{"id":14106,"date":"2011-04-10T04:00:38","date_gmt":"2011-04-09T17:00:38","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=14106"},"modified":"2011-04-10T04:00:38","modified_gmt":"2011-04-09T17:00:38","slug":"saturday-quiz-april-9-2011-answers-and-discussion","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=14106","title":{"rendered":"Saturday Quiz &#8211; April 9, 2011 &#8211; answers and discussion"},"content":{"rendered":"<p>\t\t\t\tHere are the answers with discussion for yesterday&#8217;s quiz. The information provided should help you work out why you missed a question or three! If you haven&#8217;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.<br \/>\n<!--more--><br \/>\n<strong>Question 1:<\/strong><\/p>\n<blockquote><p>\nWhen there is an external deficit, the private sector can reduce its overall indebtedness as long as the government supports saving by running a deficit.\n<\/p><\/blockquote>\n<p>The answer is <strong>False<\/strong>.<\/p>\n<p>This question relies on your understanding of the sectoral balances that are derived from the national accounts and must hold by defintion. The statement of sectoral balances doesn&#8217;t tell us anything about how the economy might get into the situation depicted. Whatever behavioural forces were at play, the sectoral balances all have to sum to zero. Once you understand that, then deduction leads to the correct answer.<\/p>\n<p>To refresh your memory the 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 <strong>sources<\/strong> of spending; and (b) from the perspective of the <strong>uses<\/strong> of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.<\/p>\n<p>From the <strong>sources<\/strong> perspective we write:<\/p>\n<p>GDP = C + I + G + (X &#8211; M)<\/p>\n<p>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 &#8211; M).<\/p>\n<p>From the <strong>uses<\/strong> perspective, national income (GDP) can be used for:<\/p>\n<p>GDP = C + S + T<\/p>\n<p>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.<\/p>\n<p>Equating these two perspectives we get:<\/p>\n<p>C + S + T = GDP = C + I + G + (X &#8211; M)<\/p>\n<p>So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.<\/p>\n<p>(I &#8211; S) + (G &#8211; T) + (X &#8211; M) = 0<\/p>\n<p>That is the three balances have to sum to zero. The sectoral balances derived are:<\/p>\n<ul>\n<li>The private domestic balance (I &#8211; S) &#8211; positive if in deficit, negative if in surplus.<\/li>\n<li>The Budget Deficit (G &#8211; T) &#8211; negative if in surplus, positive if in deficit.<\/li>\n<li>The Current Account balance (X &#8211; M) &#8211; positive if in surplus, negative if in deficit.<\/li>\n<\/ul>\n<p>These balances are usually expressed as a per cent of GDP but that doesn&#8217;t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.<\/p>\n<p>A simplification is to add (I &#8211; S) + (X &#8211; M) and call it the non-government sector. Then you get the basic result that the government balance equals exactly $-for-$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances).<\/p>\n<p>This is also a basic rule derived from the national accounts and has to apply at all times.<\/p>\n<p>To help us answer the specific question posed, we can identify three states all involving public and external deficits:<\/p>\n<ul>\n<li>Case A: Budget Deficit (G &#8211; T) < Current Account balance (X - M) deficit.<\/li>\n<li>Case B: Budget Deficit (G &#8211; T) = Current Account balance (X &#8211; M) deficit.<\/li>\n<li>Case C: Budget Deficit (G &#8211; T) > Current Account balance (X &#8211; M) deficit.<\/li>\n<\/ul>\n<p>For the private sector reduce it overall indebtedness (that is a <strong>net<\/strong> result) it must spend less than it earns &#8211; that is, run a surplus. So we understand the question to be examining the conditions under which the private domestic sector can run a surplus when the external sector is in deficit.<\/p>\n<p>The following Table shows three cases expressing the sectoral balances as percentages of GDP in each case there is an external deficit. So the constant external deficit then allows you to understand the relationship between the other two balances &#8211; government and private domestic.<\/p>\n<p>In Cases A and B, the private balance is in deficit or balanced which means that no net debt repayments could occur even though the government sector is in deficit.<\/p>\n<p>In Case C, we see that the deficit has risen to 3 per cent of GDP and larger than the external deficit as a percent of GDP (2 per cent). At that point, the private sector balance goes into surplus which facilitates reductions in debt levels overall.<\/p>\n<p>So the coexistence of a budget deficit (adding to aggregate demand) and an external deficit (draining aggregate demand) does not necessarily lead to the private domestic sector being in surplus.