The Weekend Quiz – March 26-27, 2016 – 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:

A fact that is overlooked by those promoting austerity programs, is that when economic growth resumes, the automatic stabilisers work in a counter-cyclical fashion to ensure that the government fiscal balance returns to its appropriate level.

The answer is False.

The factual statement in the proposition is that the automatic stabilisers do operate in a counter-cyclical fashion when economic growth resumes. This is because 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 increases when there is an economic slowdown.

The question is false though because this process while important may not ensure that the government fiscal balance returns to its appropriate level.

The automatic stabilisers just push the fiscal balance towards deficit, into deficit, or into a larger deficit when GDP growth declines and vice versa when GDP growth increases. These 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).

We also measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal 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.

This decomposition provides (in modern terminology) the structural (discretionary) and cyclical fiscal balances. The fiscal components are adjusted to what they would be at the potential or full capacity level of output.

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 fiscal 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 fiscal outcome 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 fiscal 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 fiscal outcome is presently.

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

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

In some of the blogs listed below I go into the measurement issues involved in this decomposition in more detail. However for this question it these issues are less important to discuss.

The point is that structural fiscal balance has to be sufficient to ensure there is full employment. The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work for all of us to advance public purpose.

In this context, one of the most important elements of public purpose that the state has to maximise is employment. Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment.

Given the non-government sector will typically desire to net save (accumulate financial assets in the currency of issue) over the course of a business cycle this means that there will be, on average, a spending gap over the course of the same cycle that can only be filled by the national government. There is no escaping that.

So then the national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a fiscal surplus will be possible.

But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the fiscal outcome towards increasing deficits.

Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The fiscal outcome will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.

So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – which I define as 2 per cent unemployment and zero underemployment.

Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).

So it will not always be the case that the dynamics of the automatic stabilisers will leave a structural deficit sufficient to finance the saving desire of the non-government sector at an output level consistent with full utilisation of resources.

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 2:

Rising government bond yields for new issues indicate:

(a) that government spending is becoming more expensive.

(b) that economic growth is reducing private risk assessments of alternative financial investments.

(c) that government spending is increasing the cost of borrowing for private investors.

(d) that private investors consider public debt to be riskier.

(e) Answers (a) and (d) depending on the situation.

(f) Answers (b) and (d) depending on the situation.

The answer is Option (f) – that is, it could reflect that economic growth is reducing private risk assessments of alternative financial investments. but it also could reflect the fact that private investors consider public debt to be riskier.

The first option provided “that government spending is becoming more expensive” assumes that there is some revenue constraint on government spending. The interest servicing payments come from the same source as all government spending – its infinite (minus $1!) capacity to issue fiat currency. There is no “cost” – in real terms to the government doing this.

The concept of more or less expensive is therefore inapplicable to government spending.

The third option “that government spending is increasing the cost of borrowing for private investors” is also based on the flawed mainstream concept of crowding out. The normal presentation of the crowding out hypothesis, which is a central plank in the mainstream economics attack on government fiscal intervention, is more accurately called “financial crowding out”.

In this blog – Studying macroeconomics – an exercise in deception – I provide detailed analysis of this hypothesis.

By way of summary, the underpinning of the crowding out hypothesis is the old Classical theory of loanable funds, which is an aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

Mainstream textbook writer Mankiw assumes that it is reasonable to represent the financial system to his students as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”

This doctrine 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.

The supply of funds comes from those people who have some extra income they want to save and lend out. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.

This framework is then used to analyse fiscal policy impacts and the alleged negative consequences of fiscal deficits – the so-called financial crowding out – is derived. Mankiw (in his First Principles) says:

One of the most pressing policy issues … has been the government budget deficit … In recent years, the U.S. federal government has run large budget deficits, resulting in a rapidly growing government debt. As a result, much public debate has centred on the effect of these deficits both on the allocation of the economy’s scarce resources and on long-term economic growth.

So what would happen if there is a fiscal deficit? The erroneous mainstream logic is that investment falls because when the government borrows to finance its fiscal deficit, it increases competition for scarce private savings pushes up interest rates. The higher cost of funds crowds thus crowds out private borrowers who are trying to finance investment. This leads to the conclusion that given investment is important for long-run economic growth, government fiscal deficits reduce the economy’s growth rate.

The analysis relies on layers of myths which have permeated the public space to become almost “self-evident truths”. Obviously, national governments are not revenue-constrained so their borrowing is for other reasons – we have discussed this at length. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 | Deficit spending 101 – Part 2 | Deficit spending 101 – Part 3.

But governments do borrow – for stupid ideological reasons and to facilitate central bank operations – so doesn’t this increase the claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?

The answer to both questions is no! Modern Monetary Theory (MMT) does not claim that central bank interest rate hikes are not possible. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.

But the Classical claims about crowding out are not based on these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending.

