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The Weekend Quiz – April 2-3, 2016 – answers and discussion

Here are the answers with discussion for this Weekend’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:

The only time that fiscal surplus represents increased national savings is when the government creates a sovereign fund.

The answer is False.

From the perspective of Modern Monetary Theory (MMT) the national government’s ability to make timely payment of its own currency is never numerically constrained by revenues from taxing and/or borrowing. Therefore the creation of a sovereign fund by purchasing assets in financial markets in no way enhances the government’s ability to meet future obligations. In fact, the entire concept of government pre-funding an unfunded liability in its currency of issue has no application whatsoever in the context of a flexible exchange rate and the modern monetary system.

The misconception that “public saving” is required to fund future public expenditure is often rehearsed in the financial media. In rejecting the notion that public surpluses create a cache of money that can be spent later we note that Government spends by crediting an account held by the commercial banks at the central bank. There is no revenue constraint. Government cheques don’t bounce! Additionally, taxation consists of debiting an account held by the commercial banks at the central bank. The funds debited are “accounted for” but don’t actually “go anywhere” and “accumulate”.

Thus is makes no sense to say that a sovereign government is saving in its own currency. Saving is an act that revenue-constrained households do to enhance their future consumption opportunities. The sacrifice of consumption now provides more funds in the future (via compounding). But the government doesn’t have to sacrifice spending now to spend in the future.

The concept of pre-funding future liabilities does apply to fixed exchange rate regimes, as sufficient reserves must be held to facilitate guaranteed conversion features of the currency. It also applies to non-government users of a currency. Their ability to spend is a function of their revenues and reserves of that currency.

So at the heart of the mis-perceptions about sovereign funds is the false analogy mainstream macroeconomics draws between private household budgets and the government fiscal position. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.

However, trying to squeeze the economy to generate these mythical “pools of funds” which are then allocated to the sovereign fund as if they exist is very damaging. You can think of this in two stages.

First, the national government spends less than it taxes and this leads to ever decreasing levels of net private savings (unless there is a strong positive net exports response). The private deficits are manifest in the public surpluses and increasingly leverage the private sector. The deteriorating private debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity.

Second, while that process is going on, the Federal Government is actually spending an equivalent amount that it is draining from the private sector (through tax revenues) in the financial and broader asset markets (domestic and abroad) buying up speculative assets including shares and real estate.

Accordingly, creating a sovereign fund amounts to the government competing in the private equity market to fuel speculation in financial assets and distort allocations of capital.

However, as you can see from pulling it apart, this behaviour has been grossly misrepresented as providing “future savings”. Say the sovereign government ran a $15 billion surplus in the last financial year. It could then purchase that amount of financial assets in the domestic and international capital markets. But from an accounting perspective the Government would no longer have run that surplus because the $15 billion would be recorded as spending and the fiscal position would break even.

In these situations, the public debate should be focused on whether this is the best use of public funds. It would be hard to justify this sort of spending when basic infrastructure provision and employment creation has been ignored for many years by neo-liberal governments.

So all we are talking about is a different portfolio of assets.

The following blog may be of further interest to you:

Question 2:

The massive build-up of Chinese holdings of US government debt indicates that Chinese investors have been funding the US government deficits.

The answer is False.

Note: this is a question about macroeconomic outcomes. We might have concerns about the distributional consequences within the US that might arise from an on-going external deficit – that is that some might benefit while others will be losing jobs as manufacturing heads to China. But when we think in macroeconomic terms (which is mostly the case in this blog) we are dealing with aggregates and so the distributional questions, while very important, are abstracted from.

That statement is not entirely accurate because one of the important insights that progressive economists such as Kalecki provided was that distribution of income does impact on aggregate demand. Please read my blog – Michal Kalecki – The Political Aspects of Full Employment – for more discussion on this point.

Now, back to the question.

First, China can only do what the Americans and everyone else it trades with allow them to do. They cannot sell a penny’s worth of output in USD and therefore accumulate the USD which they then use to buy US treasury bonds if the US citizens didn’t buy their exports in the first place.

Presumably, people buy imported goods made in China instead of locally-made goods (which are more expensive) because they perceive it is in their best interests to do so.

There is often a curious inconsistency among those who advocated free markets. They hate government involvement in the economy yet propose complex regulative structures (for example, tariffs) which would increase government control on resource allocation and, not to mention it, force citizens (against their will) to purchase goods and services they reject in an open comparison (on price and whatever other characteristics).