<\/p>\n<p>It is only when the budget deficit is large enough (3 per cent of GDP) and able to offset the demand-draining external deficit (2 per cent of GDP) that the private domestic sector can save overall (Case C).<\/p>\n<p>The economics lying behind the accounting statements (which are true by definition) is that the budget deficits underpin spending and allow income growth to be sufficient to generate savings greater than investment in the private domestic sector.<\/p>\n<p>But they can only do that as long as they can offset the demand-draining impacts of the external deficits and thus provide sufficient income growth for the private domestic sector to save.<\/p>\n<p><a href=\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2010\/06\/Sectoral_balances_public_external_deficits.jpg\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2010\/06\/Sectoral_balances_public_external_deficits.jpg\" alt=\"\" title=\"Sectoral_balances_public_external_deficits\" width=\"566\" height=\"150\" class=\"alignnone size-full wp-image-10152\" \/><\/a><\/p>\n<div style=\"clear: both;\"><\/div>\n<p>The following blogs may be of further interest to you:<\/p>\n<ul>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=4870\">Stock-flow consistent macro models<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=2418\">Norway and sectoral balances<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=1801\">The OECD is at it again!<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=9869\">Saturday Quiz &#8211; May 22, 2010 &#8211; answers and discussion<\/a><\/li>\n<\/ul>\n<p><strong>Question 2:<\/strong><\/p>\n<blockquote><p>\nTaxation is an essential part of a fiat monetary system and allows the national government to spend.\n<\/p><\/blockquote>\n<p>The answer is <strong>Maybe<\/strong> verging on true in the real world.<\/p>\n<p>You might consider this a trick in the sense that taxation is not required by a currency-issuing government to &#8220;fund&#8221; its spending. That is true. But that observation just raises the question as to what the purpose of taxation is in a fiat monetary system. Then you have to think a bit more deeply than the obvious &#8230; and a bit more deeply again.<\/p>\n<p>In a fiat monetary system the currency has no intrinsic worth. Further the government has no intrinsic financial constraint. Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. The starting point of this new understanding is that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.<\/p>\n<p>In this way, it is clear that the imposition of taxes creates unemployment (people seeking paid work) in the non-government sector and allows a transfer of real goods and services from the non-government to the government sector, which in turn, facilitates the government&#8217;s economic and social program.<\/p>\n<p>The crucial point is that the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. Accordingly, government spending provides the paid work which eliminates the unemployment created by the taxes.<\/p>\n<p>It is the introduction of State Money (government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages).<\/p>\n<p>Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account, but doesn&#8217;t desire to spend all it earns, other things equal. As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts <em>per se<\/em> do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.<\/p>\n<p>The purpose of State Money is for the government to move real resources from private to public domain. It does so by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.<\/p>\n<p>So the point is that for a fiat currency to be used in an economy, people in the non-government sector have to have a motive to get hold of it. The imposition of a tax obligation that can only be extinguished in the fiat unit of account provides that motive.<\/p>\n<p>However, the government could impose any obligation, which could only be met by people in the non-government sector by acquiring the fiat currency and returning it to the government. This is the reason <\/p>\n<p>Imposing a fine for people every time they walked down the street would be one alternative to taxation to accomplish a &#8220;demand&#8221; for the particular fiat currency. Once people have to get hold of that currency they will willingly exchange goods and services in return for public spending.