The Modern Monetary Theory (MMT) approach to economics must be starting to make some waves, because today, Paul Krugman, followed his earlier attack on it and his debate with Jamie Galbraith and others last summer, with another swing at MMT. The debate last summer was an extensive one at Paul’s blog site at the New York Times, and, in addition, there were a number of posts at other sites replying to Paul. The debate was a classic in the developing conflict of views between the “deficit doves” (represented by Paul) and the “deficit owls” (represented by Jamie Galbraith and other MMT writers).
Given the earlier debate, you’d expect that Paul’s second try at MMT would reflect a bit of learning on his part, and also a characterization of the views of MMT practitioners that is a little more fair than he provided in his first attempt. This post will analyze Paul’s new attack and assess how much he’s learned. But first, I’ll review the earlier debate.
Background: The First Engagement
Paul Krugman, well-known for his opposition to the austerity concerns of the deficit terrorists and his advocacy of additional Government stimulus to lower unemployment and end the recession, just ignited a paradigm conflict which promises to clarify for many, the issues dividing “deficit doves” like Paul, from the ‘deficit owl” economists who take a Modern Monetary Theory (MMT) approach to economics, which holds, among other things, that Government deficits and surpluses are not, in themselves important, and that Government spending has to be evaluated relative to its impact on public purposes. Paul said:
”Right now, the real policy debate is whether we need fiscal austerity even with the economy deeply depressed. Obviously, I’m very much opposed — my view is that running deficits now is entirely appropriate.
“But here’s the thing: there’s a school of thought which says that deficits are never a problem, as long as a country can issue its own currency. The most prominent advocate of this view is probably Jamie Galbraith, but he’s not alone.”
That’s not what Jamie or the other Modern Monetary Theory (MMT) economists say either in his testimony, or elsewhere. What they say is that as long as a Government can issue its own currency, and has not incurred debt in foreign currencies making it subject to its bankers, then it can never default on its debts, because it has “run out of money” (become insolvent). It can voluntarily decide to default, i.e. refuse to spend to fulfill its obligations, for various political reasons. But if it has an understanding of its real monetary powers and the will to persist, it can never be forced to default because of decisions made by banks, other nations which hold its debts, or international credit agencies which either foolishly or malevolently, downgrade its credit even though it cannot default. So, Governments sovereign in their own currency never present any solvency risk to investors, or to creditors they’ve made promises to, however great their deficits or national debts may be, barring political stupidity and a decision to voluntarily default when there is no legal or economic need to do so.
Paul also says:
”Now, Jamie and I are, I think, in complete agreement about what we should be doing now. So we’re talking theory, not practice. But I can’t go along with his view that
So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system.
OK, I don’t think that’s right. To spend, the government must persuade the private sector to release real resources. It can do this by collecting taxes, borrowing, or collecting seigniorage by printing money. And there are limits to all three. Even a country with its own fiat currency can go bankrupt, if it tries hard enough.”
I’m not sure what Paul means by “real resources.” But if he means non-financial resources, then I think the problem is one of getting the private sector to accept Government fiat money in return for those ‘real” resources. Why will the private sector go along with this “as long as the Republic exists . . .”? Because the private sector needs Government fiat money to pay its taxes, since that is the kind of payment the Government requires. As long as it needs Government money for this purpose, it can be “persuaded” to exchange it for resources.
If Paul includes financial resources in the category of “real resources,” then the Government can tax or borrow to get the private sector to release some of its financial resources. But when it creates money itself, without borrowing or taxing, it’s not persuading the private sector to release financial resources, only non-financial resources.
Here’s Paul again on debt service:
”Let’s think in terms of a two-period model, although I won’t need to say much about the first period. In period 1, the government borrows, issuing indexed bonds (I could make them nominal, but then I’d need to introduce expectations about inflation, and we’ll end up in the same place.) This means that in period 2 the government owes real debt service in the amount D.”
But, the Government doesn’t have to issue debt if it spends in period 1. If it chooses not to, it won’t owe real debt service in period 2. So any further argument based on the inference that Government must owe debt service in period 2 is questionable.
Paul goes on to talk about how that debt service may be fulfilled. He mentions that the Government can get a surplus of current revenue relative to current spending, but also asks us to imagine constraints on that possibility, and then brings up the “printing press.” He says:
”But the government also has a printing press. The real revenue it collects by using this press is [M(t) – M(t-1)]/P(t), where M is the money supply and P the price level.