Many economists do not fully understand how to interpret the balance of payments in a fiat monetary system. For example, most will associate the rise in the current account deficit (exports less than imports plus net invisibles) with an outflow of capital. They then argue that the only way the US (if we use it as an example) can counter this is if US financial institutions borrow from abroad.

They then assume that this is a problem because it means, allegedly, that the US nation is “living beyond its means”. It it true that the higher the level of US foreign debt, the more its economy becomes linked to changing conditions in international credit markets. But the way this situation is usually constructed is dubious.

Second, exports are a cost – a nation has to give something real to foreigners that it we could use domestically – so there is an opportunity cost involved in exports.

Third, imports are a benefit – they represent foreigners giving a nation something real that they could use themselves but which the local economy will benefit from having. The opportunity cost is all theirs!

Thus, on balance, if a nation can persuade foreigners to send more ships filled with things than it has to send in return (net export deficit) then that is a net benefit to the local economy. I am abstracting from all the arguments (valid mostly!) that says we cannot measure welfare in a material way. I know all the arguments that support that position and largely agree with them.

So how can we have a situation where foreigners are giving up more real things than they get from the local economy (in a macroeconommic sense)? The answer lies in the fact that the local nation’s current account deficit “finances” the desire of foreigners to accumulate net financial claims denominated in $AUDs.

Think about that carefully. The standard conception is exactly the opposite – that the foreigners finance the local economy’s profligate spending patterns.

In fact, the local trade deficit allows the foreigners to accumulate these financial assets (claims on the local economy). The local economy gains in real terms – more ships full coming in than leave! – and foreigners achieve their desired financial portfolio. So in general that seems like a good outcome for all.

The problem is that if the foreigners change their desire to accumulate financial assets in the local currency then they will become unwilling to allow the “real terms of trade” (ships going and coming with real things) to remain in the local nation’s favour. Then the local econmy has to adjust its export and import behaviour accordingly. If this transition is sudden then some disruptions can occur. In general, these adjustments are not sudden.

So if you understand this then you will be able to appreciate the following juxtaposition:

  • Neo-liberal myth: US government has to borrow $billions from foreigners to keep funding its deficit.
  • MMT reality: US consumers, through their import purchases, are funding $billions in foreign savings (accumulation of $US-denominated financial assets by foreigners), which then is stored in $US holdings of government debt rather than bank deposits.

Here is a transactional account of how this works which starts off with a US citizen buying a Chinese product.

  • US citizen buys a nice Chinese car.
  • If the US consumer pays cash, then his/her bank account is debited and the Chinese car dealer’s account is credited – this has the impact of increasing foreign savings of US dollar-denominated financial assets. Total deposits in the US banking system, so far, are unchanged.
  • If the US consumer takes out a loan to buy the car, then his/her bank’s balance sheet now records the loan as an asset and creates a deposit (the loan) on the liability side. When the US consumer then hands the cheque over to the car dealer (representing the Chinese firm – ignore intervening transactions) the Chinese car company has a new asset ($US bank deposit) and my loan boosts overall bank deposits (loans create deposits). Foreign savings in US dollars rise by the amount of the loan.
  • So the trade deficit (1 car in this case) results from the Chinese car firm’s desire to net save US dollar-denominated financial assets and sell goods and services to the US in order to get those assets – it is the only way they can accumulate financial assets in a foreign currency.

What if the Chinese car company then decided to buy US Government debt instead of holding the US dollar-denominated bank deposits?
Some more accounting transactions would occur.

  • The Chinese company would put in an order for the bonds which would transfer the bank deposit into the hands of the central bank (Federal Reserve) who is selling the bond (ignore the specifics of which particular account in the Government is relevant) and in return hand over a bit of paper called a bond to the Chinese car maker’s lawyers or representative.
  • The US Government’s foreign debt rises by that amount.
  • But this merely means that the US Government promises, on maturity of the bond, to credit the Chinese car firm’s bank account (add reserves to the commercial bank the car firm deals with) with the face value of the bond plus interest and debit some account at the central bank (or whatever specific accounting structure deals with bond sales and purchases).

If you understand all of that then you will clearly understand that this merely amounts to substituting a non-interest bearing reserve balance for an interest-bearing Government bond. That transaction can never present any problems of solvency for a sovereign government.

The US consumers get all the real goods and services and the Chinese have bits of paper.

I know some so-called progressives worry about the stock of debt that the Chinese are holding. But the US government holds all the cards. The debt is in US dollars and they never leave the US system.

