The Weekend Quiz – February 29-March 1, 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:

Estimates of the structural fiscal balances are typically based on overly pessimistic estimates of potential GDP and thus should be disregarded.

The answer is True.

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 Non-Accelerating-Inflation-Rate-of-Unemployment (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.

The following blog posts 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 2:

For a nation with a strong terms of trade (and external surplus), it is wise for the government to run fiscal surpluses and accumulate them in a sovereign fund to create more future space for non-inflationary spending.

The answer is False.

The public finances of a country such as Australia – which issues its own currency and floats it on foreign exchange markets are not reliant at all on the dynamics of our industrial structure. To think otherwise reveals a basis misunderstanding which is sourced in the notion that such a government has to raise revenue before it can spend.

So it is often considered that a mining boom which drives strong growth in national income and generates considerable growth in tax revenue is a boost for the government and provides them with “savings” that can be stored away and used for the future when economic growth was not strong. Nothing could be further from the truth.

The fundamental principles that arise in a fiat monetary system are as follows:

• The central bank sets the short-term interest rate based on its policy aspirations.
• Government spending capacity is independent of taxation revenue. The non-government sector cannot pay taxes until the government has spent.
• Government spending capacity is independent of borrowing which the latter best thought of as coming after spending.
• Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
• Fiscal deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about “crowding out”.
• The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.
• Government debt-issuance is a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

These principles apply to all sovereign, currency-issuing governments irrespective of industry structure. Industry structure is important for some things (crucially so) but not in delineating “public finance regimes”.

The mistake lies in thinking that such a government is revenue-constrained and that a booming mining sector delivers more revenue and thus gives the government more spending capacity.

Nothing could be further from the truth irrespective of the rhetoric that politicians use to relate their fiscal decisions to us and/or the institutional arrangements that they have put in place which make it look as if they are raising money to re-spend it! These things are veils to disguise the true capacity of a sovereign government in a fiat monetary system.

In the midst of the nonsensical intergenerational (ageing population) debate, which is being used by conservatives all around the world as a political tool to justify moving to fiscal surpluses, the notion arises that governments will not be able to honour their liabilities to pensions, health etc unless drastic action is taken.

Hence the hype and spin moved into overdrive to tell us how the establishment of sovereign funds. The financial markets love the creation of sovereign funds because they know there will be more largesse for them to speculate with at the expense of public spending. Corporate welfare is always attractive to the top end of town while they draft reports and lobby governments to get rid of the Welfare state, by which they mean the pitiful amounts we provide to sustain at minimal levels the most disadvantaged among us.

Anyway, the claim is that the creation of these sovereign funds create the fiscal room to fund the so-called future liabilities. Clearly this is nonsense.

A sovereign government’s ability to make timely payment of its own currency is never numerically constrained. So it would always be able to fund the pension liabilities, for example, when they arose without compromising its other spending ambitions.

The creation of sovereign funds basically involve the government becoming a financial asset speculator. So national governments start gambling in the World’s bourses usually at the same time as millions of their citizens do not have enough work.

The logic surrounding sovereign funds is also blurred. If one was to challenge a government which was building a sovereign fund but still had unmet social need (and perhaps persistent labour underutilisation) the conservative reaction would be that there was no fiscal room to do any more than they are doing. Yet when they create the sovereign fund the government spends in the form of purchases of financial assets.

So we have a situation where the elected national government prefers to buy financial assets instead of buying all the labour that is left idle by the private market. They prefer to hold bits of paper than putting all this labour to work to develop communities and restore our natural environment.

An understanding of modern monetary theory will tell you that all the efforts to create sovereign funds are totally unnecessary. Whether the fund gained or lost makes no fundamental difference to the underlying capacity of the national government to fund all of its future liabilities.

A sovereign 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 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.

First, running fiscal surpluses does not create national savings. There is no meaning that can be applied to a sovereign government “saving its own currency”. It is one of those whacko mainstream macroeconomics ideas that appear to be intuitive but have no application to a fiat currency system.

In rejecting the notion that public surpluses create a cache of money that can be spent later we note that governments spend by crediting bank accounts. There is no revenue constraint. Government cheques don’t bounce! Additionally, taxation consists of debiting an account at an RBA member bank. The funds debited are “accounted for” but don’t actually “go anywhere” and “accumulate”.

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 all this nonsense is the false analogy neo-liberals draw 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.

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

• A mining boom will not reduce the need for public deficits
• The Futures Fund scandal
• A modern monetary theory lullaby

Question 3:

A currency-issuing government, that is, one that issues its own floating currency never faces solvency risk with respect to the debt it issues.

The answer is False.

The answer would be True if the sentence had added (to the debt it issues) … in its own currency. The national government can always service its debts so long as these are denominated in domestic currency.

It also makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.

The situation changes when the government issues debt in a foreign-currency. Given it does not issue that currency then it is in the same situation as a private holder of foreign-currency denominated debt.

Private sector debt obligations have to be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate.

Private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.

Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.

The solvency risk the private sector faces on all debt is inherited by the national government if it takes on foreign-currency denominated debt.

In those circumstances it must have foreign exchange reserves to allow it to make the necessary repayments to the creditors. In times when the economy is strong and foreigners are demanding the exports of the nation, then getting access to foreign reserves is not an issue.

But when the external sector weakens the economy may find it hard accumulating foreign currency reserves and once it exhausts its stock, the risk of national government insolvency becomes real.

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

• Modern monetary theory in an open economy
• Debt is not debt
• The deficit and debt debate
• Debt and deficits again!

That is enough for today!

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