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The Weekend Quiz – November 27-28, 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:

When the government matches its deficit with debt-issuance it changes the portfolio of wealth held in the non-government sector. The impact on purchasing power is equivalent to a leakage from the expenditure system (akin to taxation, saving or imports) which reduces the expansionary impact of the government deficit spending.

The answer is False.

It is true that taxation, imports or saving are all leakages from the expenditure system which reduce the expenditure multiplier effect of exogenous spending such as government expenditure.

Please read my blog post – Spending multipliers – for more discussion on this point.

However, the same does not apply to debt-issuance.

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 introduces the so-called ‘Government Budget Constraint’ that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

They claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

So 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: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. 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 “hit” a 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.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

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 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.

The point is that the debt-issuance is merely alters the portfolio composition of the assets held in the non-government sector.

Question 2:

A public employment guarantee program, which required workers to attend a government centre each day and do jigsaw puzzles, will have the same impact on national income as when a private company hired workers to build cars to meet market demand and are paid an equivalent wage.

The answer is True.

Last week’s quiz discussed the ideas of J.M. Keynes’ on public works.

You can refresh your memory by reading the answers – (November 20, 2021).

Effectively, critics of public works programs focus on the seeming futility of that work to denigrate it and rarely examine the flow of funds and impacts on aggregate demand. They know that people will instinctively recoil from the idea if the nonsensical nature of the work is emphasised.

When Keynes said that when private spending was too low to maintain full employment then government spending interventions were necessary. He said that while hiring people to dig holes only to fill them up again would work to stimulate demand, there were much more creative and useful things that the government could do.

So substitute jigsaw puzzles for digging holes and we have a similar situation.

Keynes maintained that in a crisis caused by inadequate private willingness or ability to buy goods and services, it was the role of government to generate demand.

So Keynes noted that:

“To dig holes in the ground,” paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.

Keynes clearly understood that digging holes will stimulate aggregate demand when private investment has fallen but not increase “the real national dividend of useful goods and services”.

He also noted that once the public realise how employment is determined and the role that government can play in times of crisis they would expect government to use their net spending wisely to create useful outcomes.

Now, while we might think it more desirable for workers to be employed building products to meet market demand (I, personally do not make that conclusion – it all depends is my view – and jigsaw assembly might be an excellent, environmentally caring way to undertake ‘work’ for pay), the fact remains that as long as the government is paying on-going wages to the workers to solve jigsaw puzzles then this will be just as beneficial for aggregate demand on a dollar-for-dollar basis (which is why I noted the two workforces received the same wage).

Both sets of workers employed will spend a proportion of their weekly incomes on other goods and services which, in turn, provides wages to workers providing those outputs. They spend a proportion of this income and the “induced consumption” (induced from the initial spending on the workers’ wasges) multiplies throughout the economy.

This is the idea behind the expenditure multiplier.

The workers might enjoy solving the puzzles and so job satisfaction is a bonus to the macroeconomic impacts arising from the wage outlays.

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

Question 3:

An fiscal deficit of 2 per cent of GDP is less expansionary than a deficit of 3 per cent of GDP.

(a) We would need to know the structural and cyclical components to answer this question.

(b) True.

(c) False.

The answer is True.

The question probes an understanding of the forces (components) that drive the fiscal balance that is reported by government agencies at various points in time.

The first option is designed cast doubt in your mind because if you were asked which outcome signalled the most expansionary discretionary position adopted by the government then this option would be correct.

In other words, you cannot tell from the information provided anything about the discretionary fiscal stance adopted by the government

But in outright terms, a fiscal deficit that is equivalent to 3 per cent of GDP is the most expansionary.

To see the difference between these statements we have to explore the issue of decomposing the observed fiscal balance 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 federal (or national) government fiscal balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the fiscal 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.

People think a fiscal surplus signifies that the fiscal impact of government is contractionary (withdrawing net spending) and a deficit is 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 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 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 business cycle by expanding the fiscal in a recession and contracting it in a boom.

So just because the balance is in deficit or the deficit increases as a proportion of GDP 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 ‘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 position (and the underlying fiscal parameters) 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 in surplus at full capacity, then we would conclude that the discretionary structure of the fiscal balance was contractionary and vice versa if the 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 blog posts 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.

So the data provided by the question could indicate a more expansionary fiscal intent from government but it could also indicate a large automatic stabiliser (cyclical) component.

But it remains true that the total deficit outcome (the sum of the structural and cyclical components) tells us the public sector impact on aggregate demand and the higher that is as a proportion of GDP the more expansionary is the impact of the government sector.

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

That is enough for today!

