Saturday Quiz – January 4, 2014 – answers and discussion

January 5, 2014
bill
Saturday quiz
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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:

It is common to use the term deleveraging to describe the reduction in indebtedness for a particular sector or group in the economy. In most nations at present, both the government and the private domestic sectors are carrying historically large debt ratios. However, under current public sector debt-issuance arrangements and given the national accounting relations, only one of these sectors can reduce its debt level at a time.

The answer is False.

For the answer to be false we need to find a situation where the government and private domestic sectors can run surpluses simultaneously and thus run down debt levels.

So this is a question about the sectoral balances – the government budget balance, the external balance and the private domestic balance – that have to always add to zero because they are derived as an accounting identity from the national accounts. The balances reflect the underlying economic behaviour in each sector which is interdependent – given this is a macroeconomic system we are considering.

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.

You can also write this as:

(S – I) + (T – G) = (X – M)

Which gives an easier interpretation (especially in relation to this question).

The sectoral balances derived are:

The private domestic balance (S – I) – positive if in surplus, negative if in deficit.
The government fiscal balance (T – G) – positive if in surplus, negative 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.

Using this version of the sectoral balance framework:

(S – I) + (T – G) = (X – M)

So the domestic balance (left-hand side) – which is the sum of the private domestic sector and the government sector equals the external balance.

For the left-hand side of the equation to be positive (that is, in surplus overall) and the individual sectoral components to be in surplus overall, the right-hand side has to be positive (that is, an external surplus) and of sufficient magnitude.

This is also a basic rule derived from the national accounts and has to apply at all times.

The following graph and accompanying table shows a 8-period sequence where for the first four years the nation is running an external deficit (2 per cent of GDP) and for the last four year the external sector is in surplus (2 per cent of GDP).

For the question to be true we should never see the government surplus (T – G > 0) and the private domestic surplus (S – I > 0) simultaneously occurring – which in the terms of the graph will be the green and navy bars being above the zero line together.

You see that in the first four periods that never occurs which tells you that when there is an external deficit (X – M < 0) the private domestic and government sectors cannot simultaneously run surpluses, no matter how hard they might try. The income adjustments will always force one or both of the sectors into deficit.

The sum of the private domestic surplus and government surplus has to equal the external surplus. So that condition defines the situations when the private domestic sector and the government sector can simultaneously pay back debt.

It is only in Period 5 that we see the condition satisfied (see red circle).

That is because the private and government balances (both surpluses) exactly equal the external surplus.

If the private domestic sector tried to push for higher saving overall (say in Period 6), national income would fall (because overall spending fell) and the government surplus would vanish as the automatic stabilisers responded with lower tax revenue and higher welfare payments.

Periods 7 and 8 show what happens when the private domestic sector runs deficits with an external surplus. The combination of the external surplus and the private domestic deficit adding to demand drives the automatic stabilisers to push the government budget into further surplus as economic activity is high. But this growth scenario is unsustainable because it implies an increasing level of indebtedness overall for the private domestic sector which has finite limits. Eventually, that sector will seek to stabilise its balance sheet (which means households and firms will start to save overall). That would reduce domestic income and the budget would move back into deficit (or a smaller surplus) depending on the size of the external surplus.

So what is the economics that underpin these different situations?

If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative – that is net drain of spending – dragging output down.

The external deficit also means that foreigners are increasing financial claims denominated in the local currency. Given that exports represent a real cost and imports a real benefit, the motivation for a nation running a net exports surplus (the exporting nation in this case) must be to accumulate financial claims (assets) denominated in the currency of the nation running the external deficit.

A fiscal surplus also means the government is spending less than it is “earning” and that puts a drag on aggregate demand and constrains the ability of the economy to grow.

In these circumstances, for income to be stable, the private domestic sector has to spend more than they earn.

You can see this by going back to the aggregate demand relations above. For those who like simple algebra we can manipulate the aggregate demand model to see this more clearly.

Y = GDP = C + I + G + (X – M)

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

So if the G is spending less than it is “earning” and the external sector is adding less income (X) than it is absorbing spending (M), then the other spending components must be greater than total income.

Only when the government deficit supports aggregate demand at income levels which permit the private sector to save out of that income will the latter achieve its desired outcome. At this point, income and employment growth are maximised and private debt levels will be stable.

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Question 2

When a government runs a continuous deficit (spending more than they are receiving in revenue), the risk is that the accumulated public spending will build up over time and cause inflation.

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.

So 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 because a sovereign government is never revenue constrained being the monopoly issuer of the currency.

The point is that there is no inflation risk per se with continuous budget deficits. The only time inflation becomes a risk from the demand side if nominal spending outstrips the capacity of the real economy to expand output.

A continuously increasing budget deficit might create those conditions, but a correctly calibrated continuous budget deficit will not because it will be just filling the non-government spending gap.

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Question 3:

A central bank could always directly purchase treasury debt to facilitate the government deficit without compromising its monetary policy stance as long as it is running a near zero interest rate policy target.

The answer is False.

A central bank could always directly purchase treasury debt to facilitate a government deficit but not because its short-term policy rate is already so low.

They could also do the same with higher positive policy rates by ensuring they offer a support rate on the excess reserves.

So what is the explanation?

The central bank conducts what are called liquidity management operations for two reasons. First, it has to ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. Second, it must maintain aggregate bank reserves at a level that is consistent with its target policy setting given the relationship between the two.

So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.

Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also can set a support rate which is paid on commercial bank reserves held by the central bank (which might be zero).

Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan and the US have typically not offered a return on reserves until the onset of the current crisis.

If the support rate is zero then persistent excess liquidity in the cash system (excess reserves) will instigate dynamic forces which would drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.

The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.

Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.

The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.

So the fundamental principles that arise in a fiat monetary system are as follows.

The central bank sets the short-term interest rate based on its policy aspirations.
Government spending is independent of borrowing which the latter best thought of as coming after spending.
Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
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.
Government debt-issuance is a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.

Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.

In other words, the government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.

However, as long as the central bank has a mandate to maintain a positive target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.

The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.

The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.

However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This breaks the nexus between debt-issuance and bank reserve management and would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.

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