A related theory which is taught under the banner of IS-LM theory (in macroeconomic textbooks) assumes that the central bank can exogenously set the money supply. Then the rising income from the deficit spending pushes up money demand and this squeezes interest rates up to clear the money market. This is the Bastard Keynesian approach to financial crowding out.

Neither theory is remotely correct and is not related to the fact that central banks push up interest rates up because they believe they should be fighting inflation and interest rate rises stifle aggregate demand.

Further, from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Its what astute financial market players call “a wash”. The funds used to buy the government bonds come from the government!

There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.

But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.

Acknowledging the point that increased aggregate demand, in general, generates income and saving, Luigi Passinetti the famous Italian economist had a wonderful sentence I remember from my graduate school days – “investment brings forth its own savings” – which was the basic insight of Keynes and Kalecki – and the insight that knocked out classical loanable funds theory upon which the neo-liberal crowding out theory was originally conceived.

So that leaves the two options:

(b) that economic growth is reducing private risk assessments of alternative financial investments.

(d) that private investors consider public debt to be riskier.

In terms of Option (b) the following discussion is relevant. In macroeconomics, we summarise the plethora of public debt instruments with the concept of a bond. The standard bond has a face value – say $A1000 and a coupon rate – say 5 per cent and a maturity – say 10 years. This means that the bond holder will will get $50 dollar per annum (interest) for 10 years and when the maturity is reached they would get $1000 back.

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.

Once bonds are issued they are traded in the secondary market between interested parties. Clearly secondary market trading has no impact at all on the volume of financial assets in the system – it just shuffles the wealth between wealth-holders. In the context of public debt issuance – the transactions in the primary market are vertical (net financial assets are created or destroyed) and the secondary market transactions are all horizontal (no new financial assets are created). Please read my blog – Deficit spending 101 – Part 3 – for more discussion on this point.

Further, most primary market issuance is now done 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 they would avoid it under the tap system. But 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.

The mathematical formulae to compute the desired (lower) price is quite tricky and you can look it up in a finance book.

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.

When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).

When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.

Further, rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this). But they may also indicated a recovering economy where people are more confidence investing in commercial paper (for higher returns) and so they demand less of the “risk free” government paper.

So you see how an event (yield rises) that signifies growing confidence in the real economy is reinterpreted (and trumpeted) by the conservatives to signal something bad (crowding out). In this case, the reason long-term yields would be rising is because investors were diversifying their portfolios and moving back into private financial assets. The yield reflects the last auction bid in the bond issue. So if diversification is occurring reflecting confidence and the demand for public debt weakens and yields rise this has nothing at all to do with a declining pool of funds being soaked up by the binging government!

In terms of Option (d), it might be the case that bond investors form irrational views about the risk embodied in a sovereign bond and thus demand higher yields. The mechanisms will be the same as outlined above. They will be prepared to bid lower prices in the issue tenders and thus extract a higher yield to cover their assessment of increased risk.

The reality is that for true sovereigns, Option (b) will be the overwhelming reason public debt yields rise which is a good sign in a growing economy.

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?

Question 3:

When the national government’s fiscal balance moves into surplus:

(a) it is a sign that the government is trying to constrain economic activity.

(b) it is a sign that the government is worried that inflation is rising.

(c) you cannot conclude anything about the government’s policy intentions.

(d) Options (a) and (b).

The answer is that you cannot conclude anything about the government’s policy intentions.

The actual fiscal deficit outcome that is reported in the press and by Treasury departments is not a pure measure of the fiscal policy stance adopted by the government at any point in time. As a result, a straightforward interpretation of

Economists conceptualise the actual fiscal outcome as being the sum of two components: (a) a discretionary component – that is, the actual fiscal stance intended by the government; and (b) a cyclical component reflecting the sensitivity of certain fiscal items (tax revenue based on activity and welfare payments to name the most sensitive) to changes in the level of activity.

The former component is now called the “structural deficit” and the latter component is sometimes referred to as the automatic stabilisers.

The structural deficit thus conceptually 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 fiscal 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 fiscal outcome goes into deficit which might lead people to think the “government” is expanding the economy.

So just because the fiscal outcome 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 fiscal 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 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.

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

The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal 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 fiscal 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 fiscal outcome 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 fiscal 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 fiscal outcome is presently.

So you could have a downturn which drives the fiscal outcome 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.

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, they systematically understate the degree of discretionary contraction coming from fiscal policy.

The only qualification is if the NAIRU measurement actually represented full employment. Then this source of bias would disappear.

Why all this matters is because, as an example, the Australian government thinks we are close to full employment now (according to Treasury NAIRU estimates) when there is 5.2 per cent unemployment and 7.5 per cent underemployment (and about 1.5 per cent of hidden unemployment). As a result of them thinking this, they consider the structural deficit estimates are indicating too much fiscal expansion is still in the system and so they are cutting back.

Whereas, if we computed the correct structural balance it is likely that the Federal fiscal deficit even though it expanded in both discretionary and cyclical terms during the crisis is still too contractionary.

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