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

This Post Has 4 Comments

  1. Question 2. “A public employment guarantee program, which required workers to attend a government centre each day and do jigsaw puzzles, will have the same impact on national income as when a private company hired workers to build cars to meet market demand and are paid an equivalent wage.”

    Maybe initially for a short time this could be true. And there is no time frame specified in the question. At the end of the day, from the public program, you end up with some completed jigsaw puzzles which might be nice for others to appreciate (possibly but doubtful). Alternatively, you end up with cars and trucks which can often be considered as a type of investment good- they allow many other people to go to work and produce other goods and services. Doesn’t building investment goods at least potentially raise real income in the future?

    And in reality, building a modern car has embedded in the process that it requires hundreds of different parts and materials that need to be supplied to build the product. And they are more substantial and complicated than cardboard jigsaw puzzle pieces and no doubt acquiring them provides more jobs and income throughout the economy than making jigsaw puzzles does.

    And there is no mention of taxation here. So I assume this is new spending from the currency issuing government without any increase in taxes. But many governments (like my State and City) do public programs but are not currency issuers and that is not specified in the question either.

    And from an MMT perspective it is still recognized that the people earning a wage doing jigsaw puzzles are still mostly supported by the people doing more productive things. If they are doing work that nobody needs or values and being supported by those who actually do work that is needed and valued- well that is mainly a transfer of resources from one group to another group.

    I think if the question had asked about the initial impact on income from a currency issuing government program, I would agree the answer was ‘True’. But without the time frame and government structure being specified- I think the more correct answer is ‘False’.

    I have not read the explanation you provide in the answers before writing this comment- and if I am wrong again, will admit it. I figure I have to be right one of these times though. Some law of averages or something… I’m not so stupid I would always be wrong. Hopefully.

    Damn. So having read your answer now, it seems I have to argue with Keynes and you both. I still think that putting people to work making investment goods would be better than having them dig holes or put together jigsaw puzzles. And that future real income would benefit more if people were doing useful things now rather than rather useless make work type things. And the issue about which type of government is implementing this program still remains. I can’t imagine that the rather small city I live in could overall raise income levels by hiring people as a public program to do jigsaw puzzles. Certainly not as much as if a car manufacturer hired them to build cars that might be sold all over the country.

  2. Jerry, lets say the market is fully supplied at the current wage/price structure, and yet some labour remains unemployed. In which case, digging holes will employ those workers, though helping the elderly with home maintenance would certainly be more useful to society.

    I presume this is what Bill and Keynes are getting at.

  3. I was writing the below yesterday but had to set off for daily shores (now I am not sure because I like Neil’s comment “market is fully supplied…” more than what I wrote).

    Anyway, I just want to share.

    “I happened to read your (Jerry Brown) comment first (before the quiz answer), which I like and agreed with. But when I saw the other side – Bill’s quiz answer, I found that is more acceptable (paradigm stable and consistent).

    Meaning, I had a chance to compare the two texts, one observation is that you jumped from the sectoral balance view to the non-currency issuing view from time to time (although practical and useful but theoretically and conceptually imbalance, like mixing macro and micro, thus, it renders weakness to your argument), whereas Bill stays with the sectoral view consistently (e.g., aggregate demands, vertical flows, spending multiplier).

    So, from that standpoint, and further, if the answer False/True is on a continuum scale (which normally is in social sciences), it tips away from the false to true more in this context. (I understand about the practical implementation view, but it does not make the “position” wrong, like Neil said “maybe this what “they” are getting at”).

    Anyway, keep it coming, one day you will get it right I hope (smile)”.

  4. Thank you, Neil and Vorapot. You both make good points but I am not willing to concede that I was wrong here- at least about some of it. I wrote most of the comment before reading Bill’s answer so it took maybe a scattershot approach of making different points. But I am happy with some of the points I made. Mostly, there is no time frame specified in the question and while I think it could work out that initially, national income might be the same in either case, constructing jigsaw puzzles does not provide the same potential national income in the future as building investment goods. At least in any real sense.

    And the other issue is about whether the public jigsaw job program is being implemented by a currency issuing government or not. Keynes is quoted as saying- “To dig holes in the ground,” paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.” Well in the first place, I think he is talking about a time when unemployment is high and Bill’s question did not specify any prior economic conditions at all. And the other thing is that MMT does not consider a currency issuing government to be spending ‘out of savings’ ever. MMT says that type of government cannot ‘save’ in its own currency. And a local government that may have to tax first to finance such a program may find that very difficult to do.

    Anyways, all I would need is one instance where the statement in the question was not necessarily true to show that it is not true always. It’s a low bar that I am not proud to achieve- but we all know how exacting these questions often are 🙂

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