<\/p>\n<p>The following blogs may be of further interest to you:<\/p>\n<ul>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=8117\">A modern monetary theory lullaby<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=332\">Deficit spending 101 &#8211; Part 1<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=352\">Deficit spending 101 &#8211; Part 2<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=381\">Deficit spending 101 &#8211; Part 3<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=2905\">Fiscal sustainability 101 &#8211; Part 1<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=2916\">Fiscal sustainability 101 &#8211; Part 2<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=2943\">Fiscal sustainability 101 &#8211; Part 3<\/a><\/li>\n<\/ul>\n<p><strong>Question 3:<\/strong><\/p>\n<blockquote><p>\nWhen a sovereign government issues debt it has no impact on the overall holdings of assets held by the non-government sector.\n<\/p><\/blockquote>\n<p>The answer is <strong>True<\/strong>.<\/p>\n<p>The fundamental principles that arise in a fiat monetary system are as follows.<\/p>\n<ul>\n<li>The central bank sets the short-term interest rate based on its policy aspirations.<\/li>\n<li>Government spending is independent of borrowing and the latter best thought of as coming after spending.<\/li>\n<li>Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.<\/li>\n<li>Budget deficits that are not accompanied by corresponding monetary operations (debt-issuance) put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about &#8216;crowding out&#8217;.<\/li>\n<li>The &#8220;penalty for not borrowing&#8221; is that the interest rate will fall to the bottom of the &#8220;corridor&#8221; prevailing in the country which may be zero if the central bank does not offer a return on reserves.<\/li>\n<li>Government debt-issuance is a &#8220;monetary policy&#8221; operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.<\/li>\n<\/ul>\n<p>National governments have cash operating accounts with their central bank. The specific arrangements vary by country but the principle remains the same. When the government spends it debits these accounts and credits various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at their bank. It is the same effect as if it had have all been done electronically.<\/p>\n<p>All federal spending happens like this. You will note that:<\/p>\n<ul>\n<li>Governments do not spend by &#8220;printing money&#8221;. They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is &#8220;printed&#8221; but that is a separate process from the daily spending and taxing flows.<\/li>\n<li>There has been no mention of where they get the credits and debits come from! The short answer is that the spending comes from no-where but we will have to wait for another blog soon to fully understand that. Suffice to say that the Federal government, as the monopoly issuer of its own currency is not revenue-constrained. This means it does not have to &#8220;finance&#8221; its spending unlike a household, which uses the fiat currency.<\/li>\n<li>Any coincident issuing of government debt (bonds) has nothing to do with &#8220;financing&#8221; the government spending.<\/li>\n<\/ul>\n<p>All the commercial banks maintain reserve accounts with the central bank within their system. These accounts permit reserves to be managed and allows the clearing system to operate smoothly. The rules that operate on these accounts in different countries vary (that is, some nations have minimum reserves others do not etc). For financial stability, these reserve accounts always have to have positive balances at the end of each day, although during the day a particular bank might be in surplus or deficit, depending on the pattern of the cash inflows and outflows. There is no reason to assume that these flows will exactly offset themselves for any particular bank at any particular time.<\/p>\n<p>The central bank conducts &#8220;operations&#8221; to manage the liquidity in the banking system such that short-term interest rates match the official target &#8211; which defines the current monetary policy stance. The central bank may: (a) Intervene into the interbank (overnight) money market to manage the daily supply of and demand for reserve funds; (b) buy certain financial assets at discounted rates from commercial banks; and (c) impose penal lending rates on banks who require urgent funds, In practice, most of the liquidity management is achieved through (a). That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non-government sectors.<\/p>\n<p>Fiscal policy impacts on bank reserves &#8211; government spending (G) adds to reserves and taxes (T) drains them. So on any particular day, if G > T (a budget deficit) then reserves are rising overall. Any particular bank might be short of reserves but overall the sum of the bank reserves are in excess. It is in the commercial banks interests to try to eliminate any unneeded reserves each night given they usually earn a non-competitive return. Surplus banks will try to loan their excess reserves on the Interbank market. Some deficit banks will clearly be interested in these loans to shore up their position and avoid going to the discount window that the central bank offeres and which is more expensive.