Chapter 2: How to Think and Do
Macroeconomics
Chapter Outline
2.1 Introduction
2.2 Thinking in a Macroeconomic Way
2.3 What Should a Macroeconomic Theory be Able to Explain?
- Real GDP growth
- Unemployment
- Real wages and productivity
- Private sector indebtedness
- Central bank balance sheets
- Japan case study
- Summary
Appendix
- The Buckeroos model
- Implications of the Buckeroos model
Learning Objectives
1. Recognise the importance of the fallacy of composition in understanding macroeconomics.
2. Gain an awareness that macroeconomics is a highly contested discipline in terms of theory and
policy prescription.
3. Note the importance of referring to the stylised facts in analysing theory and policy
prescription.
4. Develop critical thinking skills about the working of a macroeconomy with its own sovereign
currency
2.1 Introduction
In Chapter 1, we noted that any science, whether physical or social, develops theories to gain an
understanding of the specific phenomena that it is trying to explain. This necessitates abstraction.
In economics there are two broad schools of thought, which means that economics is a contested
discipline, with ongoing debates about both theory and policy. We outlined the subject matter of
macroeconomics and highlighted the distinct features of Modern Monetary Theory (MMT).
Finally we provided a discussion of macroeconomic policy objectives, by introducing the
concept of public purpose.
All disciplines have their own language and way of thinking. In the next Section of this Chapter,
we argue that thinking as a macroeconomist is particularly challenging, because the discipline is
highly contested with self-styled experts offering diverse views. An important contemporary
example is the MMT rejection of the neoclassical claim that a currency-issuing national
government is like a household and subject to same type of ‘budget’ constraint. More generally
some propositions, which make sense at an intuitive, personal level, fail to hold an aggregate
level. This is referred to as the fallacy of composition. A number of examples, both economic
and non-economic, are provided. We then discuss what macroeconomics should be able to
explain and outline two empirical examples relating to unemployment and the conduct of fiscal
policy in which there are sharp theoretical differences between MMT and orthodoxy.
Finally in the Appendix, we provide a brief outline the Buckaroos model, which has been
implemented at the University of Missouri at Kansas City (UMKC) in the United States. UMKC
students are required to undertake a certain number of hours of voluntary labour for community
service providers prior to graduation. The Buckaroos model is a means of operationalising the
administration of this scheme and provides insights about the operation of a modern monetary
economy.
2.2 Thinking in a Macroeconomic Way
Macroeconomics is a controversy-ridden area of study. In part, this is because the topic of study
is seen as being of great significance to our nation and our daily lives even though the details that
are discussed are mostly difficult for us to understand.
The popular press and media in general are flooded with macroeconomics – the nightly news
bulletins invariably have commentators speaking about macroeconomic issues – such as the real
GDP growth rate, the inflation rate or the unemployment rate. The population has been more
exposed to macroeconomic terminology over the last two or so decades and the advent of social
media has given voice to anyone who wants to be a macroeconomic commentator.
The so-called blogosphere is replete with self-styled macroeconomic experts who wax lyrical
about all and sundry, often relying on intuitively logical arguments to make their cases. The
problem is that common sense is a dangerous guide to reality and not all opinion should be given
equal privilege in public discourse. Our propensity to generalise from personal experience, as if
the experience constitutes general knowledge, dominates the public debate – and the area of
macroeconomics is a major arena for this sort of problematic reasoning.
A typical statement that is made in the public arena is that the government might run out of
money if it doesn’t curb spending. Conservative politicians who seek to limit the spending ambit
of government often attempt to give this statement authority by appealing to our intuition and
experience.
They draw an analogy between the household and the sovereign government to assert that the
microeconomic constraints that are imposed on individual or household choices apply equally
without qualification to the government.
So we are told that governments, like households, have to live within their means. This analogy
resonates strongly with voters because it relates the more amorphous finances of a government to
our daily household finances.
As we noted in Chapter 1, we know that we cannot run up our household debt forever and that
we have to moderate our spending when we reach the borrowing limits on our credit cards. We
can borrow to enhance current spending, but eventually we have to sacrifice spending to pay the
debts back. We cannot indefinitely live beyond our financial means.
Neoliberals draw an analogy between the two – household and government – because they know
we will judge government deficits as being reckless, more so if fiscal deficits rise. But the
government is not a big household. It can consistently spend more than its revenue if it creates
the currency.
