I read an article in the Financial Times earlier this week (September 23, 2023) -…
Textbooks get out of date and need revision in the light of recent data or events. Some textbooks are exposed as being just plain wrong and should be re-written completely. Obviously authors in the latter category are reluctant to admit that their textbook is not an adequate description of the way – for example, the economy works – and so they not only resist updating their offering but they also defend it against all the evidence. Anyway, after reading Paul Krugman’s most recent attempt to come to grips with Modern Monetary Theory (MMT) I concluded that it was way past the date that he should be rewriting his macroeconomics textbook. Otherwise he is misleading the students who are forced to use it in their studies. So Paul, its time to update your textbook.
The interchanges between Paul Krugman and MMT were last covered in my blog from last Friday (August 12, 2011) – To challenge something you have to represent it correctly.
Paul Krugman has decided to have another go at illustrating what he considers to be deficiencies in MMT in his August 15, 2011 blog – MMT, Again – and there has been some progress.
Now the debate is clearly about inflation/hyperinflation rather than solvency. I consider that progress. He clearly agrees that a national government that issues its own currency can never become bankrupt in terms of liabilities accumulated in that currency.
It means the debate is on more sensible ground rather than having to listen to critics who think a sovereign nation has run out of money. As I note below, one of the current crop of (hopeless) Republican candidates is against extending unemployment benefits in the US because the country has “run out of money”.
So by rejecting that stupidity and pushing the debate into the realm of what happens when aggregate demand is growing we have the basis of a more sensible interchange and one that can explicate the basic ideas of MMT relative to the mainstream macroeconomics.
The problem is that Paul Krugman, despite being one of the more reasonable commentators in the press with regard to the current need for more fiscal stimulus in the US (and elsewhere) still overlays a mainstream understanding of the monetary system onto his analysis and is seemingly “progressive” only because he considers the current period to be a “special case” (his liquidity trap obsession).
In his view, it is the special nature of the current situation that justifies quite aggressive fiscal action but in more “normal” times such action will be unsustainable and deficits become the problem.
The errors in his analysis (and depiction of MMT) are easy to highlight. When I read his most recent blog I decided to leave it go – how many times can you say the same thing? But many readers have asked me to address the issue – as if they think his view has some credence.
Paul Krugman says that:
In a way, I really should not spend time debating the Modern Monetary Theory guys. They’re on my side in current policy debates, and it’s unlikely that they’ll ever have the kind of real – and really bad – influence that the Austrians have lately acquired. But I really don’t feel like getting right back to textbook revision, so here’s another shot.
As above – it is past the time that Paul’s textbook should be revised.
As a matter of clarification. I am often asked by journalists and radio interviewers questions along the lines of “where has MMT been tried?” as if it is a regime that can be implemented. That sort of intent is echoed in the above quote – if we ever get our way we might be dangerous but not as bad as those loopy Austrian School types who now parade as Tea Party activists (although I am not sure that there is a 100 per cent overlap given that the views of the Tea Partiers are almost incoherent and difficult to catalogue).
The point is that MMT is a depiction of the monetary system we mostly live in – in the US, Australia, Japan, the UK and almost everywhere else. It isn’t a matter of waiting for it to be implemented – the system we explain is already operating. The problem is that the way in which the mainstream macroeconomists (and the vast majority of the journalists) represent this monetary system is at odds with reality.
Mainstream macroeconomics make erroneous conclusions because it doesn’t capture the essence of the monetary system and the behaviour of individuals and institutions within it. So you get ridiculous statements like “cutting spending increases spending” which then gain political traction despite the obvious evidence that cutting spending damages growth and increases unemployment.
Paul Krugman poses an example to demonstrate how the method of “financing” the deficit matters. Let me categorically say the following: a national government that issues its own currency does not need to “finance” its spending. It makes no sense to think otherwise. Such a government is not a household that uses the currency issued by the government. Users of the currency are always financially constrained and have to fund their spending either by earning income, running down savings, borrowing or selling prior accumulated assets.
A sovereign government is not remotely like that. So all the so-called “financing” operations that lead people to think they are funding government spending (tax collections; debt issuance; privatisation) etc serve other functions in a fiat monetary system.
Paul Krugman says:
But I do get the premise that modern governments able to issue fiat money can’t go bankrupt, never mind whether investors are willing to buy their bonds. And it sounds right if you look at it from a certain angle. But it isn’t.
Let’s have a more or less concrete example. Suppose that at some future date – a date at which private demand for funds has revived, so that there are lending opportunities – the US government has committed itself to spending equal to 27 percent of GDP, while the tax laws only lead to 17 percent of GDP in revenues. And consider what happens in that case under two scenarios. In the first, investors believe that the government will eventually raise revenue and/or cut spending, and are willing to lend enough to cover the deficit. In the second, for whatever reason, investors refuse to buy US bonds.
We can accept this as an extreme example. The current US government spending is not equal to 27 per cent of GDP. The averages since 1950 have been around 20 per cent with tax revenue averaging about 18 per cent of GDP per annum.