<\/p>\n<p>The upshot, however, is that the competition between the surplus banks to shed their excess reserves drives the short-term interest rate down. These transactions net to zero (a equal liability and asset are created each time) and so non-government banking system cannot by itself (conducting horizontal transactions between commercial banks &#8211; that is, borrowing and lending on the interbank market) eliminate a system-wide excess of reserves that the budget deficit created.<\/p>\n<p>What is needed is a vertical transaction &#8211; that is, an interaction between the government and non-government sector. So bond sales can drain reserves by offering the banks an attractive interest-bearing security (government debt) which it can purchase to eliminate its excess reserves.<\/p>\n<p>However, the vertical transaction just offers portfolio choice for the non-government sector rather than changing the holding of financial assets.<\/p>\n<p>So debt-issuance does not increase the assets that are held by the non-government sector $-for-$&#8221; nor does it reduce the capacity of the private sector to borrow from banks because they use their deposits to buy the bonds (crowding out).<\/p>\n<p>The latter crowding out myth is based on the erroneous belief that the banks need deposits and reserves before they can lend. Mainstream macroeconomics wrongly asserts that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn&#8217;t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.<\/p>\n<p>But this is an incorrect depiction of how banks operate. Bank lending is not &#8220;reserve constrained&#8221;. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).<\/p>\n<p>The point is that building bank reserves will not increase the bank&#8217;s capacity to lend. Loans create deposits which generate reserves.<\/p>\n<p>The following blogs may be of further interest to you:<\/p>\n<ul>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=661\">Quantitative easing 101<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=6617\">Building bank reserves will not expand credit<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=6624\">Building bank reserves is not inflationary<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=1623\">Money multiplier and other myths<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=1266\">Will we really pay higher interest rates?<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=1667\">A modern monetary theory lullaby<\/a><\/li>\n<\/ul>\n<p><strong>Question 4:<\/strong><\/p>\n<blockquote><p>\n10-year bond yields in Japan and the US have risen slightly in the last week suggesting that bond markets are demanding increased risk coverage for these assets.\n<\/p><\/blockquote>\n<p>The answer is <strong>False<\/strong>.<\/p>\n<p>While it might be possible that bond markets are demanding an increased risk coverage on 10-year bonds one cannot conclude that from merely examining the movements in bond yields. That is because yields fluctuate for several reasons.<\/p>\n<p>The only thing that one can reliably conclude (which isn&#8217;t saying much at all) is that yields are rising because bond prices are falling in response to lower demand.<\/p>\n<p>In macroeconomics, we summarise the plethora of public debt instruments with the concept of a bond. The standard bond has a face value &#8211; say $A1000 and a coupon rate &#8211; say 5 per cent and a maturity &#8211; say 10 years. This means that the bond holder will will get $50 dollar per annum (interest) for 10 years and when the maturity is reached they would get $1000 back.<\/p>\n<p>Bonds are issued by government into the primary market, which is simply the institutional machinery via which the government sells debt to &#8220;raise funds&#8221;. In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the the institutional machinery is voluntary and reflects the prevailing neo-liberal ideology &#8211; which emphasises a fear of fiscal excesses rather than any intrinsic need.<\/p>\n<p>Once bonds are issued they are traded in the secondary market between interested parties. Clearly secondary market trading has no impact at all on the volume of financial assets in the system &#8211; it just shuffles the wealth between wealth-holders. In the context of public debt issuance &#8211; 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 &#8211; <a href=\"https:\/\/billmitchell.org\/blog\/?p=381\">Deficit spending 101 &#8211; Part 3<\/a> &#8211; for more discussion on this point.