Whereas households have to save (spend less than they earn) or borrow to spend more in the
future, governments can purchase whatever they like whenever there are goods and services for
sale in the currency they issue. Governments always have the capacity to spend in their own
currencies. Governments like Britain, the United States, Japan and Australia can never run out of
money. We make brief reference to the Japanese economy later in this Chapter.
In addition, fiscal surpluses (taxation revenue greater than government spending) today do not
provide greater capacity to governments to meet future spending needs, nor do fiscal deficits
(taxation revenue less than government spending) erode that capacity.
MMT teaches that our experience in managing our own household budgets provides no guidance
about the management of the government fiscal position, yet on a daily basis, we are told it does.
We are users of the currency that the government issues.
The government has to consider the real resources that are available to the economy and how
best to deploy them. These are not financial considerations – there are no intrinsic ‘financial’
constraints that are relevant to a currency-issuing government.
A household always has to consider its financial means. Common sense tells us that if we have
‘too much debt’ then we can save and reduce that debt. But, putting aside whether public debt is
problematic (see Chapter 14), if the government tries to ‘save’ (another inapplicable conceptual
transfer from the individual level) then public debt will probably rise.
Indeed, in the 1930s macroeconomics started life as a separate discipline of study from
microeconomics because the dominant way of thinking at the time was riddled with errors of
logic that led to spurious analytical reasoning and poor policy advice.
Microeconomics develops theories about individual behavioural units in the economy – the
person, household, or firm. For example, it might seek to explain the employment decisions of a
firm or the saving decisions of an individual income recipient. However, microeconomic theory
ignores knock-on effects on others when examining these firm level or household level
decisions. That is clearly inappropriate if we look at the macroeconomy, where we must consider
the impacts on others.
We have learned that macroeconomics studies the aggregate outcomes of the behaviour of all
firms and households. The question is how do we go from the individual unit (microeconomic)
level to the economy-wide (macroeconomic) level? This is a question that the so-called
aggregation problem seeks to address.
Prior to the 1930s, there was no separate study called macroeconomics. The dominant
neoclassical school of thought in economics at the time considered macroeconomics to be a
simple aggregation of the reasoning conducted at the individual unit or atomistic level.
To make statements about industry or markets or the economy as a whole, they sought to
aggregate their atomistic analysis. For reasons that will become clearer, simple aggregation
proved to be flawed.
The solution was to fudge the task and introduce the notion of a ‘representative household’ to be
the demand side of a goods and services (product) market and the ‘representative firm’ to be the
supply side of that market. Together they bought and sold a ‘composite good’. These aggregates
were fictions and assumed away many of the interesting aspects of market interaction.
For example, if we simply sum all the individual demand relationships between price and
spending intention we could form a representative household demand function.
But what if the spending intentions of each household or a segment of them were interdependent
rather than independent? What if one household changed their demand once they found out what
the spending intentions of the next-door neighbour were (for example, the notion of keeping up
with the Joneses!)? What if the actions of one household impinge on the feasible choices of
another? Then a simple summation of demands is inappropriate.
But these issues were abstracted from and the representative firm and household were just bigger
versions of the atomistic unit and the underlying principles that sought to explain the behaviour
of the representative firm or household were simply those that were used to explain behaviour at
the individual level which ignored any impacts on others. Accordingly, changes in behaviour or
circumstances that might benefit the individual or the firm are automatically claimed to be of
benefit to the economy as a whole.
In the Great Depression, this erroneous logic guided policy in the early 1930s and the crisis
deepened. At that time, John Maynard Keynes and others sought to expose the logical error that
the dominant orthodoxy had made in their approach to aggregation. In that debate this mode of
thinking was considered to incorporate a compositional fallacy. This led to the development of
macroeconomics as a separate discipline from microeconomics. Karl Marx had appreciated this
fallacy in the mid-1800s but his contributions were largely ignored in the popular economic
theory of the early 20th century.
Compositional fallacies are errors in logic that arise when we infer that something, which is
true at the individual level, is also true at the aggregate level. The fallacy of composition
arises when actions that are logical, correct and/or rational at the individual or micro level have
no logic (and may be wrong and/or irrational) at the aggregate or macro level.
Keynes led the attack on the mainstream thinking at the time – mid-1930s – by exposing several
fallacies of composition, including the paradox of thrift and the wage cutting solution to
unemployment.
A contemporary example of the flawed reasoning that follows a fallacy of composition is the
proposal to engage in fiscal austerity in response to higher fiscal deficits. Prior to considering the
paradox of thrift and fiscal austerity, let us first consider two simpler examples, the first of which
is non-economic and the second has economic relevance.
