The Weekend Quiz – March 6-7, 2021 – 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:

Assume that the national accounts of a nation is reveal that its external surplus is equivalent to 2 per cent of GDP and the private domestic sector is saving overall 3 per cent of GDP. We would also observe::

(a) A fiscal deficit equal to 1 per cent of GDP.

(b) A fiscal surplus equal to 1 per cent of GDP.

(c) A fiscal deficit equal to 5 per cent of GDP.

(d) A fiscal surplus equal to 5 per cent of GDP.

The answer is Option (a) – A fiscal deficit equal to 1 per cent of GDP.

This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances.

To refresh your memory the sectoral balances are derived as follows. The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.

From the sources perspective we write:

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 also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all taxes and transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).

Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).

Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):

(2) GNP = C + I + G + (X – M) + FNI

To render this approach into the sectoral balances form, we subtract total taxes and transfers (T) from both sides of Expression (3) to get:

(3) GNP – T = C + I + G + (X – M) + FNI – T

Now we can collect the terms by arranging them according to the three sectoral balances:

(4) (GNP – C – T) – I = (G – T) + (X – M + FNI)

The the terms in Expression (4) are relatively easy to understand now.

The term (GNP – C – T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way). In other words, it represents private domestic saving.

The left-hand side of Equation (4), (GNP – C – T) – I, thus is the overall saving of the private domestic sector, which is distinct from total household saving denoted by the term (GNP – C – T).

In other words, the left-hand side of Equation (4) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.

The term (G – T) is the government financial balance and is in deficit if government spending (G) is greater than government tax revenue minus transfers (T), and in surplus if the balance is negative.

Finally, the other right-hand side term (X – M + FNI) is the external financial balance, commonly known as the current account balance (CAD). It is in surplus if positive and deficit if negative.

In English we could say that:

The private financial balance equals the sum of the government financial balance plus the current account balance.

We can re-write Expression (6) in this way to get the sectoral balances equation:

(5) (S – I) = (G – T) + CAB

which is interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAB > 0) generate national income and net financial assets for the private domestic sector.

Conversely, government surpluses (G – T < 0) and current account deficits (CAB < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.

Expression (5) can also be written as:

(6) [(S – I) – CAB] = (G – T)

where the term on the left-hand side [(S – I) – CAB] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.

This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).

The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)) plus net income transfers.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

So what economic behaviour might lead to the outcome specified in the question?

The following table shows three situations where the external sector is in surplus of 2 per cent of GDP and the private domestic balance is in surplus of varying proportions of GDP.

In Period 1, the private domestic balance is in surplus (1 per cent of GDP), which means it is saving overall (spending less than the total private income) and the fiscal outcome is also in surplus (1 per cent of GDP). The net injection to demand from the external sector (equivalent to 2 per cent of GDP) is sufficient to “fund” the overall private sector saving drain from expenditure without compromising economic growth. The growth in income would also allow the fiscal outcome to be in surplus (via tax revenue).

In Period 2, the rise in overall private domestic saving drains extra aggregate demand and necessitates a more expansionary position from the government (relative to Period 1), which in this case manifests as a balanced public fiscal outcome,’

Period 3, relates to the data presented in the question – an external surplus of 2 per cent of GDP and private domestic saving equal to 3 per cent of GDP. Now the demand injection from the external sector is being more than offset by the demand drain from private domestic saving. The income adjustments that would occur in this economy would then push the fiscal outcome into deficit of 1 per cent of GDP.

The movements in income associated with the spending and revenue patterns will ensure these balances arise.

The general rule is that the government fiscal deficit (surplus) will always equal the non-government surplus (deficit).

So if there is an external surplus that is less than the overall private domestic sector saving (a surplus) then there will always be a fiscal deficit. The higher the overall private saving is relative to the external surplus, the larger the deficit.

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:

When a government’s fiscal deficit rises we can conclude that it is pursuing an expansionary fiscal policy.

The answer is False.

The actual fiscal deficit outcome that is reported in the press and by Treasury departments is not a pure measure of the discretionary fiscal policy stance adopted by the government at any point in time. As a result, a straightforward interpretation of

Economists conceptualise the actual fiscal outcome as being the sum of two components: (a) a discretionary component – that is, the actual fiscal stance intended by the government; and (b) a cyclical component reflecting the sensitivity of certain fiscal items (tax revenue based on activity and welfare payments to name the most sensitive) to changes in the level of activity.

The former component is now called the “structural deficit” and the latter component is sometimes referred to as the automatic stabilisers.

The structural deficit thus conceptually reflects the chosen (discretionary) fiscal stance of the government independent of cyclical factors.

The cyclical factors refer to the automatic stabilisers which operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.

In times of economic decline, the automatic stabilisers work in the opposite direction and push the fiscal balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

The problem is then how to determine whether the chosen discretionary fiscal stance is adding to demand (expansionary) or reducing demand (contractionary). It is a problem because a government could be run a contractionary policy by choice but the automatic stabilisers are so strong that the fiscal outcome goes into deficit which might lead people to think the “government” is expanding the economy.

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.

To overcome this ambiguity, economists decided to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

As a result, 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 Full Employment Budget Balance was a hypothetical construction 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.

This framework allowed economists to decompose the actual fiscal balance into (in modern terminology) the structural (discretionary) and cyclical fiscal balances with these unseen fiscal components being adjusted to what they would be at the potential or full capacity level of output.

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.

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 question then relates to how the “potential” or benchmark level of output is to be measured. The calculation of the structural deficit spawned a bit of an industry among the profession raising 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.

As the neo-liberal resurgence gained traction in the 1970s and beyond and governments abandoned their commitment to full employment , the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blog posts – The dreaded NAIRU is still about and Redefing full employment … again!.

