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The Weekend Quiz – August 13-14, 2022 – 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:

In a fiat monetary system with an on-going external deficit, if a government wants the domestic private sector to reduce its overall debt levels without employment losses, then it has increase its fiscal deficit beyond the size of the external deficit.

The answer is True.

This question is an application of the sectoral balances framework that can be derived from the National Accounts for any nation.

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 (CAB). 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.

To help us answer the specific question posed, we can identify three states all involving public and external deficits:

  • Case A: Fiscal Deficit (G – T) < Current Account balance (X – M) deficit.
  • Case B: Fiscal Deficit (G – T) = Current Account balance (X – M) deficit.
  • Case C: Fiscal Deficit (G – T) > Current Account balance (X – M) deficit.

The following Table shows these three cases expressing the balances as percentages of GDP.

Case A shows the situation where the external deficit exceeds the public deficit and the private domestic sector is in deficit.

In this case, there can be no overall private domestic sector de-leveraging.

With the external balance set at a 2 per cent of GDP, as the government moves into larger deficit, the private domestic balance approaches balance (Case B).

Case B also does not permit the private sector to save overall.

Once the fiscal deficit is large enough (3 per cent of GDP) to offset the demand-draining external deficit (2 per cent of GDP) the private domestic sector can save overall (Case C).

In this situation, the fiscal deficits are supporting aggregate spending which allows income growth to be sufficient to generate savings greater than investment in the private domestic sector but have to be able to offset the demand-draining impacts of the external deficits to provide sufficient income growth for the private domestic sector to save.

Sectoral Balance Interpretation of Result Case A Case B Case C
External Balance (X – M) Deficit is negative -2 -2 -2
Fiscal Balance (G – T) Deficit is positive 1 2 3
Private Domestic Balance (S – I) Deficit is negative -1 0 1

For the domestic private sector (households and firms) to reduce their overall levels of debt they have to net save overall.

The behavioural implications of this accounting result would manifest as reduced consumption or investment, which, in turn, would reduce overall aggregate demand.

The normal inventory-cycle view of what happens next goes like this.

Output and employment are functions of aggregate spending.

Firms form expectations of future aggregate demand and produce accordingly.

They are uncertain about the actual demand that will be realised as the output emerges from the production process.

The first signal firms get that household consumption is falling is in the unintended build-up of inventories.

That signals to firms that they were overly optimistic about the level of demand in that particular period.

Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall.

Firms lay-off workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.

At that point, the economy is heading for a recession.

So the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur.

Given the question assumes on-going external deficits, the implication is that the exogenous intervention would come from an expanding public deficit.

Clearly, if the external sector improved the expansion could come from net exports.

It is possible that at the same time that the households and firms are reducing their consumption in an attempt to lift the saving ratio, net exports boom.

A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).

So it is possible that the public fiscal balance could actually go towards surplus and the private domestic sector increase its saving ratio if net exports were strong enough.

The important point is that the three sectors add to demand in their own ways.

Total GDP and employment are dependent on aggregate demand.

Variations in aggregate demand thus cause variations in output (GDP), incomes and employment. But a variation in spending in one sector can be made up via offsetting changes in the other sectors.

So the fiscal deficit has to increase continually to support the net saving desires of the private domestic sector.

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

Question 2:

The only time that fiscal surplus represents increased national savings is when the government creates a sovereign fund.

The answer is False.

From the perspective of Modern Monetary Theory (MMT) the national 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 by purchasing assets in financial markets 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.

In rejecting the notion that public surpluses create a cache of money that can be spent later we note that Government spends by crediting an account held by the commercial banks at the central bank.

There is no revenue constraint – government cheques don’t bounce!

Additionally, taxation consists of debiting an account held by the commercial banks at the central bank.

The funds debited are “accounted for” but don’t actually “go anywhere” and “accumulate”.

Thus is makes no sense to say that a sovereign government is saving in its own currency.

Saving is an act that revenue-constrained households do to enhance their future consumption opportunities.

The sacrifice of consumption now provides more funds in the future (via compounding).

But the government doesn’t have to sacrifice spending now to spend in the future.

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 the mis-perceptions about sovereign funds is the false analogy mainstream macroeconomics draws between private household fiscals and the government fiscal.

Households, the users of the currency, must finance their spending prior to the fact, which means that the 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.

However, trying to squeeze the economy to generate these mythical “pools of funds” which are then allocated to the sovereign fund as if they exist is very damaging.

You can think of this in two stages.

First, the national government spends less than it taxes and this leads to ever decreasing levels of net private savings (unless there is a strong positive net exports response).

The private deficits are manifest in the public surpluses and increasingly leverage the private sector.

The deteriorating private debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity.

Second, while that process is going on, the Federal Government is actually spending an equivalent amount that it is draining from the private sector (through tax revenues) in the financial and broader asset markets (domestic and abroad) buying up speculative assets including shares and real estate.

