How to fail a simple macroeconomics examination

In the opening sequence of the HBO series, Newsroom, the anchor is participating in a public forum at an East coast US university (in Boston). During the Q&A, he is asked by a student (“a sorority girl”) in the audience, who is suitably bright-eyed and full of American blather, “Is America the greatest country in the world?” He initially blusters but the convener of the forum pushes him for a “human moment” and what follows is 3 classic minutes of TV, starting with “its not the greatest country in the World, Professor, that’s my answer” and concluding with “So when you ask what makes us the greatest country in the World, I don’t know what the fuck you are talking about. Yosemite?”. He then said among other things that “We used to be …”, “we stood up for what was right”, “we waged wars on poverty, not poor people”, “we aspired to intelligence, we didn’t belittle it” and more. The latest shenanigans in the US Congress where the GOP representatives have become a mindless rabble is certainly testimony to the sort of things the mythical Newsroom anchor was talking about in the series. The Sydney Morning Herald article (October 16, 2013) – US shutdown stalemate enters realm of the absurd – reports on how the GOP reps do not “agree either on tactics or strategy” and Boehner announced to the press that there had been “no decisions about what exactly we will do”. This is one day before the lunatic right-fringe of their party is intent on causing mayhem. My prediction – some ridiculous deal will be done and the US government will not default. We will see. But today I am providing a little glimpse into examination processes by using what might have been a first-year answer to an examination question to highlight some important points. I hope you enjoy the little window into life at a university.

Before we get going here is the Newsroom opening segment. See full monologue transcript – at We Just Decided To.

Now, here is the examination question: “Do increased budget deficits at times of mass unemployment reduce the financial capacity of the non-government sector to invest in new projects?”

And this might have been the examination answer:

There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),

PI = PS + CS + GS

In a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole …

The quantities in the equation are not predetermined from year to year, and government actions affect them. The goal of government policy is to expand current and future incomes …

Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another. And bailouts and stimulus plans only enhance future incomes when the activities they favor are more productive than the activities they displace …

“Stimulus” spending must be financed, which means it displaces other current uses of the same funds, and so does not help the economy today … Suppose the stimulus plan takes the form of lower taxes … we can’t get something for nothing this way either. If the government doesn’t also spend less, lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes …

Even when there are lots of idle workers, government bailouts and stimulus plans are not likely to add to employment. The reason is that bailouts and stimulus plans must be financed. The additional government debt means that existing current resources just move from one use to another, from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment …

I suppressed some of the answer for privacy and relevance purposes and retained the essential part of the text above.

Mark out of 20: 0/20 with a recommendation to immediately give up pretensions to being an economist and perhaps go into another field of endeavour although what this person might be suited to is another question. Evangelical pursuits? – perhaps. GOP representative? – has the intellectual fibre!

Anyway, what is wrong with the answer? Why did I mark it so harshly? Surely there is some correct elements provided?

First, the “student” introduced a version of the sectoral balances framework (suppressing the sovereign currency borders) by providing the following macroeconomics identity:

PI = PS + CS + GS

So private investment (PI) equals the sum of private savings (PS), corporate savings (retained earnings) (CS), and government savings (GS) (the surplus).

He then says that “(i)n a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole”.

Which fails to recognise the currency borders and therefore the impact of net exports. But no marks are deducted for that lapse.

Further, the conceptualisation of the budget outcome having something to do with “savings” reflects a failure to understand the differences between the constraints facing the non-government sector relative to the opportunity set available to the currency issuing government.

What does that mean? Quite simply that it makes no sense at all to compare a budget surplus, which is the result of the government spending less than it is taking out of the economy in the form of taxation, with saving.

Why not? Because saving is the act of a financially-constrained private entity whose sacrifices current spending in the hope of expanding their future spending capacity. So for a household, the act of saving means they forego current consumption to accumulate financial assets which will enable them to consume more in the future (via the interest they earn over and above the principal on the wealth that the saving flow creates).

In the case of a government, which issues its own currency, this construction has no applicability. A budget surplus provides that government with no extra capacity to spend in the future, in the same way that a budget deficit provides no less capacity for that government to spend in the future.

It might be argued that the surplus funds were invested in a sovereign fund which enhances future spending capacity. That is also a myth because a currency-issuing government can spend as much of its own currency as it wants whenever it wants. Of-course, that is not the same thing as saying that it should spend unlimited amounts just because it can.

Regular readers will know that the constraints on government spending are not financial (that is how many dollars it has at its disposal) but real – that is, the amount of real goods and services that are available for sale in the currency that the government issues.

In that context, it makes no sense to say that the government is saving when it is reducing the purchasing power of viable to the non-government sector (that is, running a surplus).

Mark deductions were made at that point for this fundamental misunderstanding of the differences between a financially-constrained, non-government entity and the currency-issuing government.

Lets focus on the next part of the answer:

Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

The essence of the answer is that “stimulus spending must be financed, which means it displaces other current uses of the same funds, and so does not help the economy today.”