Consider a large crowd attending a sporting event. The stadium provides seating for all
attendees. A spectator would get a better view of an incident occurring near the sideline by
standing up. Would all members of the crowd get a better view by standing up? Clearly the
answer to this question is no.
Consider an employee who loses their job on Thursday evening. On Friday morning they consult
the vacancies advertised in the local newspaper and online and apply for suitable jobs. They also
knock on the doors of local employers and present a C.V. and request a job. Within a week they
have secured a new job, following their thorough job search. Would it be correct to argue that if
all the unemployed searched as conscientiously for jobs, then the unemployment problem would
be solved? The answer is no. To make the discussion simple, assume all the unemployed are
qualified to fill the available job vacancies, but 100 workers are competing for 50 jobs. At best,
50 of these job seekers will remain unemployed, irrespective of how thoroughly they search for
jobs. This topic is further discussed in The Parable One hundred dogs and 94 bones (CofFEE).
The paradox of thrift tells us that what applies at a micro level that is the ability to increase
saving if one is disciplined enough, does not apply at the macro level. Thus if everyone attempts
to increase saving, overall incomes would fall and total saving in the economy would not
increase.
There is an old saying – look after the pennies and the pounds will look after themselves.
So by reducing their individual consumption spending a person can increase the proportion they
save and enjoy higher future consumption possibilities as a consequence. The loss of spending to
the overall economy of this individual’s adjustment would be small and so there would be no
detrimental impacts on overall economic activity, which is crucially driven by aggregate
spending.
But imagine if all individuals (consumers) sought the same goal and started to withdraw their
spending en masse? Then total spending would fall significantly and, as you will learn from
Chapter 7 national income falls (as production levels react to the lower spending) and
unemployment rises. The impact of lost consumption on aggregate demand (spending) would be
such that the economy would plunge into a recession and everyone would suffer.
Moreover, as a result of the lower national income, it is possible that total saving would actually
fall along with consumption spending so the economy as a whole would be saving less. As we
will see later, if poor sales due to an increased desire to save, negatively impact investment,
aggregate saving would certainly fall.
The paradox of thrift tells us that what applies at a micro level (that is, the ability to increase
saving if one is disciplined enough) does not apply at the macro level (if everyone attempts to
increase saving, overall incomes fall and individuals would be thwarted in their attempts to
increase their savings in total).
Why does the paradox of thrift arise? In other words, what is the source of this compositional
fallacy?
The explanation lies in the fact that a basic rule of macroeconomics, which you will learn once
you start thinking in a macroeconomic way, is that spending creates income and output. This
economic activity, in turn, explains how employment is generated. Adjustments in spending
drive adjustments in total production (output) in the economy as firms react to higher (lower)
sales by increasing (reducing) employment and output.
So if all individuals reduce their spending (by attempting to save) the level of income falls rather
than stays constant. By contrast if just one person reduced their spending it is safe to assume that
their income would not be affected and that the impacts on all others would be so small they
could be ignored.
But we know that if all consumers act en masse then not only does their spending fall, but
national income also falls and the logic that applied at the individual level will be spurious or
fallacious at the aggregate level.
As total saving (the sum of all household saving) is a residual after all households have made
their consumption spending choices from the available disposable income then national income
changes, in turn, feedback on total saving. When national income falls, consumption falls and
total saving may decline in absolute terms.
Certainly total saving will be less than individuals planned due to the fall in equilibrium national
income.
By assuming that we could simply add up the microeconomic relations to get the representative
firm or household, the mainstream at the time were assuming that the aggregate unit faced the
same constraints as the individual sub-units. So the individual saver might reasonably assume
that changing their consumption choices would not impact their income.
During the Global Financial Crisis (GFC), the conservative reaction to the increasing
government deficits has been to enact fiscal austerity measures, by cutting government
expenditure and/or increasing taxes, and to encourage nations to cut domestic costs in order to
stimulate their export sectors via increased competitiveness.
In isolation, that is, where one nation does this while all other nations are maintaining strong
economic growth, this strategy might have a chance of working. But if all nations engage in
austerity and cut their growth rates, then overall spending declines, and imports will fall across
the board, as will exports. This is another example of a Fallacy of Composition.
It is the interdependence between all countries via trade, as well as a fall in net government
spending that undermines the policy prescription in this case. Further, it is obvious that not all
countries can rely on export-led growth (to more than offset a decline in net Government
spending) since for every exporter there must be an importer.
MMT contains a coherent logic that will teach you to resist falling into intuitive traps and
compositional fallacies. MMT teaches you to think in a macroeconomic way.