<\/p>\n<p>Further, most primary market issuance is now done via auction. Accordingly, the government would determine the maturity of the bond (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) being specified.<\/p>\n<p>The issue would then be put out for tender and the market then would determine the final price of the bonds issued. Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.<\/p>\n<p>Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (inflation or something else). So for them the bond is unattractive and they would avoid it under the tap system. But under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.<\/p>\n<p>The mathematical formulae to compute the desired (lower) price is quite tricky and you can look it up in a finance book.<\/p>\n<p>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.<\/p>\n<p>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).<\/p>\n<p>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.<\/p>\n<p>Further, rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this).<\/p>\n<p>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 &#8220;risk free&#8221; government paper.<\/p>\n<p>So you see how an event (yield rises) that signifies growing confidence in the real economy is reinterpreted (and trumpeted) by the conservatives to signal something bad (crowding out). In this case, the reason long-term yields would be rising is because investors were diversifying their portfolios and moving back into private financial assets.<\/p>\n<p>The yield reflects the last auction bid in the bond issue. So if diversification is occurring reflecting confidence and the demand for public debt weakens and yields rise this has nothing at all to do with a declining pool of funds being soaked up by the binging government!<\/p>\n<p>The following blogs may be of further interest to you:<\/p>\n<ul>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=9271\">Saturday Quiz &#8211; April 17, 2010 &#8211; answers and discussion<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=6857\">Time to outlaw the credit rating agencies<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=5419\">Studying macroeconomics &#8211; an exercise in deception<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=2967\">Time for a reality check on debt &#8211; Part 1<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=1266\">Will we really pay higher interest rates?<\/a><\/li>\n<\/ul>\n<p><strong>Premium Question 5:<\/strong><\/p>\n<blockquote><p>\nMany countries are facing higher public debt to GDP ratios as a consequence of the crisis and some are approaching 100 per cent. Assume the current public debt to GDP ratio is 100 per cent and that central banks keep nominal interest rates and inflation constant and zero. The proponents of fiscal austerity say that by running primary surpluses they can reduce the public debt to GDP ratio even if they create a short-term recession and invoke the automatic stabilisers (which push the budget towards deficit). However, they also claim that it is likely that their strategy will promote growth. The austerity strategy cannot reduce the debt ratio (under our assumptions) if a recession results.\n<\/p><\/blockquote>\n<p>The answer is <strong>False<\/strong>.<\/p>\n<p>First, some background.<\/p>\n<p>While Modern Monetary Theory (MMT) places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue, the mainstream debate is dominated by the concept.<\/p>\n<p>The unnecessary practice of fiat currency-issuing governments of issuing public debt $-for-$ to match public net spending (deficits) ensures that the debt levels will rise when there are deficits.<\/p>\n<p>Rising deficits usually mean declining economic activity (especially if there is no evidence of accelerating inflation) which suggests that the debt\/GDP ratio may be rising because the denominator is also likely to be falling or rising below trend.<\/p>\n<p>Further, historical experience tells us that when economic growth resumes after a major recession, during which the public debt ratio can rise sharply, the latter always declines again.<\/p>\n<p>It is this endogenous nature of the ratio that suggests it is far more important to focus on the underlying economic problems which the public debt ratio just mirrors.<\/p>\n<p>Mainstream economics starts with the flawed analogy between the household and the sovereign government such that any excess in government spending over taxation receipts has to be &#8220;financed&#8221; in two ways: (a) by borrowing from the public; and\/or (b) by &#8220;printing money&#8221;.<\/p>\n<p>Neither characterisation is representative of what happens in the real world in terms of the operations that define transactions between the government and non-government sector.