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.

The estimated NAIRU (it is not observed) became the standard measure of full capacity utilisation. If the economy is running an unemployment equal to the estimated NAIRU then mainstream economists concluded that the economy is at full capacity. Of-course, they kept changing their estimates of the NAIRU which were in turn accompanied by huge standard errors. These error bands in the estimates meant their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.

Typically, the NAIRU estimates are much higher than any acceptable level of full employment and therefore full capacity. The change of the the name from Full Employment Budget Balance to Structural Balance was to avoid the connotations of the past where 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 which are benchmarked using 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 because typically the estimated NAIRU always exceeds a reasonable (non-neo-liberal) definition of full employment.

So the estimates of structural deficits provided by all the international agencies and treasuries etc all conclude that the structural balance is more in deficit (less in surplus) than it actually is – that is, bias the representation of fiscal expansion upwards.

As a result, they systematically understate the degree of discretionary contraction coming from fiscal policy.

The only qualification is if the NAIRU measurement actually represented full employment. Then this source of bias would disappear.

So in terms of the question, a rising fiscal deficit can accompany a contractionary fiscal position if the cuts in the discretionary net spending leads to a decline in economic growth and the automatic stabilisers then drive the cyclical component higher and more than offset the discretionary component.

Without delving further into the actual factors that are delivering the fiscal outcome in Britain one cannot make the conclusion implied in the question.

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

• A modern monetary theory lullaby
• Saturday Quiz – April 24, 2010 – answers and discussion
• The dreaded NAIRU is still about!
• Structural deficits – the great con job!
• Structural deficits and automatic stabilisers
• Another economics department to close

Question 3:

Given a fiat currency issuing nation is not revenue constrained, it is incorrect to say that recipients of income support provided by such a national government are living off the hard work of those who are working and paying income taxes.

The answer is False.

This question explores the true relevance of the dependency ratio, which will rise as demographic changes age our populations. It also aims to disabuse the reader of the notion that the income support benefits are paid for by taxes that those in employment (and other income generating activities) might pay.

Initially, we have to be very clear as to what “living off the hard work of those who pay taxes” means. In this sense, it is not a focus on the “income” that the non-workers receive but the command over real good and services that that income provides them with. We will come back to the “funds” issue soon.

So the focus has to be on the real side of the economy because that is, ultimately, the only way our material living standards can be expressed. Nominal aggregates mean very little by themselves.

Income support recipients (who do not work – for whatever reason) clearly command real resources that they have not themselves produced. These real goods and services are produced by those who do work (and the presumption is that most workers pay taxes of some sort or another).

The use of the emotive term “living off the hard work” was deliberate and designed, as a foil, to invoke the idea that governments have created welfare states which provide unsustainable benefits to the poor and marginalised at the expense of those who are materially successful – the classic conservative argument against government welfare provision.

But it doesn’t alter the fact that the statement is false because real goods and services have to be consumed by those who are on income support payments and the goods and services are produced by those who are not.

A slight complicating factor is that the income support recipients also pay taxes if there are indirect tax systems in place but that doesn’t alter the story about the provision of real goods and services.

Now the second part of the answer relates to the question of funding. In terms of where the funds come from to provide the income support for those who do not work the answer is simple: no-where.

While taxation raises revenue for national governments it doesn’t “fund” its spending. Currency-issuing governments can spend without revenue should they wish to.

Abba Lerner’s 1951 book The Economics of Employment was really a rewritten version of the 1941 article The Economic Steering Wheel where he elaborated his version of Keynesian thinking. He conceptualised macroeconomic policy as being about “steering” the fluctuations in the economy. Fiscal policy was the steering wheel and should be applied for functional purposes. Laissez-faire (free market) was akin to letting the car zigzag all over the road and if you wanted the economy to develop in a stable way you had to control its movement.

This led to the concept of functional finance and the differentiation from what he called sound finance (that proposed by the free market lobby). Sound finance was all about fiscal rules – the type you read about every day in the mainstream financial press. Sound finance is about balancing the fiscal outcome over the course of the business cycle and only increasing the money supply in line with the real rate of output growth; etc – noting the approach erroneously assumes the central bank can control the money supply.

Lerner thought that these rules were based more in conservative morality than being well founded ways to achieve the goals of economic behaviour – full employment and price stability.

He said that once you understood the monetary system you would always employ functional finance – that is, fiscal and monetary policy decisions should be functional – advance public purpose and eschew the moralising concepts that public deficits were profligate and dangerous.

Lerner thought that the government should always use its capacity to achieve full employment and price stability. In Modern Monetary Theory (MMT) we express this responsibility as “advancing public purpose”. In his 1943 book (page 354) we read:

The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound and what is unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance …

Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money,” etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability …

Mainstream advocacy of fiscal rules that are divorced from a functional context clearly do not make much sense even though their use dominates public policy these days. It may be that a fiscal surplus is necessary at some point in time – for example, if net exports are very strong and fiscal policy has to contract spending to take the inflationary pressures out of the economy. This will be a rare situation but in those cases I would as a proponent of MMT advocate fiscal surpluses.

Lerner outlined three fundamental rules of functional finance in his 1941 (and later 1951) works.

• The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
• By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
• If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the fiscal outcome, or limiting the national debt, so much the worse for these principles. The government press shall print any money that may be needed to carry out rules 1 and 2.

So in an operational sense, taxation serves to reduce the spending capacity of the non-government sector to ensure that there is non-inflationary space for government to deliver public services. It doesn’t fund anything.

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

• I just found out – state kleptocracy is the problem
• Functional finance and modern monetary theory
• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.