The Chinese may decide they have accumulated enough and will seek to alter the real terms of trade (that is, reduce its desire to export to the US). In that situation the US will no longer be able to exploit the material advantages and the adjustment might be sharp and painful. But that doesn’t negate that while the situation is as described the material benefits are flowing in favour of the US citizens (overall).

The following blogs may be of further interest to you:

Question 3:

If employment growth matches the pace of growth in the civilian population (people above 15 years of age) then the economy will experience a constant unemployment rate as long as participation rates do not change.

The answer is True.

The Civilian Population is shorthand for the working age population and can be defined as all people between 15 and 65 years of age or persons above 15 years of age, depending on rules governing retirement. The working age population is then decomposed within the Labour Force Framework (used to collect and disseminate labour force data) into two categories: (a) the Labour Force; and (b) Not in the Labour Force. This demarcation is based on activity principles (willingness, availability and seeking work or being in work).

The participation rate is defined as the proportion of the working age population that is in the labour force. So if the working age population was 1000 and the participation rate was 65 per cent, then the labour force would be 650 persons. So the labour force can vary for two reasons: (a) growth in the working age population – demographic trends; and (b) changes in the participation rate.

The labour force is decomposed into employment and unemployment. To be employed you typically only have to work one hour in the survey week. To be unemployed you have to affirm that you are available, willing and seeking employment if you are not working one hour or more in the survey week. Otherwise, you will be classified as not being in the labour force.

So the hidden unemployed are those who give up looking for work (they become discouraged) yet are willing and available to work. They are classified by the statistician as being not in the labour force. But if they were offered a job today they would immediately accept it and so are in no functional way different from the unemployed.

When economic growth wanes, participation rates typically fall as the hidden unemployed exit the labour force. This cyclical phenomenon acts to reduce the official unemployment rate.

So clearly, the working age population is a much larger aggregate than the labour force and, in turn, employment. Clearly if the participation rate is constant then the labour force will grow at the same rate as the civilian population. And if employment grows at that rate too then while the gap between the labour force and employment will increase in absolute terms (which means that unemployment will be rising), that gap in percentage terms will be constant (that is the unemployment rate will be constant).

The following Table simulates a simple labour market. You can see that while unemployment rises steadily over time the unemployment rate is constant. So as long as employment growth is equal to the growth in the underlying population and the participation rate doesn’t change, the unemployment rate will be constant although more people will be unemployed.

Understanding these aggregates is very important because as we often see when Labour Force data is released by national statisticians the public debate becomes distorted by the incorrect way in which employment growth is represented in the media.

In situations where employment growth keeps pace with the underlying population but the participation rate falls then the unemployment rate will also fall. By focusing on the link between the positive employment growth and the declining unemployment there is a tendency for the uninformed reader to conclude that the economy is in good shape. The reality, of-course, is very different.

The following blog may be of further interest to you:

This Post Has 3 Comments

  1. Bill, I think youve got the answer to Q2 wrong.

    The USA is perfectly capable of funding its own deficits. They don’t have to borrow billions from other countries to fund them. But the question didn’t ask whether it was nexessary for China to fund the deficits, it asked whether China has been funding those deficits. And unless you use a ridiculously narrow definition of fund, it has.

  2. Dear Bill- I have been an enthusiastic follower of your blog since I discovered it, and your clear explanations of macroeconomics have helped explain why the political dialogue about the economy in the US is so topsy-turvy.

    I follow the logic of the answer to Q2, and agree with the perspective that a current account deficit means the local economy is acquiring real goods in exchange for bits of paper. Overall that seems like a net plus, but I am less enthusiastic about the situation when Chinese companies are using their USD financial assets to acquire US companies. I realize that this ownership is subject to US laws and regulations, but losing control of local firms still seems like a potential downside to running a current account deficit. Am I missing something?

  3. Dear CDM (at 2016/04/03 at 10:46) and others who have asked me the same question

    You said:

    I follow the logic of the answer to Q2, and agree with the perspective that a current account deficit means the local economy is acquiring real goods in exchange for bits of paper. Overall that seems like a net plus, but I am less enthusiastic about the situation when Chinese companies are using their USD financial assets to acquire US companies.

    The US citizens have two major options if they don’t like this. First, stop buying Chinese imports and support import-competing (though more expensive) alternatives and put pressure on companies making stuff in China to bring back production to the US. Second, pressure their governments to bring in foreign restrictions on asset purchases in the US. Australia does that to some extent (on real estate).

    The Chinese are not forcing Americans to buy their stuff.

    The Chinese then have options too which the US citizens might not like.

    best wishes

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