”What determines the price level? Let’s assume a simple quantity theory, with the price level proportional to the money supply:
P(t) = V*M(t)”
I think there’s more than a little slipperiness here. First, there’s the assumption that there must be borrowing and debt service, and therefore “debt.” This assumption becomes very important to Paul’s argument later. Second, Paul shifts the ground by talking about “real revenue” and defining it as above. The debt service obligations of the Government are satisfied by nominal revenue, not “real revenue,” if by this Paul means revenue adjusted for price. Third, Paul’s expression for real revenue deflates the change in quantity of money by the price at time t, but why not by the change in price (P(t) – P(t-1)? In other words, why isn’t he looking at the change in real revenue, rather than a change expression biased toward time (t)? Fourth, he asserts that P(t) is determined by M(t) scaled by a proportionality constant “V.” But what is “V”? He doesn’t say. But another, more complete formulation of the Quantity Theory of Money by Bill Mitchell is:
”. . . MV = PY, where M is the stock of money, V is the velocity or the times the stock turns over per measurement period, P is the price level and Y is the real output level.”
Looking at this expression, and re-arranging so that we get: P/M = V/Y, we see that Paul’s proportionality constant “V” = V(velocity)/Y(Real Output). As Bill Mitchell says, to work with the quantity theory, economists have to assume that velocity is constant at a particular point in time, and that Real Output refers to that value at full employment so that it too is a constant. Only then, is price a simple function of the money supply.
However, velocity is generally not constant but varies widely in any economic system. And, in addition, Real Output at full employment is not the condition assumed in the Modern Monetary Theory formulations Paul is criticizing. In formulations such as Jamie’s, Government spending is needed because the non-Government sector is running too low a deficit or a surplus, and this is causing low aggregate demand and unemployment. In short, the quantity theory, given its assumptions, is only applicable when an economy reaches full employment. Only then will its application predict price inflation if Government deficit spending continues.
However, MMT also predicts that inflation becomes a danger when the economy reaches full employment, so the question is, what is Paul trying to say that is different from what Jamie and other MMT economists would say? Well after presenting his model in a little more detail, and a graph showing the inflation rate increasing to infinity when debt gets too great, his conclusion is:
”So there is a maximum level of debt you can handle. In practice, if it makes sense to say such a thing with regard to a stylized model, at some point lower than the critical level implied by this model the government would decide that default was a better option than hyperinflation.
“And going back to period 1, lenders would take this possibility into account. So there are real limits to deficits, even in countries that can print their own currency”
And comparing this to his earlier quote from Jamie above, we see that this conclusion postulates hyperinflation and voluntary default as issues that can come up, but not as Jamie says, “insolvency,” or “bankruptcy,” if by this one means running out of money rather than voluntary default. But what about “high interest rates” and the Government’s inability to borrow? Doesn’t Paul have a point here?
I think not. It’s Paul who constructs the situation as one in which the Government must borrow and perform debt service, and it is he who assumes that the interest rates the Government will pay will be determined by the market. Jamie and the MMT theorists make no such assumptions. That is why Jamie says:
“. . . the government can and does spend without borrowing if it chooses to do so . . . “ and also that “ … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system.”
In other words, to successfully meet this point of Jamie’s, Paul needs to discuss the situation of increasing deficits, rather than the situation of increasing debt, and then show that the hyperinflation that would accompany very high deficits could make the Government insolvent. Instead, however, he shifts the ground of the argument and ends up claiming that the money supply and the debt could reach levels high enough that the resulting price increases (inflation) would induce the Government to voluntarily default, even while it retained the authority to credit private sector accounts to pay obligations in its own currency.
This, of course, could very well happen, since political leaders are free to do all sorts of things they are not forced to do by actual constraints on their authority or capability. But it is the hyperinflation issue Paul is raising here, and also the issue of voluntary political default, not the issue of economic solvency risk which Jamie was speaking to and which Paul himself originally raised in his blog post.
After Jamie and others responded to Paul’s post, many claiming that Paul had distorted MMT, and Jamie showing that there were wide areas of agreement between them, and also that increases in the quantity of money would not flow directly into price increases in the absence of full employment, Jamie ends with:
”My position is that the government should focus on real problems: unemployment, care for the aging, energy, climate change, and the disaster in the Gulf of Mexico.
”The so-called long-term deficit is not a real problem. And the capital markets demonstrate every day that they agree with this judgment, by buying long-term Treasury bonds for historically-low interest rates.”
