back to that at the end of the discussion here.

But what is a structural deficit? Well it is the component of the actual budget outcome that reflects the chosen (discretionary) fiscal stance of the government independent of cyclical factors.

The cyclical factors refer to the automatic stabilisers which operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.

In times of economic decline, the automatic stabilisers work in the opposite direction and push the budget balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

The problem is then how to determine whether the chosen discretionary fiscal stance is adding to demand (expansionary) or reducing demand (contractionary). It is a problem because a government could be run a contractionary policy by choice but the automatic stabilisers are so strong that the budget goes into deficit which might lead people to think the “government” is expanding the economy.

So just because the budget goes into deficit 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 ambiguity, economists decided to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the budget balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

As a result, 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. As I have noted in previous blogs, the change in nomenclature here is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.

The Full Employment Budget Balance was a hypothetical construction 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.

This framework allowed economists to decompose the actual budget balance into (in modern terminology) the structural (discretionary) and cyclical budget balances with these unseen budget components being adjusted to what they would be at the potential or full capacity level of output.

The difference between the actual budget outcome and the structural component is then considered to be the cyclical budget outcome and it arises because the economy is deviating from its potential.

So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the budget balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.

If the budget is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual budget outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual budget outcome is presently.

So you could have a downturn which drives the budget into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

The question then relates to how the “potential” or benchmark level of output is to be measured. The calculation of the structural deficit spawned a bit of an industry among the profession raising 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.

As the neo-liberal resurgence gained traction in the 1970s and beyond and governments abandoned their commitment to full employment , the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blogs – The dreaded NAIRU is still about and Redefing full employment … again!.

The NAIRU became a central plank in the front-line attack on the use of discretionary fiscal policy by governments. It was argued, erroneously, that full employment did not mean the state where there were enough jobs to satisfy the preferences of the available workforce. Instead full employment occurred when the unemployment rate was at the level where inflation was stable.

The estimated NAIRU (it is not observed) became the standard measure of full capacity utilisation. If the economy is running an unemployment equal to the estimated NAIRU then mainstream economists concluded that the economy is at full capacity. Of-course, they kept changing their estimates of the NAIRU which were in turn accompanied by huge standard errors. These error bands in the estimates meant their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.

Typically, the NAIRU estimates are much higher than any acceptable level of full employment and therefore full capacity. The change of the the name from Full Employment Budget Balance to Structural Balance was to avoid the connotations of the past where full capacity arose when there were enough jobs for all those who wanted to work at the current wage levels.

Now you will only read about structural balances which are benchmarked using the NAIRU or some derivation of it – which is, in turn, estimated using very spurious models. This allows them to compute the tax and spending that would occur at this so-called full employment point. But it severely underestimates the tax revenue and overestimates the spending because typically the estimated NAIRU always exceeds a reasonable (non-neo-liberal) definition of full employment or capacity utilisation.

So the estimates of structural deficits provided by all the international agencies and treasuries etc all conclude that the structural balance is more in deficit (less in surplus) than it actually is – that is, bias the representation of fiscal expansion upwards.

As a result, if the government in question aims to balance its budget within a certain time frame by imposing fiscal austerity, the impact of the the discovery that the output gap is actually smaller than was originally thought would be to suggest that the structural deficit was larger than previously thought.

In other words, the degree of fiscal austerity already in place (based on the larger output gap measures) would be considered to modest and the discretionary cutbacks would have to be intensified to balance the structural budget.

Spare the thought!

The following blogs may be of further interest to you:

• A modern monetary theory lullaby
• Saturday Quiz – April 24, 2010 – answers and discussion
• The dreaded NAIRU is still about!
• Structural deficits – the great con job!
• Structural deficits and automatic stabilisers
• Another economics department to close

Question 3:

When the private domestic sector decides to save more of its total income, the national government has to increase its net spending (deficit) to avoid output and employment losses.

The answer is False.

The answer also relates to the sectoral balances framework developed in Question 1 and the two answers should be read as complements. When the private sector decides to lift its saving ratio, we normally think of this in terms of households reducing consumption spending. However, it could also be evidenced by a drop in investment spending (building productive capacity).

Note also we are discussing the private domestic sector overall rather than the household sector. The overall sector can still be in deficit while the household sector saves (from disposable income).

The normal inventory-cycle view of what happens next goes like this. Output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.

The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.

Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms layoff workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.

At that point, the economy is heading for a recession. Interestingly, the attempts by households overall to increase their saving ratio may be thwarted because income losses cause loss of saving in aggregate – the is the Paradox of Thrift. While one household can easily increase its saving ratio through discipline, if all households try to do that then they will fail. This is an important statement about why macroeconomics is a separate field of study.

Typically, the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur – in the form of an expanding public deficit. The budget position of the government would be heading towards, into or into a larger deficit depending on the starting position as a result of the automatic stabilisers anyway.

If there are not other changes in the economy, the answer would be false. However, there is also an external sector. It is possible that at the same time that the households are reducing their consumption as an attempt to lift the saving ratio, net exports boom. A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).