Accordingly, creating a sovereign fund amounts to the government competing in the private equity market to fuel speculation in financial assets and distort allocations of capital.

However, as you can see from pulling it apart, this behaviour has been grossly misrepresented as providing “future savings”.

Say the sovereign government ran a $15 billion surplus in the last financial year.

It could then purchase that amount of financial assets in the domestic and international capital markets.

But from an accounting perspective the Government would no longer have run that surplus because the $15 billion would be recorded as spending and the fiscal would break even.

In these situations, the public debate should be focused on whether this is the best use of public funds.

It would be hard to justify this sort of spending when basic infrastructure provision and employment creation has been ignored for many years by neo-liberal governments.

So all we are talking about is a different portfolio of assets.

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

Question 3:

The massive build-up of Chinese holdings of US government debt allowed US citizens to enjoy a higher material standard of living overall at the expense of the residents of China.

The answer is True.

The use of the descriptor overall signals that we are considering the macroeconomic outcomes in this question.

We might have concerns about the distributional consequences within the US that might arise from an on-going external deficit – that is that some might benefit while others will be losing jobs as manufacturing heads to China.

But when we think in macroeconomic terms (which is mostly the case in this blog) we are dealing with aggregates and so the distributional questions, while very important, are abstracted from.

That statement is not entirely accurate because one of the important insights that progressive economists such as Kalecki provided was that distribution of income does impact on aggregate demand.

Please read my blog post – Michal Kalecki – The Political Aspects of Full Employment – for more discussion on this point.

First, China can only do what the Americans and everyone else it trades with allow them to do.

They cannot sell a penny’s worth of output in USD and therefore accumulate the USD which they then use to buy US treasury bonds if the US citizens didn’t buy their stuff.

Presumably, people buy imported goods made in China instead of locally-made goods (which are more expensive) because they perceive it is their best interests to do so.

There is often a curious inconsistency among those who advocated free markets.

They hate government involvement in the economy yet propose complex regulative structures (for example, tariffs) which would increase government control on resource allocation and, not to mention it, force citizens (against their will) to purchase goods and services they reject in an open comparison (on price and whatever other characteristics).

Many economists do not fully understand how to interpret the balance of payments in a fiat monetary system.

For example, most will associate the rise in the current account deficit (exports less than imports plus net invisibles) with an outflow of capital.

They then argue that the only way the US (if we use it as an example) can counter this is if US financial institutions borrow from abroad.

They then assume that this is a problem because it means, allegedly, that the US nation is “living beyond its means”. It it true that the higher the level of US foreign debt, the more its economy becomes linked to changing conditions in international credit markets.

But the way this situation is usually constructed is dubious.

First, exports are a cost – a nation has to give something real to foreigners that it we could use domestically – so there is an opportunity cost involved in exports.

Second, imports are a benefit – they represent foreigners giving a nation something real that they could use themselves but which the local economy will benefit from having.

The opportunity cost is all theirs!

Thus, on balance, if a nation can persuade foreigners to send more ships filled with things than it has to send in return (net export deficit) then that is a net benefit to the local economy.

I am abstracting from all the arguments (valid mostly!) that says we cannot measure welfare in a material way.

I know all the arguments that support that position and largely agree with them.

So how can we have a situation where foreigners are giving up more real things than they get from the local economy (in a macroeconommic sense)?

The answer lies in the fact that the local nation’s current account deficit “finances” the desire of foreigners to accumulate net financial claims denominated in $AUDs.

Think about that carefully.

The standard conception is exactly the opposite – that the foreigners finance the local economy’s profligate spending patterns.

In fact, the local trade deficit allows the foreigners to accumulate these financial assets (claims on the local economy).

The local economy gains in real terms – more ships full coming in than leave! – and foreigners achieve their desired financial portfolio. So in general that seems like a good outcome for all.

The problem is that if the foreigners change their desire to accumulate financial assets in the local currency then they will become unwilling to allow the “real terms of trade” (ships going and coming with real things) to remain in the local nation’s favour.

Then the local econmy has to adjust its export and import behaviour accordingly. If this transition is sudden then some disruptions can occur.

In general, these adjustments are not sudden.

So if you understand this then you will be able to appreciate the following juxtaposition:

  • Neo-liberal myth: US consumers have to borrow $billions from foreigners to keep consuming.
  • MMT reality: US consumers are funding $billions in foreign savings (accumulation of $US-denominated financial assets by foreigners).

Here is a transactional account of how this works which starts off with a US citizen buying a Chinese product.