<\/p>\n<p>Further, the basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.<\/p>\n<p>The mainstream framework for analysing movements in the public debt ratio is derived from the so-called <strong>government budget constraint<\/strong> model (GBC).<\/p>\n<p>For a detailed explanation of this framework see the blogs that are recommended at the end of this answer. I am assuming this knowledge for the rest of the answer.<\/p>\n<p>A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.<\/p>\n<p>The standard mainstream framework (derived from the GBC) focuses on the ratio of debt to GDP rather than the level of debt <em>per se<\/em>. The following equation captures the approach:<\/p>\n<p><a href=\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2009\/03\/debt_gdp_ratio.gif\" rel=\"lightbox[930]\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2009\/03\/debt_gdp_ratio.gif\" alt=\"debt_gdp_ratio\" title=\"debt_gdp_ratio\" width=\"218\" height=\"45\" class=\"alignleft size-full wp-image-943\" \/><\/a><\/p>\n<div style=\"clear:both\"><\/div>\n<p>In English, this can be read as saying that the change in the debt ratio &#8211; &Delta;B\/Y (at time t) which is the term to the left of the equals sign &#8211; is the sum of two terms on the right-hand side of the equals sign:<\/p>\n<ul>\n<li>The difference between the real interest rate (<em>r<\/em>) and the real GDP growth rate (<em>g<\/em>) times the initial public debt ratio.<\/li>\n<li>The ratio of the primary deficit (<em>G-T<\/em>) to GDP (Y).<\/li>\n<\/ul>\n<p>The real interest rate is the difference between the nominal interest rate and the inflation rate.<\/p>\n<p>This equation is really derived from an accounting identity and therefore is true by definition, which is not the same thing as saying it has any significance. In Modern Monetary Theory (MMT) playing around with this framework has little significance.<\/p>\n<p>Mainstream economics, however, uses the framework to highlight their claim that running deficits is dangerous. Even progressives who fall into the deficit-dove category use this frameowrk in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.<\/p>\n<p>The standard formula above can easily demonstrate that a nation running a primary <strong>deficit<\/strong> can reduce its public debt ratio over time as long as economic growth is strong enough.<\/p>\n<p>Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.<\/p>\n<p>Here is why that is the case.<\/p>\n<p>A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary budget balance is zero, public debt increases at a rate r but the public debt ratio increases at <em>r<\/em> &#8211; <em>g<\/em>.<\/p>\n<p>Consider this example which is captured in Year 1 in the Table below.<\/p>\n<p>To make matters simple, assume a public debt ratio at the start of the period of 100 per cent (so B\/Y(-1) = 1).<\/p>\n<p>Assume that the rate of real GDP growth is minus 2 per cent (that is, the nation is in recession) and the automatic stabilisers push the primary budget balance into deficit equal to 1 per cent of GDP. As a consequence, the public debt ratio will rise by 3 per cent.<\/p>\n<p>The government reacts to the recession in the correct manner and increases its discretionary net spending to take the deficit in Year 2 to 2 per cent of GDP (noting a positive number in this instance is a deficit).<\/p>\n<p><a href=\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2010\/11\/Public_debt_ratio_simulation_A_Nov_27_2010.jpg\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2010\/11\/Public_debt_ratio_simulation_A_Nov_27_2010.jpg\" alt=\"\" title=\"Public_debt_ratio_simulation_A_Nov_27_2010\" width=\"486\" height=\"308\" class=\"alignnone size-full wp-image-12515\" \/><\/a><\/p>\n<div style=\"clear:both\"><\/div>\n<p>The central bank maintains its zero interest rate policy and the inflation rate also remains at zero.<\/p>\n<p>The increasing deficit stimulates economic growth in Year 2 such that real GDP grows by 2 per cent. In this case the public debt ratio falls by 0.1 per cent.<\/p>\n<p>So even with an increasing (or unchanged) deficit, real GDP growth can reduce the public debt ratio, which is what has happened many times in past history following economic slowdowns.<\/p>\n<p>The discussion also demonstrates why tightening monetary policy makes it harder for the government to reduce the public debt ratio &#8211; which, of-course, is one of the more subtle mainstream ways to force the government to run surpluses.<\/p>\n<p>Now to the specific proposition outlined in the question. Here are the assumptions adopted:<\/p>\n<ul>\n<li>Current public debt to GDP ratio is 100 per cent = 1.