To which Paul responded:
”My response: there’s no question that right now there is no problem: if the Fed issues money, it will in fact just sit there. That’s what happens when you’re in a liquidity trap. And there’s also no question that right now, the proposition that the government can “create wealth by printing money”, which some other commenters call absurd, is the simple truth: deficit-financed government spending, paid for with either debt or newly created cash, will put resources that would otherwise be idle to work.
”But we won’t always be in this situation — or at least I hope not! Someday the private sector will see enough opportunities to want to invest its savings in plant and equipment, not leave them sitting idle, and the economy will return to more or less full employment without needing deficit spending to keep it there. At that point, money that the government prints won’t just sit there, it will feed inflation, and the government will indeed need to persuade the private sector to make resources available for government use.
”And that’s why I don’t accept the idea that deficits are never a problem.”
Of course, as Scott Fullwiler replied to Paul, this conclusion and also Paul’s first post both set up a “straw man,” because Jamie never claimed that deficits are never a problem, and even pointed to circumstances (conditions of full employment) where deficits could lead to inflation. Given the comments on Paul’s first blog, including a very clear comment by Marshall Auerback, it should have been clear to him that he was distorting the position of both Jamie and MMT. But evidently, Paul didn’t want to admit that.
Jamie himself responded to Paul by calling attention to their very close agreement on what ought to be done to end the Great Recession. But then he asks the key political question of the coming months from then until now: “Should we, or should we not, act *today* to cut *projected* deficits at some future date?” Say by cutting Medicare and/or Social Security or other valued programs. And Jamie answers that question with a resounding “no.” And adds that there’s no economic reason to cut these programs, that the forecasts suggesting large deficits and high interest rates after a full employment recovery are inconsistent, implausible, and contradictory, that good policy can’t be based on bad forecasts, and that we ought to solve the unemployment problem first and then, as in the 1990s, tax revenues will rise and deficits will shrink. And then he ends with:
”Paul, I challenge you to drop the long-term deficit argument entirely — it will be used in a few months, in a dishonest way by unscrupulous people, to support cuts in Social Security and Medicare that cannot be justified by economic logic. These are cuts which, I am sure, you will oppose when they are proposed.
”Don’t set yourself up.”
Of course, here Jamie is referring to the deficit terrorist coalition in Washington, DC led by Peter G. Peterson, and his network of organizations, and now also encompassing CNN, The Washington Post, many in Congress and key elements in the Administration, including President Obama and Jack Lew, the Director of OMB. Some deficit terrorists have been taking the line lately that now is not the time for spending cuts and perhaps even is a time for further stimulus, but that we must plan for reducing deficits now, and must establish a legislative framework to enact and implement cuts in future years that will keep us on an incremental course toward eventual surpluses. And they call for shared pain and even across the board spending cuts, including cuts in entitlement programs to place us on a long-term path of deficit reduction without reference to the public purposes that Government needs to, and ought to, fulfill in the future.
Jamie and the MMT economists are opposed to the very idea, the very framing of Government’s role in the economy in a way that makes fiscal policy subject to projections (always notoriously unreliable) of deficits, national debts, and debt-to-GDP ratios. The position of MMT is that these numbers are just endogenous consequences of real economic activity including Government fiscal activity, and that it is this activity that ought to drive them, and not the other way around. In their view, and in mine, as well, the role of Government in the economy is to spend to enable people to fulfill what Jamie’s father, John Kenneth Galbraith, called “the public purpose.” As Jamie says: “. . . the government should focus on real problems: unemployment, care for the aging, energy, climate change, and the disaster in the Gulf of Mexico.” It should not be spending time and resources worrying about a long-term deficit crisis that is nothing but a fantasy.
The New Engagement
In his renewed criticism today, Paul says:
“Right now, deficits don’t matter — a point borne out by all the evidence. But there’s a school of thought — the modern monetary theory people — who say that deficits never matter, as long as you have your own currency.”
Now this is almost word for word the same thing that Paul said earlier (see above) in the face of many comments and other posts in the blogosphere denying this, and outlining the MMT position. Paul has simply ignored what Jamie, and other MMT commenters told him, and he’s also ignored posts like Randy Wray’s at New Deal 2.0, and my own, rehearsed just above, that appeared at the time, as well as others, which very clearly stated that MMT economists don’t say that.
