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:
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.
To refresh your memory the sectoral balances are derived as follows. The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.
From the sources perspective we write:
GDP = C + I + G + (X – M)
which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).
Expression (1) tells us that total income in the economy per period will be exactly equal to total spending from all sources of expenditure.
We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all taxes and transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).
Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).
Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):
(2) GNP = C + I + G + (X – M) + FNI
To render this approach into the sectoral balances form, we subtract total taxes and transfers (T) from both sides of Expression (3) to get:
(3) GNP – T = C + I + G + (X – M) + FNI – T
Now we can collect the terms by arranging them according to the three sectoral balances:
(4) (GNP – C – T) – I = (G – T) + (X – M + FNI)
The the terms in Expression (4) are relatively easy to understand now.
The term (GNP – C – T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way). In other words, it represents private domestic saving.
The left-hand side of Equation (4), (GNP – C – T) – I, thus is the overall saving of the private domestic sector, which is distinct from total household saving denoted by the term (GNP – C – T).
In other words, the left-hand side of Equation (4) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.
The term (G – T) is the government financial balance and is in deficit if government spending (G) is greater than government tax revenue minus transfers (T), and in surplus if the balance is negative.
Finally, the other right-hand side term (X – M + FNI) is the external financial balance, commonly known as the current account balance (CAD). It is in surplus if positive and deficit if negative.
In English we could say that:
The private financial balance equals the sum of the government financial balance plus the current account balance.
We can re-write Expression (6) in this way to get the sectoral balances equation:
(5) (S – I) = (G – T) + CAB
which is interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAB > 0) generate national income and net financial assets for the private domestic sector.
Conversely, government surpluses (G – T < 0) and current account deficits (CAB < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.
Expression (5) can also be written as:
(6) [(S – I) – CAB] = (G – T)
where the term on the left-hand side [(S – I) – CAB] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.
This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).
The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)) plus net income transfers.
All these relationships (equations) hold as a matter of accounting and not matters of opinion.
Consider the following Table which shows six periods, which all have a constant external deficit equal to 2 per cent of GDP.
| Period 1 | Period 2 | Period 3 | Period 4 | Period 5 | Period 6 | |
| External Balance (X – M) | -2 | -2 | -2 | -2 | -2 | -2 |
| Fiscal Balance (G – T) | -2 | -1 | 0 | 1 | 2 | 3 |
| Private Domestic Balance (S – I) | 4 | 3 | 2 | 1 | 0 | -1 |
State 1 show a government running a surplus equal to 2 per cent of GDP (a minus government balance means taxes are greater than spending).
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 fiscal surplus moderates to 1 per cent of GDP the private domestic deficit is reduced.
State 3 is a fiscal 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 fiscal balance 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.
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Question 2:
National 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 post – Will we really pay higher interest rates? (April 8, 2009) – 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 post – Deficit spending 101 – Part 3 (March 2, 2009) – 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.
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Question 3:
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.
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That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.