Keynes and others considered that fallacies of composition, such as the paradox of thrift,
provided a prima facie case for considering the study of macroeconomics as a separate
discipline. These examples show that we must be very careful when drawing general conclusions
on the basis of our own experience (that is, specific-to-general reasoning).
2.3 What Should a Macroeconomic Theory be Able to Explain?
Any macroeconomic theory should help us understand the real world and provide explanations
of historical events and reasonable forward-looking forecasts as to what might happen as a
consequence of known events – for example, changes in policy settings. A theory doesn’t stand
or fall on its absolute predictive accuracy because it is recognised that forecasting errors are a
typical outcome of trying to make predictions about the unknown future.
However, systematic forecast errors (that is, continually failing to predict the direction of the
economy) and catastrophic oversights (for example, the failure to predict the 2008 Global
Financial Crisis) are an indication that a macroeconomic theory is seriously deficient.
In this section we present some stylised facts about the way in which modern industrialised
economies have performed over the last several decades. These facts will be referred to
throughout the textbook as a reality check when we compare different approaches to the
important macroeconomic issues such as unemployment, inflation, interest rates and government
deficits.
The facts provide a benchmark against which any macroeconomic theory can be assessed. If a
macroeconomic theory generates predictions which are consistently at odds with what we
observe then we conclude that it doesn’t advance our understanding of the real world and should
be discarded.
Real GDP growth
Real Gross Domestic Product is the measure of actual production of goods and services in the
economy over the course of a particular period. We will learn how the national statistics offices
measure it and how we interpret movements in real GDP in Chapter 4 when we study the
National Income and Product Accounts (NIPA). For now, we consider economic growth to be
measured by the percentage change in real GDP, and in that sense, it is one measure of the
prosperity of a nation. We will learn that employment growth is also dependent on output growth
and so a higher real GDP growth usually means higher employment and lower unemployment.
Table 2.1 shows the average annual real GDP growth rates by decade from 1960 for various
countries. The sample of nations chosen include the three large industrialised European nations
representative of the ‘north’ and ‘south’ (Germany, Italy and Spain) all of which are members of
the Eurozone; Britain, a European nation outside the Eurozone; a small open economy
predominantly exporting primary commodities and with a relatively underdeveloped industrial
base (Australia), and two large, non-European industrialised nations (Japan and the USA).
Table 2.1 Average annual real GDP growth by decades, per cent
Australia Germany Italy Japan Spain UK US
1960-70 5.0 4.5 5.7 10.2 8.6 3.1 4.7
1970-80 3.3 3.3 4.0 5.2 5.3 2.6 3.2
1980-90 3.4 2.0 2.6 4.4 3.0 2.7 3.1
1990-00 3.2 2.2 1.5 1.5 2.8 2.1 3.2
2000-10 3.2 0.8 0.5 0.6 2.7 1.9 1.8
2010-15 2.6 2.0 -0.5 1.4 -0.3 2.0 2.1
Source: National statistical agencies.
Several things are clear. First, real economic growth has been lower on average in the current
period than in the 1960s for each country. Second, the European nations (Italy and Spain) have
clearly performed poorly in the recent period. Third, the European nations within the Eurozone,
including Germany, have performed relatively poorly since 2000. Fourth, Australia has generally
performed better than the other nations in the table.
Among the questions that our macroeconomic approach needs to be able to answer in a
consistent fashion are: Why has real GDP growth on average slowed? What explains Australia’s
superior growth rate between 2010 and 2015? Why have Italy and Spain endured negative
growth in the period 2010 to 2015?
Unemployment
One of the stark facts about modern economies has been the way in which unemployment has
evolved over the last three or more decades. While different nations have recorded varying
experiences, the common thread is that unemployment rates have risen overall and, in most
cases, endured at higher levels for many years.
In Figure 2.1, the unemployment rates – the percentage of willing workers who are unable to find
work – are shown for the seven nations depicted in Table 2.1 from 1960 to 2015. Please note that
the vertical scales are different.
The accompanying data in Table 2.2 provides further information upon which to assess the
historical behaviour of unemployment.
Figure 2.1 Comparative unemployment rates, per cent, 1960 to 2015
Source: Australian Bureau of Statistics; Federal Statistical Office, Germany; National Institute of Statistics, Italy;
Ministry of Finance, Japan; National Statistics Institute, Spain; Office of National Statistics, Britain, Bureau of
Economic Analysis, US.