Paul has no quotes from MMT writings supporting his position, he has no links to anything to support it. He just makes the same error once again, even after being told in comments on his own blog by MMT authorities that he erred, and also after his error was recorded in discussions easily available over the web in the progressive blogosphere.
The conclusion is inescapable that either Paul deliberately misconstrues the MMT position so he can undermine it, or has never bothered to research what people have said about the debate in July of last year. Taking the more charitable of the two interpretations, it is simply shoddy research to fail to acknowledge the views of people who are telling you that your characterization of their views is demonstrably wrong, and are explaining to you that they do think that deficits matter, and exactly under what conditions they do, which by the way are the same conditions under which Paul seems to think they matter. Specifically he says:
”So suppose that we eventually go back to a situation in which interest rates are positive, so that monetary base and T-bills are once again imperfect substitutes; also, we’re close enough to full employment that rapid economic expansion will once again lead to inflation. . . .
Suppose, now, that we were to find ourselves back in that situation with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.”
Well, first, how could there be deficits of $1 Trillion, with the economy at or close to full employment? Wouldn’t the automatic stabilizers begin to produce great amounts of tax revenue the closer we got to full employment? Wouldn’t we begin to approach surpluses if the Government were not deliberately attempting to spend more than the productive capacity of the private economy could absorb? Why would the Government do that ? Why would it keep on spending to create a deficit of $100 Billion per month, as in Paul’s silly scenario?
That it should do so in a situation of full employment is not a prescription of MMT. It’s just bad economics. In addition, MMT predicts inflation if the Government tries to do that. This is one of the circumstances in which MMT economists think that deficits matter.
As for the hypothetical strike of bond buyers, MMT research makes it clear that bond market rates aren’t under control of the bond market, but can be determined by the Fed and the Treasury working together. Bond market rates can be driven down to near zero if the Government wants to do that, as the Japanese Government did. Since any return at all on the USD that buyers hold is better than just letting their money sit in reserve accounts, and since there’s no solvency risk for the US Government, a point Krugman is no longer contesting, bond buyers will always buy Treasurys if they hold USD, because making something on your money is preferable to making nothing at all. Further, if people acted irrationally, and simply refused to buy, then the US Government, including Congress could simply allow the Treasury to spend without debt issuance. In that case, the bond markets would no longer be relevant at all, and Paul could just forget about them. In short, the first two assumptions in Paul’s scenario are unrealistic, contrary to what MMT policy prescribes, and the prediction that inflation would occur under these conditions is a prediction of MMT anyway.
So then what? The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So?
Well, the first month’s financing would increase the monetary base by around 12 percent. And in my hypothesized normal environment, you’d expect the overall price level to rise (with some lag, but that’s not crucial) roughly in proportion to the increase in monetary base. And rising prices would, to a first approximation, raise the deficit in proportion.
So we’re talking about a monetary base that rises 12 percent a month, or about 400 percent a year.
Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.
I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation. And no amount of talk about actual financial flows, about who buys what from whom, can make that point disappear: if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base.
This last is Paul’s Quantity Theory of Money model, now formulated in an example rather than as a formal model. So, even though the example is new, the content of what Paul is saying hasn’t changed much from his first engagement with MMT last summer. He’s off insolvency as a problem, but has doubled down on the view that MMT isn’t concerned about inflation. One of the MMT critiques of Krugman’s view offered at the time was Randy Wray’s post at New Deal 2.0, entitled: “Deficits Do Matter, But Not the Way You Think.” Randy calls this “. . . Krugman’s “infinite inflation” scenario,” and he replies to it in this way.
”OK, we never claimed that a sovereign government will necessarily adopt good economic policy. The last time the US approached such a situation was in the over-full employment economy of WWII. Rather than bidding for resources against the private sector, the government adopted price controls, rationing, and patriotic savings. In that way, it kept inflation low, ran the budget deficit up to 25% of GDP, and stuffed banks and households full of safe sovereign debt. By the way, Jamie Galbraith’s father, John Kenneth Galbraith, was the nation’s chief inflation fighter. After the war, private spending power was unleashed, GDP grew relatively quickly, and government debt ratios came down (not because the debt was retired but because the denominator — GDP — grew more quickly than the numerator — debt; see here). In other words, Galbraith, senior, used rational policy to avoid the Zimbabwean fate. I do not understand why Krugman prefers to believe that our policymakers would choose hyperinflation over more rational policy. If there is anything that policymakers of developed nations in the postwar period appear to hate, it is rapid inflation. In other words, the policy choice will not be between hyperinflation and default, but rather rational use of inflation-fighting policy should the need arise in order to prevent hyperinflation.”
