Saturday Quiz – March 20, 2010 – answers and discussion

Here are the answers with discussion for yesterday’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:

If the external sector overall is in deficit, it is still possible for the private domestic sector and government sector to run surpluses and each pay down its debt as long as GDP growth is fast enough (the technical condition is that the rate of GDP growth has to be faster than the real interest rate).

The answer is False.

Once again it is a test of one’s basic understanding of the sectoral balances that can be derived from the National Accounts. Some people write to me in an incredulous way about the balances.

The least polite ones accuse me of making all this stuff about balances up. They say that there are no such constraints. They then rehearse an elaborate discussion (read: rave) about how all official national statistics office data is fraudulent constructed by governments aiming to control us with information censorship. I sometimes wonder why people waste their time with such personalised attacks on me when they must have spent 20 or more minutes typing all the stuff they add into the invective. Time is too short.

The more polite(but equally erroneous) enquiries sometimes argue that the national accounts data leaves things out which negate the balances approach. Yes, the national accounting system leaves lots of things out which are important indicators of well-being and activity (such as, unpaid home care and child-rearing services typically supplied productively by females). That is clear but doesn’t alter the veracity of the sectoral balances approach.

While I have lots of opinions it is crucial to understand that the sectoral balances derivation (which I repeat below) is not one of those opinions – it is an artefact of accounting rules and some algebra (which maintains all equalities no matter how much transformation of the original relationship eventuates).

How I interpret those balances can lead us into opinion which has to be reinforced with empirical support. But the framework itself is just an accounting structure – albeit a very useful one.

The answer is false because if the external sector overall is in deficit, then it is impossible for both the private domestic sector and government sector to run surpluses. One of those two has to also be in deficit to satisfy the accounting rules.

It also follows that it doesn’t matter how fast GDP is growing, if a sector is in deficit then it cannot be paying down its nominal debt.

To understand all this, I repeat previous discussion.

The national accounts concept underpin the basic income-expenditure model that is at the heart of introductory macroeconomics. We can view this model in 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.

So 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).

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

So if we equate these two perspectives of GDP, we get:

C + S + T = C + I + G + (X – M)

This can be simplified by cancelling out the C from both sides and re-arranging (shifting things around but still satisfying the rules of algebra) into what we call the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero. The sectoral balances derived are:

• The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
• The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
• The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.

Consider the following graph and associated table of data which shows six states. All states have a constant external deficit equal to 2 per cent of GDP (light-blue columns).

State 1 show a government running a surplus equal to 2 per cent of GDP (green columns). As a consequence, the private domestic balance is in deficit of 4 per cent of GDP (royal-blue columns).

State 2 shows that when the budget surplus moderates to 1 per cent of GDP the private domestic deficit is reduced. State 3 is a budget balance and then the private domestic deficit is exactly equal to the external deficit. So the private sector spending more than they earn exactly funds the desire of the external sector to accumulate financial assets in the currency of issue in this country.

States 4 to 6 shows what happens when the budget goes into deficit – the private domestic sector (given the external deficit) can then start reducing its deficit and by State 5 it is in balance. Then by State 6 the private domestic sector is able to net save overall (that is, spend less than its income).

Note also that the government balance equals exactly $-for-$ (as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances). This is also a basic rule derived from the national accounts.

Most countries currently run external deficits. The crisis was marked by households reducing consumption spending growth to try to manage their debt exposure and private investment retreating. The consequence was a major spending gap which pushed budgets into deficits via the automatic stabilisers.

The only way to get income growth going in this context and to allow the private sector surpluses to build was to increase the deficits beyond the impact of the automatic stabilisers. The reality is that this policy change hasn’t delivered large enough budget deficits (even with external deficits narrowing). The result has been large negative income adjustments which brought the sectoral balances into equality at significantly lower levels of economic activity.

The following blogs 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:

Federal government debt (where there is currency sovereignty) is not really a liability because the government can just roll it over continuously and thus they never have to pay it back. This is different to a household, which not only has to service its debt but also has to repay them at the due date.

The answer is False.

As a matter of clarification, it was assumed that it was debt issued in the currency of issue which is why I put the qualifier in brackets.

First, households do have to service their debts and repay them at some due date or risk default. The other crucial point is that households also have to forego some current consumption, use up savings or run down assets to service their debts and ultimately repay them.