The data show that unemployment rose in all nations shown during the 1970s and persisted at
these high levels well into the first decade of the new century. Unemployment rates in Japan
have been significantly below that of the other nations shown.
The data also show quite clear cyclical patterns. Australia is an example where cyclical patterns
have been pronounced. Unemployment was below 2 per cent for most of the early post-World
War II period and then rose sharply in the mid-1970s and continued rising as the economy went
into a deep recession in the early 1980s.
0
2
4
6
8
10
12
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Australia
0
2
4
6
8
10
12
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Germany
0
1
2
3
4
5
6
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Japan
0
5
10
15
20
25
30
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Spain
0
2
4
6
8
10
12
14
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
UK
0
2
4
6
8
10
12
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
USA
0
2
4
6
8
10
12
14
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Italy
Table 2.2 Average unemployment rates by decade, per cent
Australia Germany Italy Japan Spain UK US
1960-70 1.7 0.8 3.8 1.3 2.6 1.8 4.8
1970-80 4.1 2.5 4.8 1.7 5.0 3.8 6.3
1980-90 7.5 6.7 8.5 2.5 17.3 9.2 7.1
1990-00 8.5 7.8 10.4 3.2 19.0 7.8 5.6
2000-10 5.4 8.7 8.0 4.7 12.1 5.7 5.9
2010-15 5.6 5.5 10.7 4.2 23.1 7.2 7.6
Source: See Figure 2.1.
Economic growth in the second-half of the 1980s brought the rate down from its 1982 peak but
never to the level that had been enjoyed in the 1950s, 1960s and early 1970s.
The 1991 recession then saw the unemployment rate jump up again very quickly and reach a
peak higher than the 1982 peak. The unemployment rate started to fall again as growth ensued
after the recession was officially over but it took many years to get back to levels prior to the
1991 downturn. The US follows a similar pattern, although unemployment rates were higher in
the early post war period but lower than Australia’s in the 1990s. The GFC largely bypassed
Australia but led to high unemployment in the USA, which has fallen somewhat since.
Unemployment rates tend to behave in an asymmetric pattern – they rise very sharply and
quickly when the economy goes into a downturn in activity but then only gradually fall over a
long period once growth returns.
Any credible macroeconomic model needs to provide convincing explanations for these
movements. How was unemployment kept at low levels during the 1950s and 1960s? Why did
unemployment rates rise in the 1970s and persist at the higher levels for several decades? What
determines the cyclical pattern of the unemployment rates – that is, the asymmetry? Is there a
behavioural relationship between the GDP growth data shown in Table 2.1 and the
unemployment data in Table 2.2?
In answer to the first two questions, MMT would refer to the key proposition in macroeconomics
that total spending determines output and employment, and indirectly unemployment. Then
variations in unemployment must be attributable to variations in total spending.
On the other hand, some orthodox or mainstream economists claim that variations in output and
employment occur due to decisions made on the supply side of the economy. Workers decide
whether they wish to work under prevailing wages and conditions. Then high unemployment is
caused by high quit rates, which is a supply side phenomenon.
If this were true, the onus would then be on these economists to explain why in 2008 the
unemployment rate rose quite dramatically in four of the six countries depicted in Figure 2.1, but
not in Australia and Japan, and to a certain extent, Germany. However, quit rates are procyclical,
so workers tend to quit their current jobs, when plenty of alternative job opportunities
are available. Thus high unemployment is not associated with high quit rates, which suggests that
a demand side (spending) explanation of variations in unemployment is more plausible.
Real wages and productivity
In 1957, the renowned British economist Nicholas Kaldor wrote an article in The Economic
Journal, about the nature of long-term economic growth. He noted that there were six
“remarkable historical constancies revealed by recent empirical investigations” (page 591),
which he later considered to be the stylised facts regarding economic growth. He noted that these
constancies were not necessarily immune to cyclical variation (as the economic cycle moves up
and down), but were relatively constant over longer periods.
Among his stylised facts of economic growth was the observation that:
… the share of wages and the share of profits in the national income has shown a
remarkable constancy in ‘developed’ capitalist economies of the United States and the
United Kingdom since the second half of the nineteenth century (pages 592-93).
This observation was repeated by many economists for other nations in terms of the distribution
of national income between labour (wages) and capital (profits).
We will learn in later chapters that for the share of wages and the share of profits in national
income to remain constant over time, real wages must grow in proportion with labour
productivity. Real wages are the purchasing power equivalent of the wage a worker receives in
money terms. Labour productivity is the output that is produced per unit of labour hour. Kaldor’s
stylised fact in relation to national income shares thus meant that real wages grew in proportion
with labour productivity over a long time period.
