The Weekend Quiz – February 22-23, 2020 – 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:

A program of fiscal austerity, defined as the government running a fiscal surplus, does not necessarily undermine economic growth.

The answer is True.

To understand why you have to appreciate that generally a fiscal surplus, which drains net spending from the economy will undermine growth, on the principle that spending equals income equals output.

But, that conclusion is only true if we assume no change in the spending positions of other sectors.

In other words, the spending drain from the fiscal drag can be offset (unlikely) by an increase in spending of one or more of the non-government sector.

We define total spending and income as:

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 consider the ‘injections’ to spending (from ‘outside’) the circular spending-income flow to be I and G and X.

We consider C and M to be determined by GDP so there is circularity in the national income statement above.

In that context, we also define ‘leakages’ from the spending-income flow.

These are:

1. Saving (S) which is the difference between disposable income and consumption spending. Disposable income is total GDP minus Taxes (T).

So when households earn income they do not recycle all of it back into spending each period because they save some of it.

2. Taxes (T) go to government and are lost from the spending cycle.

3. Imports (M) are driven by GDP but the income is lost to the rest of the world.

So we have some injecctions into spending from ‘outside’ the cycle, and some leakages from the cycle.

We know that for GDP (national output) to remain constant, the injections into the expenditure stream have to equal the leakages.

Thus:

S + T + M = I + G + X

This is called an equilibrium or steady state condition in macroeconomics.

It doesn’t imply full employment or a ‘good’ outcome. It means that once this condition is satisfied, there are no forces present to change GDP.

For GDP to change, there has be a change in one of the terms, which then create income shifts that bring the leakages and injections back into equality.

If, for example, G increases as part of an expansionary policy then GDP increases and this leads to increased S, T and M.

Ultimately, once the spending multiplier is exhausted, the left-hand side (S + T + M) rises to equal the rise in the right-hand side (I + G + X) that was stimulated by the increase in G, and GDP comes to rest again at a higher level.

Please read my blog post – Spending multipliers (December 28, 2009) – for more discussion on this point.

So we can now appreciate that if the government imposes fiscal austerity by, for example, cutting government spending (G), if nothing else changes, GDP will fall and the new steady state will be reached when the initial change in G is matched by the decline in S, T and M, all of which are sensitive to changes in GDP.

But, that is not an inevitable outcome.

If the government, for example, is anticipating a major export boom, then it could start cutting G as exports (X) rise which would offset the initial austerity.

The following blog posts 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 2:

The public debt ratio is of no concern because it falls once economic growth resumes.

The answer is False.

The public debt ratio is of no concern per se unless the government is using a foreign currency or is borrowing in a foreign currency.

Further, the primary deficit may not fall when economic growth is positive if discretionary policy changes offset the declining net spending as tax revenue increases and welfare payments fall (the automatic stabilisation).

Under current institutional arrangements, governments around the world voluntarily issue debt into the private bond markets to match $-for-$ their net spending flows in each period. A sovereign government within a fiat currency system does not have to issue any debt and could run continuous fiscal deficits (that is, forever) with a zero public debt.

The reason they is covered in the following blog posts – On voluntary constraints that undermine public purpose (December 25, 2009).

The framework for considering this question is provided by the accounting relationship linking the fiscal flows (spending, taxation and interest servicing) with relevant stocks (base money and government bonds).

From an ex post (after the fact) accounting perspective, the fiscal deficit in year t is equal to the change in government debt (ΔB) over year t plus the change in high powered money (ΔH) over year t.

The mathematical expression of this is written as:

which you can read in English as saying that Fiscal deficit (BD) = Government spending (G) – Tax receipts (T) + Government interest payments (rB_t-1).

However, this is merely an accounting statement.

That means it has to be true if things have been added and subtracted properly in accounting for the dealings between the government and non-government sectors.

This framework has been interpreted by the mainstream macroeconommists as constituting an a priori (before the fact) financial constraint on government spending, which means they claim the government has to seek ‘funding’ from taxes or bond issues prior to spending.

But MMT informs us that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

The way the mainstream macroeconomics textbooks build their narrative is to draw an analogy between the household and the sovereign government and to assert that the microeconomic constraints that are imposed on individual or household choices apply equally without qualification to the government.

The framework for analysing these choices has been called the ‘Government Budget Constraint’ (GBC) in the literature.

The mainstream shift, without explanation, from an ex post sum that has to be true because it is an accounting identity, to an alleged behavioural constraint on government action.

The mainstream literature emerged in the 1960s during a period when the neo-classical microeconomists were trying to gain control of the macroeconomic policy agenda by undermining the theoretical validity of the, then, dominant Keynesian macroeconomics.