In using the algebra above (presumably to impress us that there is some technical logic being introduced – to add authority) the view espoused assumes that any fiscal stimulus reduces GS – that is, undermine the fiscal surplus. The logic then assumes this reduces the amount of funds available to PI (private investment), other things equal.

But what does that assume? First, it correctly recognises that under current institutional arrangements, which are artefacts of the old convertible currency system that was abandoned by the US government in 1971 when President Nixon closed the gold window with other governments following soon after, most governments still insists on matching their deficit spending (spending above tax revenue) with an equal issuance of government debt – more or less $-for-$.

Under the current fiat monetary system, there is no operational necessity to engage in this accounting charade. A sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

But governments have maintained these arcane practices, under pressure of conservatives, because they can manipulate public misunderstanding about rising public debt levels to artificially constrain public spending below what is necessary to maintain full employment.

Please read my blog – On voluntary constraints that undermine public purpose – for more discussion on this point.

Given these voluntary constraints, the question then arises: Where did the funds come from that the government borrows. Modern Monetary Theory (MMT) allows us to understand that in an accounting sense, the ‘money’ that is used to buy bonds (that is regarded as ‘financing government spending’) is the same ‘money’ (in aggregate) that government spent has spent in previous periods.

The “student’s” logic traces a uni-directional causality between falling GS and falling PI in the accounting identity above. The behavioural constraints he places on his analysis are that there is a finite pool of non-government savings so PS and CS are unchanged.

In other words, the only other thing that can change when GS falls (as an accounting fact) is that private investment (PI) must fall by construction. Further, this fall in PI must be $-for-$ equal to the rise in the budget deficit (fall in GS).

The “student” has chosen to rehearse the “financial crowding out” hypothesis which is a central plank in the mainstream economics attack on government fiscal intervention.

At the heart of this conception is the theory of loanable funds, which is an aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.

This is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.

So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

Thus, it was argued that aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality. A denial of the business cycle and mass unemployment no less!

Underpinning this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.

So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.

Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.

According to this theory, if there is a rising budget deficit then there is increased demand is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to “clear” the loanable funds market. This chokes off investment spending.

So allegedly, when the government borrows to “finance” its budget deficit, it crowds out private borrowers who are trying to finance investment. The mainstream economists conceive of this as the government reducing national saving (by running a budget deficit) and pushing up interest rates which damage private investment.

The “student” should have read the material summarised in the introductory suite of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3.

Any first-year student in macroeconomics should, first, be able to articulate the view that private saving is a positive function of national income. Second, be able to understand that a $X rise in net government spending (that is, the deficit) initially adds $X to national income. Why? Because spending equals income. Therefore, saving must initially rise.

What happens next depends upon the size of the expenditure multiplier, which is the extra induced consumption spending that follows an initial rise in national income in response to an initial injection of aggregate demand. Remember the story, the initial response to a spending stimulus is to increase output and income, which is then the basis for further rounds of consumption spending, given the latter is a positive function of income.

At each further round of spending, income rises as does private saving.

Even the IMF considers the expenditure multiplier to be above one, which means that a dollar extra of government spending generates more than a dollar of increased national income.

Think about how the impact of a fall in private consumption spending might work in the “student’s” model. We would motivate this by noting that PS rises.

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.

As national income falls, so does overall saving (as some proportion of the loss of income).

The attempts by households overall to increase their saving ratio may be thwarted because income losses cause loss of saving in aggregate (the Paradox of Thrift).

So 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 or a boost to net export.

So total saving always adjusts to changes in income and if a budget deficit can initially increase income then it will lead to a larger pool of savings in the economy.

By hanging onto the defunct loanable funds doctrine. which was demonstrated to be false by Keynes and others in the 1930s, the “student” has failed to appreciate the history of economic thought.

Several marks have now been deducted – already a fail grade.

Another way of thinking about that is that deficit spending creates new financial assets which are available to buy the newly issued government bonds. In this way, the debt issuance really is a monetary operation which drains bank reserves.

What is important to understand is that the purchase (or sale) of bonds by (or to) the non-government sector (domestic or foreign) alters the distribution of assets that are held by the non-government sector.

In that context, it makes no sense to say that government spending rations finite ‘savings’ which could alternatively finance private investment.

As yourself the question – what if the government sold no securities?

The ‘penalty’ for the government that doesn’t pay interest on reserves would be a Japan-like zero interest rate rather than their target cash rate in the absence of some standing facility offering a default support rate for excess reserves.

Should a default support rate be paid on excess reserves, the interest rate would converge on that support rate. Any economic ramifications (like inflation or currency depreciation) would be due to lower interest rates (stimulating excessive nominal growth rates relative to the real capacity of the economy) rather than any notion of monetisation.

Remember, bank loans create deposits which borrowers can then use to invest in capital formation (building productive capacity). A credit-worthy borrower is usually able to access loans from the commercial banks which do not need reserves up front in order to type in some numbers to a loan account.

