The Weekend Quiz – May 28-29, 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:

Higher levels of taxation are necessary to permit the government to spend more in real terms.

The answer is Perhaps.

If the economy was operating at full capacity then the answer would be true. The option – Perhaps – is best because it embraces both options – full capacity and underutilised resources.

The answer is straight-forward once you understand the role that taxation plays in a fiat monetary system.

Clearly, I was tempting the reader to follow a logic such that – Modern Monetary Theory (MMT) shows that taxpayers do fund anything and sovereign governments are never revenue-constrained because they are the monopoly issuers of the currency in use. Therefore, the government can spend whatever it likes irrespective of the level of taxation. Therefore the answer is false.

But, that logic while correct in some important aspects ignores the underlying role of taxation.

In a fiat monetary system the currency has no intrinsic worth. Further the government has no intrinsic financial constraint. Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. The starting point of this new understanding is that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

In this way, it is clear that the imposition of taxes creates unemployment (people seeking paid work) in the non-government sector and allows a transfer of real goods and services from the non-government to the government sector, which in turn, facilitates the government’s economic and social program.

The crucial point is that the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. Accordingly, government spending provides the paid work which eliminates the unemployment created by the taxes.

This train of logic also explains why mass unemployment arises. It is the introduction of State Money (government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. For aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages).

Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account, but doesn’t desire to spend all it earns, other things equal. As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

The purpose of State Money is for the government to move real resources from private to public domain. It does so by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets). From the previous paragraph it is also clear that if the Government doesn’t spend enough to cover taxes and desire to save the manifestation of this deficiency will be unemployment.

Keynesians have used the term demand-deficient unemployment. In our conception, the basis of this deficiency is at all times inadequate net government spending, given the private spending decisions in force at any particular time.

Accordingly, the concept of fiscal sustainability does not entertain notions that the continuous deficits required to finance non-government net saving desires in the currency of issue will ultimately require high taxes. Taxes in the future might be higher or lower or unchanged. These movements have nothing to do with “funding” government spending.

To understand how taxes are used to attenuate demand please read this blog – Functional finance and modern monetary theory.

So to make the point clear – the taxes do not fund the spending. They free up space for the spending to occur in a non-inflationary environment.

You might say that it is only at full employment, where there are no free resources, that increased taxation is required to take resources off the non-government sector in order for the government to spend more (and deploy these resources). That would clearly be a true statement.

But it doesn’t negate the overall conclusion that the main proposition is Perhaps – because when there are idle resources, the government can bring them into productive use without, first, denying the non-government sector of their use.

Further, you might say that governments can spend whenever they like. That is also true but if it just kept spending the growth in nominal demand would outstrip real capacity and inflation would certainly result. So in that regard, this would not be a sensible strategy and is excluded as a reasonable proposition.

That is why the I included the qualifier – real terms. If the government wants to deploy a higher share of real resources then it has to make room to do so.

The statement in the question is clearly never False.

The following blogs may be of further interest to you:

• A modern monetary theory lullaby
• Functional finance and modern monetary theory
• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3

Question 2:

If a nation is recording a current account deficit, and its private domestic sector tries to increase its saving overall as a percentage of GDP, then income adjustments will ensure the government fiscal balance is in deficit.

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.

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.

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:

(1) 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).

Expression (1) tells us that total income in the economy per period will be exactly equal to total spending from all sources of expenditure.

We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all taxes and transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).

Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).

Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):

(2) GNP = C + I + G + (X – M) + FNI

To render this approach into the sectoral balances form, we subtract total taxes and transfers (T) from both sides of Expression (3) to get:

(3) GNP – T = C + I + G + (X – M) + FNI – T

Now we can collect the terms by arranging them according to the three sectoral balances:

(4) (GNP – C – T) – I = (G – T) + (X – M + FNI)

The the terms in Expression (4) are relatively easy to understand now.

The term (GNP – C – T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way). In other words, it represents private domestic saving.

The left-hand side of Equation (4), (GNP – C – T) – I, thus is the overall saving of the private domestic sector, which is distinct from total household saving denoted by the term (GNP – C – T).

In other words, the left-hand side of Equation (4) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.

The term (G – T) is the government financial balance and is in deficit if government spending (G) is greater than government tax revenue minus transfers (T), and in surplus if the balance is negative.

Finally, the other right-hand side term (X – M + FNI) is the external financial balance, commonly known as the current account balance (CAD). It is in surplus if positive and deficit if negative.

In English we could say that:

The private financial balance equals the sum of the government financial balance plus the current account balance.

We can re-write Expression (6) in this way to get the sectoral balances equation:

(5) (S – I) = (G – T) + CAD

which is interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAD > 0) generate national income and net financial assets for the private domestic sector.

Conversely, government surpluses (G – T < 0) and current account deficits (CAD < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.

Expression (5) can also be written as:

(6) [(S – I) – CAD] = (G – T)

where the term on the left-hand side [(S – I) – CAD] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.