  • US citizen buys a nice little Chinese car.
  • If the US consumer pays cash, then his/her bank account is debited and the Chinese car dealer’s account is credited – this has the impact of increasing foreign savings of US dollar-denominated financial assets. Total deposits in the US banking system, so far, are unchanged.
  • If the US consumer takes out a loan to buy the car, then his/her bank’s balance sheet now records the loan as an asset and creates a deposit (the loan) on the liability side. When the US consumer then hands the cheque over to the car dealer (representing the Chinese firm – ignore intervening transactions) the Chinese car company has a new asset (bank deposit) and my loan boosts overall bank deposits (loans create deposits). Foreign savings in US dollars rise by the amount of the loan.
  • So the trade deficit (1 car in this case) results from the Chinese car firm’s desire to net save US dollar-denominated financial assets and sell goods and services to the US in order to get those assets – it is the only way they can accumulate financial assets in a foreign currency.

What if the Chinese car company then decided to buy US Government debt instead of holding the US dollar-denominated bank deposits?

Some more accounting transactions would occur.

  • The Chinese company would put in an order for the bonds which would transfer the bank deposit into the hands of the central bank (Federal Reserve) who is selling the bond (ignore the specifics of which particular account in the Government is relevant) and in return hand over a bit of paper called a bond to the Chinese car maker’s lawyers or representative.
  • The US Government’s foreign debt rises by that amount.
  • But this merely means that the US Government promises, on maturity of the bond, to credit the Chinese car firm’s bank account (add reserves to the commercial bank the car firm deals with) with the face value of the bond plus interest and debit some account at the central bank (or whatever specific accounting structure deals with bond sales and purchases).

If you understand all of that then you will clearly understand that this merely amounts to substituting a non-interest bearing reserve balance for an interest-bearing Government bond.

That transaction can never present any problems of solvency for a sovereign government.

The US consumers get all the real goods and services and the Chinese have bits of paper.

I know some so-called progressives worry about the stock of debt that the Chinese are holding.

But the US government holds all the cards. The debt is in US dollars and they never leave the US system.

The Chinese may decide they have accumulated enough and will seek to alter the real terms of trade (that is, reduce its desire to export to the US).

In that situation the US will no longer be able to exploit the material advantages and the adjustment might be sharp and painful.

But that doesn’t negate that while the situation is as described the material benefits are flowing in favour of the US citizens (overall).

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

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.

This Post Has 5 Comments

  1. I got the answer to Q1 wrong because I read ‘reduce its overall debt levels’ as ‘increase net savings’. In other words I mixed up stocks and flows. ‘reduce its overall debt levels’ means the flow S-I has to be positive and therefore G-T has to be positive and > X-M if the latter is < 0. Irritating.

  2. On question 2 I’m happy to accept that the correct answer is False (as usual when the question is universally qualified), but is it wrong to say that foreign assets held by the government or its agents are a meaningful kind of “public savings”?
    And aren’t most sovereign wealth funds mainly invested in foreign assets?

  3. Reply to @Johannes,
    Foreign assets can be seized by the foreign entity at any time, so they are not a risk free “saving”. More to the point, since the assets are owned by your government, not your actual public households, they are completely pointless. All such “savings” of a currency sovereign should be employed immediately to improve sustainable standards of living, there is zero point to your government (rather than your households) hoarding those assets, because it only diminishes what today might be a higher standard of living for your households, and it has zero impact on your governments capacity to issue payments in exactly the same amount those hoarded assets will return in the future to future retirees.

    So really it is not even fair to call such sovereign funds risky assets or at risk savings, it is rather just shear stupidity… is what I would call it. If the foreign nationals need the investment capital their government can and should provide it, so it is not even the foreign user of the capital raised that is dependent on your government here. It is all just financial overhead and a waste of endeavor. (Marginal, very marginal, effects on forex rates aside.)

  4. @Bijou,
    I agree with you when it comes to buying things in the nation, like making payments to retirees.

    However, if a nation is dependent on imports, like food, oil, gas, and/or fertilizer, then it may make some sense to hold foreign currency assets.

    All this is why I always knew that the policy started in 1983 to increase the US FICA tax so that the Soc. Sec. Trust Fund could buy US Bonds to hold for decades to pay Boomers their payments which were planned to start in about 2025, was a mistake. I saw it because in 2025 the US would not use the bonds to make the payments, instead it would roll them over by selling more bonds to someone. So, having held those bonds for up to 42 years did nothing to keep the US from needing to borrow to make the payments to the Boomers.

  5. I also agree with Bijou and submit that in an analogous way the need for private superannuation is also false. Our government always has the capacity to pay a livable income pension to all retirees as well as those unable to work. We know where the money comes from.

    The Keating private superannuation game is just part and parcel of the advance of neoliberalism. Private superannuation merely transfers a capital risk to private individuals while, at the same time, providing a source of substantially risk free rentier income to fund managers and operators paid for by those private individuals – somewhat akin to the parasitism of real estate agents. The only issue of consequence for a fully government funded pension scheme is whether or not there are resources available in our currency to meet the needs of the pensioners while not inflicting inflation problems onto those in the workforce. A country like Australia, which is rich in natural resources and has a relatively small population, starts way ahead of many.

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