Second, a sovereign government also has to service their debts and repay them at some due date or risk default. No different there. But, unlike a household it does not have to forego any current spending capacity (or privatise public assets) to accomplish these financial transactions.

But the public debt is a legal obligation on government and so is totally a liability.

Now can it just roll-it over continuously? Well the question was subtle because the government can always keep issuing new debt when the old issues mature and maintain a stable (or whatever). But as the previous debt-issued matures it is paid out as per the terms of the issue. So that nuance was designed to elicit specific thinking.

The other point is that the liability on a sovereign government is legally like all liabilities – enforceable in courts the risk associated with taking that liability on is zero which is very different to the risks attached to taking on private debt.

There is zero risk that a holder of a public bond instrument will not be paid principle and interest on time.

The other point to appreciate is that the original holder of the public debt might not be the final holder who is paid out. The market for public debt is the most liquid of all debt markets and trading in public debt instruments of all nations is conducted across all markets each hour of every day.

While I am most familiar with the Australian institutional structure, the following developments are not dissimilar to the way bond issuance (in primary markets) is organised elsewhere. You can access information about this from the Australian Office of Financial Management, which is a Treasury-related public body that manages all public debt issuance in Australia.

It conducts the primary market, which is the institutional machinery via which the government sells debt to the non-government sector. In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the fact that governments hang on to primary market issuance is largely ideological – fear of fiscal excesses rather than an intrinsic need. In this blog – Will we really pay higher interest rates? – I go into this period more fully and show that it was driven by the ideological calls for “fiscal discipline” and the growing influence of the credit rating agencies. Accordingly, all net spending had to be fully placed in the private market $-for-$. A purely voluntary constraint on the government and a waste of time.

A secondary market is where existing financial assets are traded by interested parties. So the financial assets enter the monetary system via the primary market and are then available for trading in the secondary. The same structure applies to private share issues for example. The company raises funds via the primary issuance process then its shares are traded in secondary markets.

Clearly secondary market trading has no impact at all on the volume of financial assets in the system – it just shuffles the wealth between wealth-holders. In the context of public debt issuance – the transactions in the primary market are vertical (net financial assets are created or destroyed) and the secondary market transactions are all horizontal (no new financial assets are created). Please read my blog – Deficit spending 101 – Part 3 – for more information.

Primary issues are conducted via auction tender systems and the Treasury determines the timing of these events in addition to the type and volumne of debt to be issued.

The issue is then be put out for tender and the market determines the final price of the bonds issued. Imagine a $A1000 bond is offered at a coupon of 5 per cent, meaning that you would get $A50 dollar per annum until the bond matured at which time you would get $A1000 back.

Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (see below). So for them the bond is unattractive unless the price is lower than $A1000. So tender system they would put in a purchase bid lower than the $A1000 to ensure they get the 6 per cent return they sought.

The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.

When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).

When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.

So for new bond issues the AOFM receives the tenders from the bond market traders. These will be ranked in terms of price (and implied yields desired) and a quantity requested in $ millions. The AOFM (which is really just part of treasury) sometimes sells some bonds to the central bank (RBA) for their open market operations (at the weighted average yield of the final tender).

The AOFM will then issue the bonds in highest price bid order until it raises the revenue it seeks. So the first bidder with the highest price (lowest yield) gets what they want (as long as it doesn’t exhaust the whole tender, which is not likely). Then the second bidder (higher yield) and so on.

In this way, if demand for the tender is low, the final yields will be higher and vice versa. There are a lot of myths peddled in the financial press about this. Rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this). But they may also indicated a recovering economy where people are more confidence investing in commercial paper (for higher returns) and so they demand less of the “risk free” government paper.

So while there is no credit risk attached to holding public debt (that is, the holder knows they will receive the principle and interest that is specified on the issued debt instrument), there is still market risk which is related to movements in interest rates.

For government accounting purposes however the trading of the bonds once issued is of no consequence. They still retain the liability to pay the fixed coupon rate and the face value of the bond at the time of issue (not the market price).

The person/institution that sells the bond before maturity may gain or lose relative to their original purchase price but that is totally outside of the concern of the government.

Its liability is to pay the specified coupon rate at the time of issue and then the whole face value at the time of maturity.

