Saturday Quiz – May 23, 2015 – 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:

In general, the OECD and IMF estimates of the impact of the automatic stabilisers attached to the fiscal balance are biased downwards.

The answer is True.

This question is about decomposing the impacts of the automatic stabilisers from those attributable to the underlying fiscal stance.

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

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

However, the complication is that we cannot then conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty is that there are automatic stabilisers operating. To see this, the most simple model of the fiscal 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 fiscal balance in a recession and contracting it in a boom.

So just because the fiscal balance 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 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 change in nomenclature 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. I will come back to this later.

The ‘Full Employment Budget Balance’ was a hypothetical construct of the fiscal balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the fiscal position (and the underlying fiscal parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.

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

Things changed in the 1970s and beyond. At the time that governments abandoned their commitment to full employment (as unemployment rise), the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blog – The dreaded NAIRU is still about!.

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.

NAIRU theorists then invented a number of spurious reasons (all empirically unsound) to justify steadily ratcheting the estimate of this (unobservable) inflation-stable unemployment rate upwards. So in the late 1980s, economists were claiming it was around 8 per cent. Now they claim it is around 5 per cent. The NAIRU has been severely discredited as an operational concept but it still exerts a very powerful influence on the policy debate.

Further, governments became captive to the idea that if they tried to get the unemployment rate below the NAIRU using expansionary policy then they would just cause inflation. I won’t go into all the errors that occurred in this reasoning.

Now I mentioned the NAIRU because it has been widely used to define full capacity utilisation. The IMF and OECD use various versions of the NAIRU to estimate potential output. If the economy is running an unemployment equal to the estimated NAIRU then it is concluded that the economy is at full capacity. Of-course, proponents of this method keep changing their estimates of the NAIRU which were in turn are accompanied by huge standard errors. These error bands in the estimates mean their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.

But they still persist in using it because it carries the ideological weight – the neo-liberal attack on government intervention.

So they changed the name from Full Employment Budget Balance to Structural Balance to avoid the connotations of the past that 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.

And to make matters worse, they now estimate the structural balance by basing it on 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 and thus concludes the structural balance is more in deficit (less in surplus) than it actually is.

They thus systematically understate the degree of discretionary contraction coming from fiscal policy.

Accordingly, the underestimate the impact of the automatic stabilisers.

The following blogs may be of further interest to you:

• The dreaded NAIRU is still about!
• Structural deficits – the great con job!
• Structural deficits and automatic stabilisers
• Another economics department to close

Question 2:

If there is an external deficit, efforts by the private domestic sector to increase its overall saving as a percentage of GDP, will ensure the government fiscal balance is in deficit, irrespective of what the government desires.

The answer is True.

This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances.

Refreshing the balances (again) – we know that from an accounting sense, if the external sector overall is in deficit, then it is impossible for both the private domestic sector and government sector to run surpluses. One of those two has to also be in deficit to satisfy the accounting rules.

The important point is to understand what behaviour and economic adjustments drive these outcomes.

So here is the accounting (again). 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.

So what economic behaviour might lead to the outcome specified in the question?

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.

Assume, now that the private domestic sector (households and firms) seeks to increase its saving ratio (as a percentage of GDP). Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income. The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.

The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction. But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract – output, employment and income all fall.

The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.

The declining income leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.

So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.

The decline in income then stifles firms’ investment plans – they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further towards and eventually into surplus

With the economy in decline, tax revenue falls and welfare payments rise which push the public fiscal balance towards and eventually into deficit via the automatic stabilisers.

If the private sector persists in trying to increase its saving ratio then the contracting income will clearly push the fiscal balance into deficit.

So we would have an external deficit, a private domestic surplus and a fiscal deficit.

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 3:

When a government runs a continuous fiscal deficit, the public spending builds up over time and may eventually exposes the economy to inflation risk.

The answer is False.

This question tests whether you understand that fiscal 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 fiscal 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 fiscal deficit might create those conditions, but a correctly calibrated continuous fiscal deficit will not because it will be just filling the non-government spending gap.

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