In fact, MMT writers frequently write about demand-pull inflation and the conditions under which it can occur. They are very concerned about the real outcomes of Government fiscal policy with special emphasis on both unemployment and inflation. They advocate managing fiscal policy using frameworks that make such real outcomes and their relation to public purpose the focus of fiscal policy. What they are against is the idea that fiscal policy should be managed using a framework that makes deficits, the national debt, and the debt-to-GDP ratio the focus of and regulator of fiscal policy, fiscal sustainability, and fiscal responsibility.
According to MMT, changes in these are the symptoms of what is happening macro-economically, and not the drivers of real outcomes. When you manage fiscal policy, short-term or long-term, to reach particular objectives defined as acceptable or unacceptable levels of these indicators, you are neither achieving fiscal sustainability nor fiscal responsibility. Instead, you are acting in a fiscally irresponsible manner, because you are giving the real outcomes of fiscal policy, the effects on people and on the economy, a lower priority, than you are giving the fiscal indicators.
True fiscal sustainability is the state of fiscal policy that leads to growing real national wealth and productivity, while seeing to it that growth in productivity and wealth is 1) shared equitably enough to fulfill public purposes, and 2) accomplished in such a way that it maintains and increases the economy’s ability to produce valued goods and services in the face of challenges from the international economic and non-economic (political, ecological, cutltural, etc.) environments. True fiscal responsibility is implementing fiscal policy that will achieve that kind of fiscal sustainability. Neither the “austerian” deficit hawks, nor the more kindly deficit doves pursue real fiscal sustainability and real fiscal responsibility, because over the long term, both want to manage fiscal policy in in terms of its impact on fiscal indicators, and not in terms of its impact on real outcomes.
Along with Randy Wray, I also don’t understand why Paul thinks the Government would choose not to fight inflation when we reach full employment, but instead keep spending beyond what the economy can absorb without inflation. In addition, I don’t understand why he continues to imply that MMT policy advocates continuing to increase Government spending after we reach full employment, and also to say that MMT contends that deficits don’t matter. He’s been corrected on both of these points before. And while he does seem to have learned that Governments sovereign in their own currency have no solvency risk, he still refuses to confront the reality of what MMT has to say about deficits and inflation. He prefers instead to spar with imaginary strawmen, having nothing to do with MMT.
Most disappointingly, Paul’s new post does nothing to advance the arguments presented in the first engagement. Seeing word of his post, I expected it to try to rebut the pushback Paul got from the MMT community last summer with some new, and fresh, arguments. Instead, this post either repeats part of the old one almost verbatim, or restates his little quantity theory of money (the “infinite inflation scenario”) in the form of an example rather than a model. It introduces no new content. So, why did he offer it? Is the MMT “deficit owl” position beginning to gain some traction in the Congress, or the Executive Branch, or the Washington think tank world, or the MSM, so that Paul feels he needs to offer “a deficit dove” challenge before things get out of control, and people start listening to and hearing the deficit owls? Just speculation, and wishful thinking, of course. But then again, why did Paul offer that seriously inadequate and very poorly researched post?
Finally, some who noted the first engagement between Paul and the MMT economists have wondered what the argument is about. They see both the deficit doves and the deficit owls as advocating against austerity now and favoring fiscal stimulus. They also see that for the long run both approaches seem to advocate vigorous actions against inflation one full employment is approached or reached. So, they ask, what difference does all this make?
I think the difference is that the deficit doves agree with the deficit hawks that United States has a long-term deficit/debt problem that we must manage now with long-term frameworks and plans revolving around cuts in certain areas (which they often very much disagree on). We must plan stimulus now and government austerity later when the private sector can handle it say the doves. We must have austerity right now and also plan if for the long-term say the hawks.
In contrast, however, the deficit owl orientation is that we have no long-term deficit/debt problem when it comes to solvency risk, and we are nowhere close to having to worry about deficits causing demand-pull inflation or hyper-inflation. So, the owls say: forget about long-term plans, based on necessarily unreliable projections, aimed at stabilizing fiscal indicators. Instead, focus on fiscal plans that will rebuild and reinvent our economy, realize full employment along with price stability, create environmentally sustainable economic progress, a great educational system, and other real outcomes that people value. If we do that, they say, the fiscal indicators will take care of themselves.