There are complications to the primary sale process – some bonds sell at discounts which imply the coupon value. Further, there are arrangements between treasuries and central banks about the way in which public debt holdings are managed and accounted for. But these nuances do not alter the initial contention – public debt is a liability of the government in just the same way as private debt is a liability for those holders.

The following blog may be of further interest to you:

• Time to outlaw the credit rating agencies
• Will we really pay higher interest rates?

Question 3:

The Greek crisis would be significantly eased if it could improve its tax collection arrangements to ensure that it had more financing available to cover its spending.

The answer is True.

The Greek government effectively is like a state in a federal system where the central bank determines the interest rate (which may or may not be appropriate for the conditions in the particular sub-region in the system) and issues currency.

The state-federal analogy is a bit stretched when it comes to the Eurozone (EMU) because federal systems always have a national fiscal capacity which provides the capacity to redistribute spending across regions to meet specific demands. For ideological reasons (conservative economic beliefs), the EMU deliberately did not incorporate such a capacity into its system which is a glaring weakness that is now being exposed in the current crisis.

The Greek government is bound by the same rules that bound nations when there was a gold standard and currencies were convertible. In this case there is only one currency which is not issued by the Greek government.

Under the gold standard as applied domestically, existing gold reserves controlled the domestic money supply. Given gold was in finite supply at the time, it was considered linking the money supply to the quantity of gold available, would provide a stable monetary system.

Shifts in a nation’s gold reserves reflected (largely) trade relationships and deficit nations had to ship gold to surplus nations (as all trade imbalances were reconciled via gold shipments).

Gold reserves restricted the expansion of bank reserves and the supply of high powered money (Government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.

As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.

So a nation with an external deficit was faced with the prospect of persistent domestic recession as they had to shrink the money supply when they lost gold.

The concept of (and the term) monetisation comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money. The process was that the government would order some gold and sign a cheque for the delivery. This cheque is deposited by the miner in their bank. The bank then would exchange this cheque with the central bank in return for added reserves. The central bank then accounts for this by reducing the government account at the bank. So the government’s loss is the commercial banks reserve gain.

The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance.

As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.

With the move away from the strict gold standard and to US-dollar convertibility, the monetary system which prevailed in the Post World War 2 period up until its collapse in 1971, little changed.

Monetary policy had to defend the currency parity agreed by the nations and so an external deficit country had to endure money supply contractions and domestic recession. Fiscal policy had to ensure it did not compromise the external parity by generating income growth that would drive imports faster than exports. It was a balancing game and for most nations biased towards sluggish domestic conditions.

That is why the system collapsed and was replaced by the fiat monetary system.

But in signing up for the EMU, all member governments reinstated the constraints that were imposed (voluntarily by the system of currency convertibility).

All Greek government spending has to be financed. That can come from taxation or debt-issuance. However, in the current crisis, the bond markets are exacting premium rates (above the benchmark German bond rate) from the Greek government which is further straining their public finances.

It is known that the system of tax collection is fairly inefficient in Greece for various reasons that are not germane to our interests here and for which I am not qualified to speak anyway. So it follows that when a government is revenue-constrained as all the EMU nations are – anything that improves the efficiency of the tax collection process will reduce their need to issue debt (into a hostile market) and ease the fiscal pressures they are facing.

The following blogs may be of further interest to you:

• Euro zone’s self-imposed meltdown
• A Greek tragedy …
• España se está muriendo
• Exiting the Euro?
• Doomed from the start
• Europe – bailout or exit?
• Not the EMF … anything but the EMF!

Question 4:

The term “beggar-my-neighbour” strategy describes a situation where a nation pushes its excess supply onto its trading partners is more applicable to Germany than China in the current situation.

The answer is True.

Beggar-thy-neighbour policies are taken to mean that one nation explicitly follows a policy that will hurt another nation. The terminology is an artefact of the gold standard convertible currency era where deficit nations were disadvantaged because to manage the parity they had to use adjustments (contractions) in the domestic levels of activity (output and employment).

Chronic deficit ountries then had various ways of minimising the damage of the domestic contractio and shift aggregate demand away from imports toward domestically-producing substitution.

Various import substitution policies (tariffs or quotas) were common and often justified by the so-called infant industry argument, whereby protection was held out to be a medium-term strategy only while the nascent industry develop economies of scale and could compete in an open market. The problem (the topic of another blog) was that the “baby hardly ever grew up”.