They claimed that just as an individual or a household is conceived in orthodox microeconomic theory to maximise utility (real income) subject to their fiscal constraints, this emerging approach also constructed the government as being constrained by a fiscal or “financing” constraint.

So within this model, taxes are conceived as providing the funds to the government to allow it to spend.

Further, this approach asserts that any excess in government spending over taxation receipts then has to be “financed” in two ways: (a) by borrowing from the public; and (b) by printing money.

In a fiat currency system, the mainstream analogy between the household and the government is flawed at the most elemental level.

The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.

From a policy perspective, the mainstream rests on a series of interlinked myths:

1. Via the Quantity Theory of Money, if central banks ‘print money’ inflation follows.

2. Fiscal deficits should therefore be ‘funded’ by debt-issuance, which then ncrease interest rates by increasing demand for scarce savings and crowd out private investment. The negative impact on private investment is referred to as ‘crowding out’.

3. Central bank money creation is erroneously depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money. This is called debt monetisation and these blog posts – Deficits 101 series – show how this conception is incorrect.

4. Ultimately taxes have to rise in the mainstream conception because debt has to be ‘paid back’.

None of the above have any applicability to the real world.

To understand the answer we have to convert the above expression into one that describes the change in the public debt ratio:

The change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.

A growing economy can absorb more debt and keep the debt ratio constant.

For example, if the primary deficit is zero, debt increases at a rate r but the debt ratio increases at r – g.

So a change in the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.

Consider the following table which simulates two different scenarios. Case A shows a real interest rate of zero and a steadily increasing annual GDP growth rate across 10 years.

The initial public debt ratio is 100 per cent.

The fiscal deficit is also simulated to be 5 per cent of GDP then reduces as the GDP growth induce the automatic stabilisers. It then reaches a steady 2 per cent per annum which might be sufficient to support the saving intentions of the non-government sector while still promoting steady economic growth.

Even with a continuous fiscal deficit, the public debt ratio declines steadily and would continue to do so as the growth continued.

The central bank could of-course cut the nominal interest rate to speed the contraction in the debt ratio although I would not undertake that policy change for that reason.

In Case B we assume that the government stops issuing debt with everything else the same. The public debt ratio drops very quickly under this scenario.

However, should the real interest rate exceed the economic growth rate, then unless the primary fiscal balance offsets the rising interest payments as percent of GDP, then the public debt ratio will rise.

The only concern I would have in this situation does not relate to the rising ratio.

Focusing on the cause should be the policy concern.

If the real economy is faltering because interest rates are too high or more likely because the primary fiscal deficit is too low then the rising public debt ratio is just telling us that the central bank should drop interest rates or the treasury should increase the discretionary component of the fiscal balance.

In general though, the public debt ratio is a relatively uninteresting macroeconomic figure and should be disregarded.

If the government is intent on promoting growth, then the primary deficit ratio and the public debt ratio will take care of themselves.

You may be interested in reading these blog posts which have further information on this topic:

• On voluntary constraints that undermine public purpose
• Deficits 101 series
• Questions and answers 1
• Will we really pay higher taxes?
• Will we really pay higher interest rates?

Question 3:

The initial expansionary impact of deficit spending on aggregate demand is lower when the government matches the deficit with debt-issuance compared to a situation when it issues no debt.

The answer is False.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always allege (as noted above) that governments have to ‘finance’ all spending either through taxation; debt-issuance; and/or money creation.

However, government spending is performed in the same way irrespective of the accompanying monetary operations. So the discussion in the mainstream textbooks is always misleading.

But for the purposes of this question, what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a fiscal deficit without issuing debt?

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank.

The commercial bank in question would be where the target of the spending had an account

So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear

1. The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.

2. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).

Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the ‘cash system’ which then raises issues for the central bank about its liquidity management.

The aim of the central bank is to maintain its target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.

Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

So in this paradigm, central banks have to hold debt and conduct open market operations to manage its interest rate.

They can also achieve the same aim by just offering a return on the excess returns.

There is no sense that these debt sales have anything to do with ‘financing’ government net spending.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target.

If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the fiscal deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

• Building bank reserves does not increase the ability of the banks to lend.
• The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
• Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

Finally, when the interest payments on the debt start to flow, then the net worth of the non-government sector increase further.

Which is why the question asks about the ‘initial’ expansionary impact.

You may wish to read the following blog posts for more information:

• Why history matters
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• The complacent students sit and listen to some of that
• Saturday Quiz – February 27, 2010 – answers and discussion

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.