The Weekend Quiz – February 9-10, 2019 – 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:

Workers can enjoy a stable share of GDP over time if they secure wage increases in line with the growth in their contribution to production.

The answer is False.

The share the workers get of GDP (National Income) is called the “wage share”. Their contribution to production is labour productivity.

The wage share in nominal GDP is expressed as the total wage bill as a percentage of nominal GDP. Economists differentiate between nominal GDP ($GDP), which is total output produced at market prices and real GDP (GDP), which is the actual physical equivalent of the nominal GDP. We will come back to that distinction soon.

To compute the wage share we need to consider total labour costs in production and the flow of production ($GDP) each period.

Employment (L) is a stock and is measured in persons (averaged over some period like a month or a quarter or a year.

The wage bill is a flow and is the product of total employment (L) and the average wage (w) prevailing at any point in time. Stocks (L) become flows if it is multiplied by a flow variable (W). So the wage bill is the total labour costs in production per period.

So the wage bill = W.L

The wage share is just the total labour costs expressed as a proportion of $GDP – (W.L)/$GDP in nominal terms, usually expressed as a percentage. We can actually break this down further.

Labour productivity (LP) is the units of real GDP per person employed per period. Using the symbols already defined this can be written as:

LP = GDP/L

so it tells us what real output (GDP) each labour unit that is added to production produces on average.

We can also define another term that is regularly used in the media – the real wage – which is the purchasing power equivalent on the nominal wage that workers get paid each period. To compute the real wage we need to consider two variables: (a) the nominal wage (W) and the aggregate price level (P).

We might consider the aggregate price level to be measured by the consumer price index (CPI) although there are huge debates about that. But in a sense, this macroeconomic price level doesn’t exist but represents some abstract measure of the general movement in all prices in the economy.

Macroeconomics is hard to learn because it involves these abstract variables that are never observed – like the price level, like “the interest rate” etc. They are just stylisations of the general tendency of all the different prices and interest rates.

Now the nominal wage (W) – that is paid by employers to workers is determined in the labour market – by the contract of employment between the worker and the employer. The price level (P) is determined in the goods market – by the interaction of total supply of output and aggregate demand for that output although there are complex models of firm price setting that use cost-plus mark-up formulas with demand just determining volume sold. We shouldn’t get into those debates here.

The inflation rate is just the continuous growth in the price level (P). A once-off adjustment in the price level is not considered by economists to constitute inflation.

So the real wage (w) tells us what volume of real goods and services the nominal wage (W) will be able to command and is obviously influenced by the level of W and the price level. For a given W, the lower is P the greater the purchasing power of the nominal wage and so the higher is the real wage (w).

We write the real wage (w) as W/P. So if W = 10 and P = 1, then the real wage (w) = 10 meaning that the current wage will buy 10 units of real output. If P rose to 2 then w = 5, meaning the real wage was now cut by one-half.

Nominal GDP ($GDP) can be written as P.GDP, where the P values the real physical output.

Now if you put of these concepts together you get an interesting framework. To help you follow the logic here are the terms developed and be careful not to confuse $GDP (nominal) with GDP (real):

• Wage share = (W.L)/$GDP
• Nominal GDP: $GDP = P.GDP
• Labour productivity: LP = GDP/L
• Real wage: w = W/P

By substituting the expression for Nominal GDP into the wage share measure we get:

Wage share = (W.L)/P.GDP

In this area of economics, we often look for alternative way to write this expression – it maintains the equivalence (that is, obeys all the rules of algebra) but presents the expression (in this case the wage share) in a different “view”.

So we can write as an equivalent:

Wage share – (W/P).(L/GDP)

Now if you note that (L/GDP) is the inverse (reciprocal) of the labour productivity term (GDP/L). We can use another rule of algebra (reversing the invert and multiply rule) to rewrite this expression again in a more interpretable fashion.

So an equivalent but more convenient measure of the wage share is:

Wage share = (W/P)/(GDP/L) – that is, the real wage (W/P) divided by labour productivity (GDP/L).

I won’t show this but I could also express this in growth terms such that if the growth in the real wage equals labour productivity growth the wage share is constant. The algebra is simple but we have done enough of that already.

That journey might have seemed difficult to non-economists (or those not well-versed in algebra) but it produces a very easy to understand formula for the wage share.

Two other points to note. The wage share is also equivalent to the real unit labour cost (RULC) measures that Treasuries and central banks use to describe trends in costs within the economy. Please read my blog – Saturday Quiz – May 15, 2010 – answers and discussion – for more discussion on this point.

So it becomes obvious that the correct statement is that the real wage has to keep pace with productivity growth for the wage share to remain constant. If the nominal wage (W) and the price level (P) are growing at the pace the real wage is constant. And if the real wage is growing at the same rate as labour productivity, then both terms in the wage share ratio are equal and so the wage share is constant.

The wage share was constant for a long time during the Post Second World period and this constancy was so marked that Kaldor (the Cambridge economist) termed it one of the great “stylised” facts. So real wages grew in line with productivity growth which was the source of increasing living standards for workers.

The productivity growth provided the “room” in the distribution system for workers to enjoy a greater command over real production and thus higher living standards without threatening inflation.

Since the mid-1980s, the neo-liberal assault on workers’ rights (trade union attacks; deregulation; privatisation; persistently high unemployment) has seen this nexus between real wages and labour productivity growth broken. So while real wages have been stagnant or growing modestly, this growth has been dwarfed by labour productivity growth.

The following blogs may be of further interest to you:

• The origins of the economic crisis
• The fiscal stimulus worked but was captured by profits

Question 2:

In general, the estimates of the cyclical position of the fiscal balance provided by organisations such as OECD, the IMF and the US Congressional Budget Office are biased downwards.

The answer is True.

This question is about decomposing the impacts of the automatic stabilisers (the cyclical component of the fiscal balance) from those attributable to the underlying fiscal stance. Both the revenue and spending side of the fiscal balance are adjusted.

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 balanceis 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:

fiscal balance = revenue – spending.

fiscal 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 fiscal balance are the so-called automatic stabilisers

In other words, without any discretionary policy changes, the fiscal 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 fiscal balance moves towards deficit (or an increasing deficit).

When the economy is stronger – tax revenue rises and welfare payments fall and the fiscal balance becomes increasingly positive.

Automatic stabilisers attenuate the amplitude in the economic 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 outcome 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 position 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 post- The dreaded NAIRU is still about! (April 16, 2009).

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, for example, 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 3

A continuous fiscal deficit exposes the economy to inflation risk because the public spending builds up over time.

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

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.