<\/li>\n<li>Nominal interest rate (i) and the inflation rate (p) remain constant and zero, which means the real interest rate (r = i &#8211; p) = 0.<\/li>\n<\/ul>\n<p>The following Table shows three cases consistent with running primary surpluses:<\/p>\n<ul>\n<li>Case A &#8211; Budget surplus to GDP ratio equals the negative GDP growth rate.<\/li>\n<li>Case B &#8211; Budget surplus to GDP ratio  greater than the negative GDP growth rate.<\/li>\n<li>Case C &#8211; Budget surplus to GDP ratio  less than the negative GDP growth rate.<\/li>\n<\/ul>\n<p>As a result of modelling the assumptions in the formula (above) we can see that the change in the debt ratio (B\/Y) is zero in the event of Case A, falls in the event of Case B (by 1 per cent) and rises in the event of Case C (by 1 per cent).<\/p>\n<p><a href=\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2010\/11\/Public_debt_ratio_simulation_Nov_27_2010.jpg\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2010\/11\/Public_debt_ratio_simulation_Nov_27_2010.jpg\" alt=\"\" title=\"Public_debt_ratio_simulation_Nov_27_2010\" width=\"695\" height=\"287\" class=\"alignnone size-full wp-image-12514\" \/><\/a><\/p>\n<div style=\"clear:both\"><\/div>\n<p>As long as the primary surplus as a per cent of GDP is exactly equal to the negative GDP growth rate, there can be no reduction in the public debt ratio, under the circumstances (which are the most benign possible).<\/p>\n<p>So it is possible under Case B where the primary budget surplus is 3 per cent (noting that the surplus is presented as a negative figure) and the contraction in real GDP is 2 percent for the debt ratio to fall.<\/p>\n<p>Thus if the &#8220;facts&#8221; can be achieved, the austerity option can reduce the public debt ratio even if they cause a recession. How likely is it that this would occur in the real world when the government was pursuing such a fiscal path? Answer: unlikely.<\/p>\n<p>First, fiscal austerity will probably push the GDP growth rate further into negative territory which, other things equal, pushes the public debt ratio up. Why? The budget balance is endogenous (that is, depends on private activity levels) because of the importance of the automatic stabilisers.<\/p>\n<p>As GDP contracts, tax revenue falls and welfare outlays rise. It is highly likely that the government would not succeed in achieving a budget surplus under these circumstances.<\/p>\n<p>So as GDP growth declines further, the automatic stabilisers will push the balance result towards (and into after a time) deficit, which, given the borrowing rules that governments volunatarily enforce on themselves, also pushed the public debt ratio up.<\/p>\n<p>So austerity packages, quite apart from their highly destructive impacts on real standards of living and social standards, typically fail to reduce public debt ratios and usually increase them.<\/p>\n<p>So even if you were a conservative and erroneously believed that high public debt ratios were the devil&#8217;s work, it would be foolish (counter-productive) to impose fiscal austerity on a nation as a way of addressing your paranoia. Better to grit your teeth and advocate higher deficits and higher real GDP growth.<\/p>\n<p>That strategy would also be the only one advocated by MMT.<\/p>\n<p>The following blogs may be of further interest to you:<\/p>\n<ul>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=14044\">Budget deficit basics<\/a><\/li>\n<li><a href=\"https:\/\/billmitchell.org\/blog\/?p=13991\">How are the laboratory rats going?<\/a><\/li>\n<\/ul>\n<p>That is enough for today!\t\t<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Here are the answers with discussion for yesterday&#8217;s quiz. The information provided should help you work out why you missed a question or three! If you haven&#8217;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&hellip;<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[58],"tags":[],"class_list":["post-14106","post","type-post","status-publish","format-standard","hentry","category-saturday-quiz","entry","no-media"],"jetpack_featured_media_url":"","jetpack_sharing_enabled":true,"_links":{"self":[{"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=\/wp\/v2\/posts\/14106","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=14106"}],"version-history":[{"count":0,"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=\/wp\/v2\/posts\/14106\/revisions"}],"wp:attachment":[{"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=14106"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=14106"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/billmitchell.org\/blog\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=14106"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}