Governments were reluctant to push domestic wage levels down during this period although the business sector was continually demanding they do just that – more to garner a higher profit share than for the external competitive reasons they used to justify their demands.

But it remained that chronic deficit countries during this period enjoyed slower real wage growth and so there was an element of austerity endured in that respect.

The other major policy open to governments under fixed exchange rate system was subject to IMF approval (post World War 2) a government could devalue (or revalue) – that is, change the fixed parity they had to defend. The slight flexibility in the monetary system led to what was known as competitive devaluations where a nation would devalue to its real exchange rate.

A series of competitive devaluations involving the UK and other nations in the 1965 as they struggled with domestic recession under the fixed-exchange rate system led ultimately to the collapse of the system in 1971.

So with that background the best answer is True.

When the EMU was established, the German government realising it had lost its exchange rate flexibility, as a vehicle to maintain external surpluses, embarked on an aggressive low-wage strategy to ensure the real exchange rate (the price level-adjusted nominal parity) was competitive and so they could continue to offer export prices that were more attractive that the other EMU nations. The so-called Hartz reforms were a central plank of this deflationary strategy.

More than 45 per cent of German exports are within the EMU. Exports to China, Japan, US, and the UK total about 22 per cent.

The Germans have always been obsessed with its export competitiveness and in the period before the common currency they would let the Deutschmark do the adjustment for them. With that capacity gone in the EMU arrangement, they pursued another strategy which was to deflate labour costs not via high productivity growth but rather by punitive labour market deregulation.

The Hartz reforms were the exemplar of the neo-liberal approach to labour market deregulation. The Hartz process was broadly inline with reforms that have been pursued in other industrialised countries, following the OECD’s job study in 1994; a focus on supply side measures and privatisation of public employment agencies to reduce unemployment. The underlying claim was that unemployment was a supply-side problem rather than a systemic failure of the economy to produce enough jobs.

The reforms accelerated the casualisation of the labour market (so-called mini/midi jobs) and there was a sharp fall in regular employment after the introduction of the Hartz reforms.

The way in which the Germans pursued the Hartz reforms not only meant that they were undermining the welfare of the other EMU nations but also drove the living standards of German workers down.

So while the Germans were busily exporting into the EMU they were also undermining the capacity of those nations to continue purchasing those exports. The crisis in Greece and other smaller EMU nations is an example of the costs those nations are bearing because of the fixed exchange rate characteristics of that monetary system.

They now have to adjust via domestic deflation to bring imports down and maintain funding for their net public spending.

Some will say that China by deliberately selling its own currency and buying US dollars to promote a trade surplus is also engaging in beggar-thy-neighbour behaviour. The rumour is that the Chinese currency is perhaps 20-50 per cent undervalued, depending on who you talk to. So the Chinese government is effect “devaluing” its currency to retain a competitive edge.

The reason this is not an example of beggar-thy-neighbour behaviour is because its principle trade competitors are not constrained by a fixed exchange rate themselves. For example, the US can use domestic policy freely to counteract the demand-draining effects of the external deficit should it want to. Under the fixed exchange rate system that was not possible to any large degree.

This is not to say that the consequences of the external relationship between say the US and China is not without issues and costs. But the US government is not facing the same policy impotence that the external deficit countries faced during the convertible currency period.

The following blogs may be of further interest to you:

• China is not the problem
• Euro zone’s self-imposed meltdown
• A Greek tragedy …
• España se está muriendo
• Exiting the Euro?
• Doomed from the start
• Europe – bailout or exit?
• Not the EMF … anything but the EMF!

Question 5:

Even though the money multiplier found in macroeconomics textbooks is a flawed description of the way the monetary system operates, having some positive minimum reserve requirements does constrain credit creation activities of the private banks more than if you have no requirements other than the rule that balances have to be non-zero.

The answer is False.

While many nations do not have minimum reserve requirements other than reserve account balances at the central bank have to remain non-zero, other nations do persist in these gold standard artefacts. The ability of banks to expand credit is unchanged across either type of country.

These sorts of “restrictions” were put in place to manage the liabilities side of the bank balance sheet in the belief that this would limit volume of credit issued.

It became apparent that in a fiat monetary system, the central bank cannot directly influence the growth of the money supply with or without positive reserve requirements and still ensure the financial system is stable.