Even if the government bond issue drained the reserves that the initial government spending created (after all the individual transactions in the non-government sector were finalised each day), the central bank is always standing by to provide the desired reserves to the commercial banks to ensure the integrity of the payments system. There can be no shortage of reserves over any relevant period.

That is the way the banks and central bank interact. There can be no squeeze on private investment arising from government borrowing. It just borrows the funds that it created by spending.

The flow of available saving in an economy is never finite. It grows and contracts directly with the growth in national income.

Ultimately, private agents may refuse to hold any more cash or bonds. What would happen then?

The private sector at the micro level can only dispense with unwanted cash balances in the absence of government paper by increasing their consumption levels. Given the current tax structure, this reduced desire to net save would generate a private expansion and reduce the deficit, eventually restoring the portfolio balance at higher private employment levels with lower required budget deficits.

Whether this generates inflation depends on the ability of the economy to expand real output to meet rising nominal demand. The size of the budget deficit doesn’t compromise that and the government would have no desire to expand the economy beyond its real limit.

Would interest rates have to rise because of the competition for savings? First, savings are not finite.

Second, the central bank administers the risk-free interest rate and is not subject to direct market forces. While funds that government spends do not ‘come from’ anywhere and taxes collected do not ‘go anywhere’ there are substantial liquidity impacts from net government positions.

Mark: 0/20 – totally hopeless case, will need some very good support from the counselling division about potential study and career choices.

The “examination answer”, by the way, was actually written by one Eugene Fama – yes, one of our latest Nobel Prize winners in Economics, although as I explain in this blog – Nobel prize – hardly noble – this award has nothing to do with the actual Nobel Prize process.

Fama wrote the “answer” in a 2009 Essay – Bailouts and Stimulus Plans.

To refresh your memory, Fama “distinguished” himself in an – Interview with Eugene Fama – that the New Yorker’s John Cassidy published on January 13, 2010.

Eugene Fama is an economist at the University of Chicago and is most known for his work promoting the so-called efficient markets hypothesis.

This is a hypothesis that asserts that financial markets are driven by individuals who on average are correct and so the market allocates resources in the most efficient pattern possible. There are various versions of the EMH (weak to strong) but all suggest that excess returns are impossible because information is efficiently imparted to all “investors”. Investors are assumed to be fully informed so that they can make the best possible decisions.

I recall one person told me that “you cannot profit by riding the yield curve”. I pointed out that hedge funds profit in this way every day, to which he said that was “impossible”.

Fama told John Cassidy that the financial crisis was not caused by a break down in financial markets and denied that asset price bubbles exist. He also claimed that the proliferation of sub-prime housing loans in the US “was government policy” – referring to Fannie Mae and Freddie Mac who he claims “were instructed to buy lower grade mortgages”.

When it was pointed out that these agencies were a small part of the market as a whole and that the “the subprime mortgage bond business overwhelmingly a private sector phenomenon”, Fama claimed that the collapse in housing prices was nothing to do with the escalation in sub-prime mortgages but rather:

What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.

John Cassidy checked if he had heard it right asking “surely the start of the credit crisis predated the recession?” to which Fama replied:

I don’t think so. How could it? People don’t walk away from their homes unless they can’t make the payments. That’s an indication that we are in a recession.

Once again he was prompted to think about that – “So you are saying the recession predated August 2007″, to which Fama replied:

Yeah. It had to, to be showing up among people who had mortgages.

He was then asked “what caused the recession if it wasn’t the financial crisis”?

(Laughs) That’s where economics has always broken down. We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. (Laughs again.) …

Fama asserted that “the financial markets were a casualty of the recession, not a cause of it”.

Later, in defending the efficiency of financial markets, Fama wondered how many economists:

… would argue that the world wasn’t made a much better place by the financial development that occurred from 1980 onwards. The expansion of worldwide wealth-in developed countries, in emerging countries-all of that was facilitated, in my view, to a large extent, by the development of international markets and the way they allow saving to flow to investments, in its most productive uses. Even if you blame this episode on financial innovation, or whatever you want to blame, would that wipe out the previous thirty years of development?.

And despite him confessing that he is “not a macroeconomist” he wasn’t backward in using his position to write a stringent macroeconomic attack on the US government fiscal plans, which all the evidence now shows saved millions of jobs. Not enough jobs were saved but without the stimulus, the world would have still been wallowing in the depths of Great Depression 2.0.

The logic he used came straight out of the introductory mainstream macroeconomics textbooks and he didn’t have the guile to realise it was both operationally flawed (as a description of what actually happens) and empirically bereft (none of the major predictions of the model ever come to fruition).

Conclusion

And then this week, he gets a 1/3 share of 1.23 million US dollars – as the Nobel Prize winner.

Anyway, looking down on us from another planet, must wonder about our intelligence quotients.

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.