Figure 2.2 Real wage and productivity indexes, Australia, 1971 to 2015,
March 1982=100
Source: Australian Bureau of Statistics, National Accounts.
Figure 2.2 picks up the story in early 1971 for the Australian economy, which is representative of
the trends that have been observed over this time period in a number of advanced economies of
80
90
100
110
120
130
140
150
160
170
180
1971 1976 1981 1986 1991 1996 2001 2006 2011
March1982=100
Real wage per worker GDP per hour worked
the world. Up until the early 1980s, real wages continued to grow in proportion with labour
productivity (GDP per hour worked).
After 1981, a gap opened up between these two time series and has widened ever since. Since
March 1982, labour productivity has grown by around 70 per cent and real wages have only
increased by around 28 per cent in Australia. Don’t worry if you are having trouble interpreting
the graph and its underlying data at this stage. During the course of this textbook, we will
develop the techniques necessary to allow you to achieve competence when viewing empirical
material.
In terms of shares of national income, the growing gap between real wages and labour
productivity has meant that there has been an on-going redistribution of real income away from
workers (wages) towards capital (profits). In Australia, the wage share has dropped from around
60 per cent in the early 1980s to around 52 per cent in 2015.
How do we explain this shift in national income shares? Why did Kaldor’s stylised constancy of
national income shares end? What are the implications of such a substantial redistribution of
national income away from real wages, which have until the last few decades been the primary
driver of household consumption expenditure? What other factors now influence the growth in
household consumption expenditure?
Private sector indebtedness
Taking the example of Australia again (as representative of what has happened elsewhere in the
advanced world), Figure 2.3 shows the rise in household debt as a share of disposable income
since the early 1970s. Prior to 1988 (the beginning of our sample), the ratio was relatively steady
at around 60 per cent. In the 1990s, the ratio began to rise and by the early 2000s had reached
more than 150 per cent. The ratio fell marginally during the Global Financial Crisis but has since
begun to increase again and by the end of 2015 was above 180 per cent and rising.
Figure 2.3 Household debt to disposable income ratio, Australia, per cent, 1998 to 2015
Source: Reserve Bank of Australia.
0
20
40
60
80
100
120
140
160
180
200
1988
1989
1991
1992
1994
1995
1996
1998
1999
2001
2002
2004
2005
2006
2008
2009
2011
2012
2013
2015
Percent
Household debt to disposable income (%)
Is this large increase in the household debt ratio linked to the distributional shifts in national
income implied by Figure 2.2? What other factors might explain this shift? What are the
implications of the elevation in the household debt to disposable income ratio? Was the Global
Financial Crisis linked to this movement?
Central bank balance sheets
Figure 2.4 shows the so-called monetary base of the US economy administered by the Federal
Reserve Bank. We will learn about the monetary base in later chapters but for now we can
simply consider it to be the total reserves of the US banking system held at the central bank (the
Federal Reserve Bank) plus currency (notes and coins) in circulation. The monetary base
represents liabilities on the balance sheet of the US central bank. Up until 2008, the monetary
base was predominantly comprised of currency on issue. In December 2015, bank reserves were
around 65 per cent of the total monetary base and that proportion had increased in the period
from 2008.
Figure 2.4 US Federal Reserve Bank monetary base, 1959 to 2015,
US dollar millions
Source: Federal Reserve Bank, US.
In January 2008, the US monetary base equalled $US830,632 million. It then accelerated
upwards very quickly and by December 2015, stood at $US3,835,800 million, a huge increase by
any standard.
The rise in bank reserves at the US central bank is not an isolated event and similar balance sheet
shifts have occurred in recent years in other nations (for example, Japan and the UK). Many
0
500000
1000000
1500000
2000000
2500000
3000000
3500000
4000000
4500000
USMillions
Total US Monetary Base
mainstream economists predicted that the substantial rise in central bank reserves would flood
each economy with money and cause inflation. History tells us that inflation is low and in retreat.
How do we explain this massive shift in the balance sheet of the US Federal Reserve Bank?
What are the implications of this shift? How does the monetary base relate to the money supply?
Can the central bank carry liabilities of this size indefinitely?
Japan case study
Consult almost any macroeconomics textbook and you will find the following propositions stated
in some form or another:
1. Persistent fiscal deficits push up short-term interest rates because the alleged need to
finance higher deficits increases the demand for scarce savings relative to its supply.
2. The higher interest rates that result, undermine private investment spending (the so-called
‘crowding out’ hypothesis).