The reality is that every central bank stands ready to provide reserves on demand to the commercial banking sector. Accordingly, the central bank effectively cannot control the reserves that are demanded but it can set the price.

However, given that monetary policy (mostly – ignoring the current quantitative easing type initiatives) is conducted via the central bank setting a target overnight interest rate the central bank is really required to provide the reserves on demand at that target rate. If it doesn’t then it loses the ability to ensure that target rate is sustained each day.

Imagine the central bank tried to lend reserves to banks above the target rate. Immediately, banks with surplus reserves could lend above the target rate and below the rate the central bank was trying to lend at. This would lead to competitive pressures which would drive the overnight rate upwards and the central bank loses control of its monetary policy stance.

Every central bank conducts its liquidity management activities which allow it to maintain control of the target rate and therefore monetary policy with the knowledge of what the likely reserve demands of the banks will be each day. They take these factors into account when they employ repo lending or open market operations on a daily basis to manage the cash system and ensure they reach their desired target rate.

The details vary across countries (given different institutional arrangements relating to timing etc) but the operations are universal to central banking.

While admitting that the central bank will always provide reserves to the banks on demand, some will still try argue that by the capacity of the central bank to set the price of the reserves they provide ensures it can stifle bank lending – by hiking the price it provides the reserves at.

The reality of central bank operations around the world is that this doesn’t happen. Central banks always provide the reserves at the target rate.

So as I have described often, commercial banks lend to credit-worthy customers and create deposits in the process. This is an on-going process throughout each day. A separate area in the bank manages its reserve position and deals with the central bank.

The two sections of the bank do not interact in any formal way – so the reserve management section never tells the loan department to stop lending because they don’t have reserves. The banks know they can get the reserves from the central bank in whatever volume they need to satisfy any conditions imposed by the central bank at the overnight rate (allowing for small variations from day to day around this).

If the central bank didn’t do this then it would risk failure of the financial system.

The following blogs may be of further interest to you:

• Oh no … Bernanke is loose and those greenbacks are everywhere
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3

Question 6:

My statement that the British government could do its citizens a favour by assuming absolute power and suspending the national election for three years.

The answer is Was a joke!.

Over at Naked Capitalism a commentator who is hostile to MMT picked this quote up – read it literally – didn’t think for minute that it was humour and came up with this fairly wide-reaching conclusion about my academic work and the work of others (I didn’t correct his spelling errors):

But in a moment of exasperation (the generous interpretation) Bill reveals his frustration with those who do not understand or accept MMT. He advocates a coup by those who do know the truth (or at least one MMT guy who does, himself) in order to guarantee “… that employment growth is strong so people can actually earn an income and take care of their family”.

This is the logic of the best and the brightest and their devine right to rule – an acceptance of the assumption that greater intelligence implies a defacto claim on greater power.

Those who know – the truth about our present monetary system – should rule.

This is a profoundly anti-democratic sentiment. Democracy is built on the assumption that no one knows the Truth – that ultimately all of are arguments do not transcend circularity – which undercuts the claims of people like Bill Mitchell or groups like MMT to superior knowledge and justifies the inclusion of as many people as possible in public decision-making.

I guess the person hasn’t read many of my blogs given I use this sort of humour regularly – pushing absurdity back onto itself.

I rarely respond to discussions elsewhere which are about my blog because I have severe time limitations and prefer to keep my input concentrated here for archive purposes etc. But this comment was so far off the mark and personal and Yves (who runs NK) is doing a great service bringing MMT material to the attention of people who otherwise may not come across it that I decided to clarify the obvious.

I pointed the commentator to my Political Compass score to confirm, in non-nuanced terms, what my values with respect to democracy etc might be.

It raises the general issue that has plagued the Internet since the inception of discussion lists etc – the tendency of certain cultures to take things literally and not consider cultural diversity in style and wit. I hate using (-: but it does send signals independent of our written narrative. But it seems too obvious!

Further, Australian humour is very dry and I conjecture that the person above would have taken me seriously even if he was in the same room as me watching all my body language.

The other thing I have picked up is the tendency of antagonists to avoid really debating the substance of the issue and to try to divert the discussion, and, in doing so, try to gain some sense of authority, by invoking associations that never exist. The following syllogism is very common:

MMT points inevitably to totalitarianism.
We hate totalitarianism and it fails.
Therefore we hate MMT and it is wrong.

That is enough for today!