This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).

The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)) plus net income transfers.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

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 overall saving (as a percentage of GDP). So this is not a situation where just the household sector tries to increase its saving out of disposable income, which could be offset by an increase in firm investment.

The situation described is where the private domestic sector seeks to increase the gap between its income and spending (overall).

Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income or firms might cut back its investment spending.

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, for example, 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 outcome 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:

The reason that IMF and OECD estimates of structural fiscal deficits are to be treated with suspicion relates to the fact that typically the implicit estimates of potential GDP are too optimistic.

The answer is False.

The correct statement is the implicit estimates of potential GDP that are produced by central banks, treasuries and other bodies are too pessimistic.

The reason is that they typically use the NAIRU to compute the “full capacity” or potential level of output which is then used as a benchmark to compare actual output against. The reason? To determine whether there is a positive output gap (actual output below potential output) or a negative output gap (actual output above potential output).

These measurements are then used to decompose the actual fiscal outcome at any point in time into structural 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.

As you can see, the estimation of the benchmark is thus a crucial component in the decomposition of the fiscal outcome and the interpretation we place on the fiscal policy stance.

If the benchmark (potential output) is estimated to be below what it truly is, then a sluggish economy will be closer to potential than if you used the true full employment level of output. Under these circumstances, one would conclude that the fiscal stance was more expansionary than it truly was.

This is very important because the political pressures may then lead to discretionary cut backs to “reign in the structural deficit” even though it is highly possible that at that point in time, the structural component is actually in surplus and therefore constraining growth.

The mainstream methodology involved in estimating potential output almost always uses some notion of a NAIRU which itself is unobserved. The NAIRU estimates produced by various agencies (OECD, IMF etc) always inflate the true full employment unemployment rate and completely ignore underemployment, which has risen sharply over the last 20 years.

The following graph is for Australia but it broadly representative of the types of constructs we are dealing with. It plots three different measures of labour market tightness:

• The gap between the actual unemployment rate and the Australian Treasury estimate of the NAIRU (blue line), which is interpreted as estimating full employment when the gap is zero (cutting the horizontal axis).
• The gap between the actual unemployment rate and a 2 per cent full employment rate (red line), again would indicate full employment if the line cut the horizontal axis.
• The gap between the broad labour underutilisation rate published by the ABS (available HERE), which takes into account underemployment and our 2 per cent full employment rate (green line).

Some might ask why would we assume that 2 per cent unemployment rate is a true full employment level? We know that unemployment will always be non-zero because of frictions – people leaving jobs and reconnecting with other employers. This component is somewhere around 2 per cent. The other components of unemployment which economists define are seasonal, structural and demand-deficient. Seasonal unemployment is tied up with frictional and likely to be small.

The concept of structural unemployment is vexed. I actually don’t think it exists because ultimately comes down to demand-deficient. The concept is biased towards a view that only private market employment are real jobs and so if the market doesn’t want a particular skill group or does not choose to provide work in a particular geographic area then the mis-match unemployment is structural.

The problem is that often there are unemployed workers in areas where employers claim there are skills shortages. The firms will not employ these workers and offer them training opportunities within the paid work environment because they exercise discrimination. So what is actually considered structural is just a reflection of employer prejudice and an unwillingness to extend training opportunities to some cohorts of workers.

Also, the government can always generate enough demand to provide jobs to all in every area should it choose. So ultimately, any unemployment that looks like it is “structural” is in fact due to a lack of demand.

So there is no reason why any economy cannot get their unemployment rate down to 2 per cent.

Given that, the NAIRU estimates not only inflate the true full employment unemployment rate but also completely ignore the underemployment, which has risen sharply over the last 20 years.

In the June quarter 2006 the Australian NAIRU gap was zero whereas the actual unemployment rate was still 2.78 per cent above the full employment unemployment rate. The thick red vertical line depicts this distance.

However, if we considered the labour market slack in terms of the broad labour underutilisation rate published by the ABS then the gap would be considerably larger – a staggering 9.4 per cent. Thus you have to sum the red and green vertical lines shown at June 2008 for illustrative purposes.

This means that the Australian Treasury are providing advice to the Federal government claiming that in June 2008 the Australian economy was at full employment when it is highly likely that there was upwards of 9 per cent of willing labour resources being wasted. That is how bad the NAIRU period has been for policy advice.

But in relation to this question, in June 2008, the Australian Treasury would have classified all of the federal fiscal balance in that quarter as being structural given that the cycle was considered to be at the peak (what they term full employment).

However, if we define the true full employment level was at 2 per cent unemployment and zero underemployment, then you can see that, in fact, the Australian economy would have been operating well below the full employment level and so there would have been a significant cyclical component being reflected in the fiscal balance.

Given the federal fiscal outcome in June 2008 was in surplus the Treasury would have classified this as mildly contractionary whereas in fact the Commonwealth government was running a highly contractionary fiscal position which was preventing the economy from generating a greater number of jobs.

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