3. Persistent fiscal deficits lead to bond markets demanding increasing yields on
government debt.
4. The rising public debt to GDP ratio associated with the persistent fiscal deficits will
eventually lead bond markets to withdraw their lending to the government and the
government will run out of money.
5. Persistent fiscal deficits lead to accelerating inflation and potentially hyperinflation,
which is highly detrimental to the macro-economy.
Japan was the second largest economy after its reconstruction following the Second World War
led to spectacular growth in the 1960s. It is now the third largest economy behind the United
States and China. The period since 1990 provides a very interesting case study for
macroeconomists because it has been marked by a number of macroeconomic outcomes, which
are at odds with orthodox thinking.
Figure 2.5 Government fiscal balance as % of GDP, Japan, 1980 to 2015
Source: IMF World Economic Outlook dataset (http://www.imf.org/weo).
-12
-10
-8
-6
-4
-2
0
2
4
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
PercentofGDP
Fiscal deficit Fiscal surplus
As we can see in Figure 2.5, Japan has run a persistent deficit since 1992. A massive build-up of
private indebtedness associated with a real estate boom, accompanied the five years of fiscal
surpluses from 1987 to 1991. The boom crashed spectacularly in 1991 and began a period of
lower growth and the need for higher deficits. The convention in Japan is that the national
government matches its fiscal deficit with the issuance of bonds to the non-government sector,
principally, the private domestic sector in Japan.
Figure 2.6 shows the evolution of the public debt levels as a per cent of GDP since 1980. Gross
public debt is the total outstanding public debt issued by Japan’s national (general) government
sector. But the Government also has investments itself, which deliver returns and when we
subtract them from the Gross public debt we get the Net public debt.
Unsurprisingly, given the institutional practice of issuing debt to the private bond markets to
match the fiscal deficits, the debt ratio has risen over time as a reflection of the on-going deficits
that the Japanese government has been running to support growth in the economy and maintain
relatively low unemployment rates (see Figure 2.1).
Figure 2.6 Gross and net public debt as % of GDP, Japan, 1980 to 2015
Source: IMF World Economic Outlook dataset (http://www.imf.org/weo).
If the neoclassical propositions summarised above correctly captured the way the real world
operates, then we should have expected to see rising interest rates, increasing bond yields, and
accelerating inflation in Japan, given the persistent fiscal deficits.
0
50
100
150
200
250
300
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
PercentofGDP
Government gross debt % of GDP Government net debt % of GDP
Figure 2.7 Japan overnight interest rate, per cent, July 1985 to December 2015
Source: Bank of Japan (http://www.stat-search.boj.or.jp/index_en.html).
Did the persistent fiscal deficits in Japan drive up interest rates and government bond yields? The
answer is clearly no! Figure 2.7 shows the overnight interest rate in Japan, which is administered
by the central bank, the Bank of Japan. This is the interest rate that banks use to borrow. It has
been exceedingly low and has not responded adversely to the persistent fiscal deficits.
Figure 2.8 shows that long-term (10-year) bond yields (interest rates) on government debt are
also very low and have not responded adversely to the persistent fiscal deficits. There is no
suggestion that bond market investors have become increasingly scared of buying the Japanese
government bonds. If investors considered the government debt had become increasingly risky to
purchase they would have demanded increasing yields to compensate for that risk.
The corollary is that the investors have also not signalled an unwillingness to purchase the debt
and demand for the bonds remains high and yields remain low.
Figure 2.8 Japan government 10-year government bond yield, per cent, 1990 to 2015
Source: Ministry of Finance, Japan (http://www.mof.go.jp/english/jgbs/reference/interest_rate/historical/jgbcme_all.csv).
0
1
2
3
4
5
6
7
8
9
1985 1990 1995 2000 2005 2010 2015
Percent
Bank of Japan overnight interest rate
0
1
2
3
4
5
6
7
8
9
1990 1995 2000 2005 2010 2015
Percent
10-Year Government Bond Yield (%)
Figure 2.9 shows the inflation and deflation rates for Japan between 1980 and 2015. Inflation
occurs when there is an ongoing increase in the general price level whereas deflation describes a
situation when the general price level is continuously falling (negative inflation). You can see
that in the period after the property boom crashed and the Japanese government began to run
persistent and, at times, large fiscal deficits, the inflation rate has been low and often negative.
There is clearly not an inflationary bias in the modern Japanese economy, as predicted by the
mainstream economic theories.
Figure 2.9 Inflation and deflation in Japan, per cent, 1980 to 2015
Source: IMF World Economic Outlook dataset (http://www.imf.org/weo).
