The Weekend Quiz – June 8-9, 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:

The only way that you can have unbalanced external accounts across nations (some countries with surpluses and other deficits) is because the surplus countries desire to hold financial assets denominated in the currency of the deficit countries.

The answer is True.

I note our anonymous friend has already declared that there is “No way it’s true”. Okay, I am not God. But in this case I don’t really need to draw on any divine powers anyway to defend the conclusion that it is true.

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 Australia (if we use it as an example) can counter this is if Australian financial institutions borrow from abroad.

They then assume that this is a problem because it means, allegedly, that Australia is “living beyond its means”. It it true that the higher the level of Australian 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.

First, 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.

Second, 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!

So, 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 macroeconomic 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 goods and services 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.

This bi-lateral example extends to multi-lateral situations which become more complicated in terms of who is holding what but the underlying principle is the same.

A net exporting nation must be desiring to accumulate financial assets denominated in the currencies of the nations it runs surpluses with. It may then trade these assets for other claims (not necessarily in the original currency) but that doesn’t alter the basic motivation.

The following blog posts may be of further interest to you:

• Modern monetary theory in an open economy
• Debt is not debt!
• The piper will call if surpluses are pursued …

Question 2:

Like anything in abundance, it is true that when there is more “money” in the economy its value declines.

The answer is False.

There are situations (rare) where this proposition might be true, but, in general, the proposition is false.

The question requires you to: (a) understand the difference between bank reserves and the money supply; and (b) understand the Quantity Theory of Money.

The mainstream macroeconomics text book argument that increasing the money supply will cause inflation is based on the Quatity Theory of Money. First, expanding bank reserves will put more base money into the economy but not increase the aggregates that drive the alleged causality in the Quantity Theory of Money – that is, the various estimates of the “money supply”.

Second, even if the money supply is increasing, the economy may still adjust to that via output and income increases up to full capacity. Over time, as investment expands the productive capacity of the economy, aggregate demand growth can support the utilisation of that increased capacity without there being inflation.

In this situation, an increasing money supply (which is really not a very useful aggregate at all) which signals expanding credit will not be inflationary.

So the Maybe relates to the situation that might arise if nominal demand kept increasing beyond the capacity of the real economy to absorb it via increased production. Then you would get inflation and the “value” of the dollar would start to decline.

The Quantity Theory of Money which in symbols is MV = PQ but means that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and Q is always at full employment as a result of market adjustments.

In applying this theory the mainstream deny the existence of unemployment. The more reasonable mainstream economists admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.

In general, the Monetarists (the most recent group to revive the Quantity Theory of Money) claim that with V and Q fixed, then changes in M cause changes in P – which is the basic Monetarist claim that expanding the money supply is inflationary. They say that excess monetary growth creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).

One of the contributions of Keynes was to show the Quantity Theory of Money could not be correct. He observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed. There is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will react to the increased nominal demand by increasing output.

The mainstream have related the current non-standard monetary policy efforts – the so-called quantitative easing – to the Quantity Theory of Money and predicted hyperinflation will arise.

So it is the modern belief in the Quantity Theory of Money is behind the hysteria about the level of bank reserves at present – it has to be inflationary they say because there is all this money lying around and it will flood the economy.

Textbook like that of Mankiw mislead their students into thinking that there is a direct relationship between the monetary base and the money supply. They claim that the central bank “controls the money supply by buying and selling government bonds in open-market operations” and that the private banks then create multiples of the base via credit-creation.

Students are familiar with the pages of textbook space wasted on explaining the erroneous concept of the money multiplier where a banks are alleged to “loan out some of its reserves and create money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations. Please read my blog – Money multiplier and other myths – for more discussion on this point.

The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the central bank does not have the capacity to control the money supply. We have regularly traversed this point. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

So when we talk about quantitative easing, we must first understand that it requires the short-term interest rate to be at zero or close to it. Otherwise, the central bank would not be able to maintain control of a positive interest rate target because the excess reserves would invoke a competitive process in the interbank market which would effectively drive the interest rate down.

Quantitative easing then involves the central bank buying assets from the private sector – government bonds and high quality corporate debt. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserves. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.

For the monetary aggregates (outside of base money) to increase, the banks would then have to increase their lending and create deposits. This is at the heart of the mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. The recent experience (and that of Japan in 2001) showed that quantitative easing does not succeed in doing this.

This should come as no surprise at all if you understand Modern Monetary Theory (MMT).

The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.

The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.

Those that claim that quantitative easing will expose the economy to uncontrollable inflation are just harking back to the old and flawed Quantity Theory of Money. This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase. Should quantitative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.

So the fact that large scale quantitative easing conducted by central banks in Japan in 2001 and now in the UK and the USA has not caused inflation does not provide a strong refutation of the mainstream Quantity Theory of Money because it has not impacted on the monetary aggregates.

The fact that is hasn’t is not surprising if you understand how the monetary system operates but it has certainly bedazzled the (easily dazzled) mainstream economists.

The following blog posts may be of further interest to you:

• Money multiplier and other myths
• Islands in the sun
• Operation twist – then and now
• Quantitative easing 101
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary

Question 3:

The imposition of a fiscal rule at the national government level that the fiscal account has to be in balance at all times would eliminate fiscal balance swings driven by the automatic stabilisers.

The answer is False.

The final fiscal outcome is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the fiscal outcome 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 outcome is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the fiscal outcome is in deficit we say the fiscal impact expansionary (adding net spending).

Further, a rising deficit (falling surplus) is often considered to be reflecting an expansionary policy stance and vice versa. What we know is that a rising deficit may, in fact, indicate a contractionary fiscal stance – which, in turn, creates such income losses that the automatic stabilisers start driving the fiscal outcome back towards (or into) deficit.

So the complication is that we cannot conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty clearly relates to the operation of the automatic stabilisers.

To see this, the most simple model of the fiscal balance we might think of can be written as:

Fiscal balance = Revenue – Spending = (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 stance in a recession and contracting it in a boom.

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.

The first point to always be clear about then is that the fiscal balance is not determined by the government. Its discretionary policy stance certainly is an influence but the final outcome will reflect non-government spending decisions. In other words, the concept of a fiscal rule – where the government can set a desired balance (in the case of the question – zero) and achieve that at all times is fraught.

It is likely that in attempting to achieve a balanced fiscal outcome the government will set its discretionary policy settings counter to the best interests of the economy – either too contractionary or too expansionary.

If there was a balanced fiscal rule and private spending fell dramatically then the automatic stabilisers would push the fiscal outcome into the direction of deficit. The final outcome would depend on net exports and whether the private sector was saving overall or not. Assume, that net exports were in deficit (typical case) and private saving overall was positive. Then private spending declines.

In this case, the actual fiscal outcome would be a deficit equal to the sum of the other two balances.

Then in attempting to apply the fiscal rule, the discretionary component of the fiscal stance would have to contract. This contraction would further reduce aggregate demand and the automatic stabilisers (loss of tax revenue and increased welfare payments) would be working against the discretionary policy choice.

In that case, the application of the fiscal rule would be undermining production and employment and probably not succeeding in getting the fiscal outcome into balance.

But every time a discretionary policy change was made the impact on aggregate demand and hence production would then trigger the automatic stabilisers via the income changes to work in the opposite direction to the discretionary policy shift.

You might like to read these blog posts for further information:

• Structural deficits and automatic stabilisers
• Structural deficits – the great con job!

That is enough for today!

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