So it is possible that the public budget balance could actually go towards surplus and the private domestic sector increase its saving ratio if net exports were strong enough.

The important point is that the three sectors add to demand in their own ways. Total GDP and employment are dependent on aggregate demand. Variations in aggregate demand thus cause variations in output (GDP), incomes and employment. But a variation in spending in one sector can be made up via offsetting changes in the other sectors.

The following blogs may be of further interest to you:

• Stock-flow consistent macro models
• Norway and sectoral balances
• The OECD is at it again!
• Saturday Quiz – May 22, 2010 – answers and discussion

Question 4:

In a fixed coupon government bond auction, the higher is the demand for the bonds the lower the yields will be at that asset maturity which suggests that higher budget deficits will eventually drive short-term interest rates down.

The answer is False.

The correct answer is that yield will be lower at that asset maturity but this tells us nothing about the effect of budget deficits on short-term interest rates.

So the proposition is only partly correct – higher demand for bonds will lower yields.

You may have answered true to the overall proposition by extending your understanding of the fundamental principles of Modern Monetary Theory (MMT) that include the fact that government spending provides the net financial assets (bank reserves) and budget deficits put downward pressure on interest rates (with no accompanying central bank operations), which is contrary to the myths that appear in macroeconomic textbooks about “crowding out”.

But of-course, the central bank sets the short-term interest rate based on its policy aspirations and conducts the necessary liquidity management operations to ensure the actual short-term market interest rate is consistent with the desired policy rate. That doesn’t mean the central bank has a free rein.

It has to either offer a return on reserves equivalent to the policy rate or sell government bonds if it is to maintain a positive target rate. The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.

This situation arises because the central bank essentially lacks control over the quantity of reserves in the system.

So the correct answer is that movements in public bond yields at the primary issue stage, tell us nothing about the intentions of central bank with respect to monetary policy (interest rate setting).

Given that the correct answer includes lower yields the logic developed will tell you why the option “the higher the yields will be at that asset maturity which suggests that higher budget deficits will eventually drive short-term interest rates down” was incorrect.

Why are yields inverse to price in a primary issue? The standard bond has three parameters: (a) the face value – say $A1000; (b) the coupon rate – say 5 per cent; and (c) some maturity – say 10 years. Taken together, this public debt instrument will provide the bond holder with $50 dollar per annum in interest income for 10 years whereupon they will get the $1000 face value returned.

Bonds are issued by government into the primary market, which is simply the institutional machinery via which the government sells debt to “raise funds”. In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the the institutional machinery is voluntary and reflects the prevailing neo-liberal ideology – which emphasises a fear of fiscal excesses rather than any intrinsic need.

Governments are elected to advance a mandate. If that includes maximising welfare of all citizens then we should allow them to do that. If they do not perform well then we can vote them out. We do not need artificial constraints which hinder the government’s capacity to advance public purpose – these ideologically conceived restraints represent democratic repression.

Most primary market issuance is via auction. Accordingly, the government would determine the maturity of the bond (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) being specified.

The issue would then be put out for tender and the market then would determine the final price of the bonds issued. Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.

Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (inflation or something else). So for them the bond is unattractive and under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.

Alternatively if the market wanted security and considered the coupon rate on offer was more than competitive then the bonds will be very attractive. Under the auction system they will bid higher than the face value up to the yields that they think are market-based. The yield reflects the last auction bid in the bond issue

The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.

The following blogs may be of further interest to you:

• Saturday Quiz – April 17, 2010 – answers and discussion
• Time to outlaw the credit rating agencies
• Studying macroeconomics – an exercise in deception
• Time for a reality check on debt – Part 1
• Will we really pay higher interest rates?

Premium Question 5:

Opponents of continuous budget deficits often agree that a short-period of deficit spending when the private demand is weak is not likely to be inflationary. Their main concern is that it is the accumulated stock of spending associated with continuous budget deficits that eventually increases the risk of inflation. Their concern has validity because if nominal spending growth outstrips the capacity of the economy to respond in real terms, then inflation will be the result.

The answer is False.

This question tests whether you understand that budget deficits are just the outcome of two flows which have a finite lifespan. Flows typically feed into stocks (increase or decrease them) and in the case of deficits, under current institutional arrangements, they increase public debt holdings.

There is no “accumulated stock of spending” associated with budget deficits. The expenditure impacts of deficit exhaust each period and underpin production and income generation and saving. Aggregate saving is also a flow but can add to stocks of financial assets when stored.

Under current institutional arrangements (where governments unnecessarily issue debt to match its net spending $-for-$) the deficits will also lead to a rise in the stock of public debt outstanding. But of-course, the increase in debt is not a consequence of any “financing” imperative for the government. A sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

This is not to say that in each period the deficit may increase the inflation risk – depending on how fast nominal aggregate demand is growing relative to the real capacity of the economy to respond to it.

The following blogs may be of further interest to you:

• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3
• Fiscal sustainability 101 – Part 1
• Fiscal sustainability 101 – Part 2
• Fiscal sustainability 101 – Part 3