The above evidence shows that, despite persistent deficits and a rising public debt to GDP ratio,
along with a downgrade of Japan’s credit rating by international ratings agencies, including Fitch
in April 2015, international bond markets have not ‘punished’ the Japanese government with
high 10-year interest rates on public debt nor has the central bank lost control of the overnight
interest rate. Second, the persistent deficits have not lead to high rates of domestic inflation.
It is clear that the mainstream macroeconomic explanation of the relationships between fiscal
deficits, interest rates, bond yields and inflation rates is unable to adequately capture the real
world dynamics in Japan. Such a categorical failure to provide such an explanation suggests that
the mainstream theory is seriously deficient. An MMT explanation of these empirical outcomes
will be provided in Chapter 14, when students will have developed a thorough understanding of
the workings of a modern monetary economy with a sovereign currency and the operation of
fiscal and monetary policy.
Summary
These examples demonstrate that macroeconomics is a highly contested discipline in terms of
theory and policy prescription. When assessing the statements made by financial commentators
and economists in the public debate, one has to continually refer back to the stylised facts.
-2
0
2
4
6
8
10
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Percent
Inflation rate Deflation rate
It is important that students gain familiarity with the language of macroeconomics and
understand the key concepts and theories, which will be developed in the following chapters.
Appendix
The Buckaroos model
A modern monetary economy is characterised by a currency regime, whereby transactions
between economic agents (e.g. households, firms, financial institutions and government) can take
place. This may involve, for example, the purchase of goods and services by households from
firms; the purchase of assets (by households and firms); the payment of taxes to the Government
or the receipt of transfers (e.g. unemployment benefit) from government.
The real world Buckaroos model demonstrates the roles of the currency, spending and taxes in a
simplified economy.
At the University of Missouri at Kansas City (UMKC) in the USA, students are required to
undertake a specified number of hours of Community Service (CS) during each year of their
degree program. Failure to complete the required hours of Community Service over the duration
of the student’s degree program has negative implications for the final grade the student receives.
The Economics Department ran the initial pilot program and designed a monetary system to
administer the scheme. We briefly outline the scheme below.
Each student is assumed to be subject to a community service tax of 25 hours work per semester,
payable to the University Treasury. Assume there are University- approved community service
(CS) providers (for example, child care, aged care, environmental services, etc.) who submit bids
for student hours to Treasury. Treasury awards paper notes (let’s call these Bs as in ‘Buckaroos’)
to the CS providers (assuming health, safety and environmental standards are met). In this
economy assume one hour of ‘average community work’ is equal to B1. Paper notes are printed,
with the inscription ‘this note represents one hour of community service by a UMKC student’.
For example, Treasury may agree that students can do a total of 100 hours of work this semester
at, say, the XYZ not-for-profit agency, which provides support for elderly people who are living
alone. Treasury provides XYZ with B100, enabling 100 hours of student labour to be purchased.
CS providers then draw on their Bs to pay students for their hours of service. This can be
considered ‘spending’ by the University Treasury, through the CS provider. If the student has
undertaken 25 hours of CS in the semester, then they can then pay their B25 tax, when they
return these Bs to the University Treasury. This transfer of Bs by each student to the Treasury
extinguishes their tax liability for the semester.
The University Treasury burns the Bs received from students, or stockpiles them to be used for
future Treasury spending - whichever is more cost efficient. The number of Bs supplied to any
CS provider is limited by its need for student labour but also its ability to attract student workers.
Implications of the Buckaroos model
Treasury is the only source of Bs, which cannot be counterfeited. Treasury cannot collect B taxes
until it has spent some Bs. Treasury can only be deemed to have spent when Bs are handed over
to students for work done. Treasury cannot collect more Bs in payment of taxes than it has
previously spent.
A possible Treasury outcome is a ‘balanced budget’, with tax ‘revenues’ equalling B spending.
Thus Bs acquired by CS providers from Treasury are used to buy student labour which are then
returned to Treasury as tax payments by the students. On the other hand, a surplus (deficit) arises
in say Semester 1, if total Treasury spending is less (more) than the total taxes collected over that
period.
References
Centre of Full Employment and Equity (CofFEE) (n.d.) One hundred dogs and 94 bones,
available at: http://e1.newcastle.edu.au/coffee/pubs/briefs/dogs/dogs_and_bones.cfm.
Kaldor, N. (1957) ‘A Model of Economic Growth’, The Economic Journal, 67(268), 591–624.