The Weekend Quiz – March 21-22, 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:

Given that most governments are sovereign in their own currencies, there is no limit on the expenditure that these governments can introduce to deal with the coronavirus emergency.

The answer is False.

The question was designed to ensure you are careful in articulating each of the concepts mentioned accurately and not drawing quick but false associations.

The first part of the question lures you into thinking about a series of other propositions that follow for such a government.

So we know that the following summary features describe a government that is sovereign in its own currency:

• A national government which issues its own currency is not revenue-constrained in its own spending, irrespective of the voluntary (political) arrangements it puts in place which may constrain it in spending in any number of ways.
• The only constraints facing such a government other than the political pressures it has to manage are real – there must be real resources available for sale for government spending to purchase.
• A sovereign government can buy whatever is for sale at any time but should only net spend up to the desire by the non-government sector to save otherwise nominal spending will outstrip the real capacity of the economy to respond in quantity terms and inflation will result.
• A government that wants to increase its share of resource usage must work out ways to deprive the existing non-government users of those resources if there is full employment.
• A deficiency of spending overall relative to full capacity output will cause output to contract and employment to fall.
• Government net spending funds the private desire to save while at the same ensuring output levels are higher than otherwise.
• A government deficit (surplus) will be exactly equal ($-for-$) to a non-government surplus (deficit).
• Public debt issuance of a sovereign government is about interest-rate maintenance and has nothing to do with “funding” net government spending.

The “knee-jerk” answer would be true if after a careless reading you reasoned that when governments spend they always use up real resources in the economy.

But the question asked you to relate nominal expenditure to availability of real resources. All spending is nominal but whether it has a real effect depends on state of overall demand in the economy and also on price movements in particular areas of the economy.

You could imagine that with the health care providers holding market power which translates into price setting power and the coronavirus emergency being so large, that increased demand for health care resources could be met by price adjustments and draw in no further real resources into the sector.

Funding the response to the coronavirus will never be an issue for currency-issuing governments. Finding sufficient real resources (beds, skills, etc) will be and is proving to be so.

Question 2:

A rising government deficit will always allow the household sector to increase its saving in nominal terms.

The answer is True.

Spending equals income equals output – which is a fundamental fact arising from the way the national accounts measures economic activity.

Nominal GDP will always increase if governments inject more net spending into the economy.

As household saving is a positive function of disposable income, which is a positive function of nominal GDP, it follows that household saving will rise in nominal terms whenever GDP rises.

But that does not mean it rises in real terms. If the rising deficit only induce an inflationary response, nominal GDP rises but real GDP does not. So in real terms, household saving might not increase at all (and even fall).

Question 3:

A rising government deficit always indicates an expansionary shift in policy.

The answer is False.

The question is exploring whether you understand the way in which the fiscal balance is decomposed into the discretionary (now called structural) and cyclical components. The latter component is driven by the automatic stabilisers that are in-built into the fiscal process.

The national government fiscal balance is the difference between total revenue and total outlays.

If total revenue is greater than outlays, the fiscal position is in surplus and vice versa. It is a simple matter of accounting with no theory involved.

The problem is that the fiscal balance is used by all and sundry as a summary measure to indicate the fiscal stance of the government.

So if the fiscal balance is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if it 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 balance 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.

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 the fiscal balance moves towards deficit (or an increasing deficit).

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

Automatic stabilisers attenuate the amplitude in the business cycle by expanding the fiscal injection 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.

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 balance, given the current policy, against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.

So a full employment fiscal position would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity.

If the fiscal balance was estimated to be in surplus if the economy was at full capacity, then we would conclude that the discretionary structure of fiscal policy was contractionary and vice versa if the hypothetical 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.

As I explain in the blogs cited below, the measurement issues have a long history and current techniques and frameworks based on the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) bias the resulting analysis such that actual discretionary positions which are contractionary are seen as being less so and expansionary positions are seen as being more expansionary.

The result is that modern depictions of the structural deficit systematically understate the degree of discretionary contraction coming from fiscal policy.

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 2020 William Mitchell. All Rights Reserved.