Currently spending is around 25 per cent of GDP but that is because private spending has dropped markedly in recent years.
I realise that organisations such as the US Congressional Budget Office are forecasting much higher public spending as a percentage of GDP as a result of demographic change but they also the private capacity to spend will be lower because more people will be living on public pensions.
But whatever the reality is in the future the actual numbers involved are largely immaterial to the conceptual discussion.
So two scenarios:
1. The national government matches its net spending (deficit) dollar-for-dollar with debt issuance.
2. The national government does not match its net spending with debt issuance – that is, it doesn’t borrow but uses its intrinsic currency monopoly to spend without any accompanying monetary operation (selling debt).
As to the first scenario he outlines, you can see the mainstream roots poking out in his statement that the bond markets will only lend because they thing that the “government will eventually raise revenue and/or cut spending”. The reality is that the bond markets will lend because they want a stake in a risk-free (guaranteed) annuity. They enjoy the corporate welfare benefits that bonds provide – a risk-free assets in troubled times, a risk-free asset to price the risk embodied in their other private assets off. a guaranteed income.
Bond markets cannot get enough government debt in sovereign economies (that is, excluding the EMU) with stable political systems. They know there is no solvency or default risk.
Given that the US government (like most governments) have run budget deficits 85 per cent of the time since 1930, you would be rather foolish to think that they would regularly increase taxes and/or cut spending to run surpluses so they could “pay back” the outstanding debt. As I have noted often, governments rarely pay back debt (from a macroeconomic perspective) which is to say they do not continually honour specific debt liabilities as they mature.
Of the two scenarios, Paul Krugman then concludes that:
The second case poses no problem, say the MMTers, or at least no worse problem than the first: the US government can simply issue money, crediting it to banks, to pay its bills.
Yes, that is so – MMT doesn’t have a problem with this. One reason why this isn’t a problem is that the scenarios are not distinct in the way Paul Krugman thinks they are.
In this blog – The consolidated government – treasury and central bank – I explain that you have to take a consolidated approach to government in the first instance because the two arms of government (treasury and central bank) have an impact on the stock of accumulated financial assets in the non-government sector and the composition of the assets.
Considering the central bank to be independent and not part of government is a highly misleading basis on which to understand its operations and how they link with treasury operations.
The government deficit (treasury operation) determines the cumulative stock of financial assets in the private sector. Central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds with one exception (foreign exchange transactions).
So when you consider the way the monetary system works from this perspective you quickly realise that the treasury operations are intrinsically linked to the central bank operations.
In isolation, a national government budget deficit, which results from the government spending more (via crediting bank accounts and/or posting cheques) than it drains via taxation revenue from the non-government sector, results in an overall injection of net financial assets to the monetary system.
This boosts the balances in the reserve accounts held by private banks with the central bank. Spending adds reserves while taxation drains them.
As I will explain in more detail below, in the first scenario the government is just borrowing back its own spending. The accounting for this involves shifting balances from central bank reserves to some “bond account”. Upon matury, the reverse transaction occurs.
Logically, we cannot loan the government its own currency until it has spent it. Bank reserves have to exist before the government can borrow from them.
Conversely a national government budget surplus, which results from the government spending less than it drains via taxation revenue from the non-government sector, results in an overall withdrawal of net financial assets from the monetary system. This reduces the reserve balances held by the private banks at the central bank.
So, if the government also issues debt $-for-$ to match its deficit then the impact on the reserve balances is neutralised as noted above. Mainstream textbooks (such as Paul Krugman’s text) think this is a “funding” operation, whereas from a MMT perspective it is a bank reserve operation which allows the central bank to effective conduct its liquidity management tasks.
Please read my blog – Understanding central bank operations – for more discussion on this point.
So the two scenarios are rather blurred. In the second case, the central bank does not shift the added reserves into a “bond account” and depending on other monetary policy parameters has to address the consequences – as I will explain next.
Paul Krugman then seeks to tease out what he thinks “happens next”:
We’re assuming that there are lending opportunities out there, so the banks won’t leave their newly acquired reserves sitting idle; they’ll convert them into currency, which they lend to individuals. So the government indeed ends up financing itself by printing money, getting the private sector to accept pieces of green paper in return for goods and services. And I think the MMTers agree that this would lead to inflation; I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue.
For it is. And in my hypothetical example, it would be quite likely that the money-financed deficit would lead to hyperinflation.
And at that point you realise how mainstream Paul Krugman really is in his representation of the operations of the monetary system.
Why is this wrong?
Banks do not lend reserves as depicted. Underlying the Krugman narrative is a view of banks. They are conceived to be financial intermediaries who desire to maximise profits and take in deposits to build up reserves so that they can then on-lend the deposits at a higher rate. If the bank doesn’t have “reserves” it cannot lend – so goes the story.
However, the way banks actually operate is nothing like this depiction. They certainly seek to maximise return to their shareholders. In pursuing that charter, they seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share.
At present the lending standards are higher than they were at the peak of the last cycle.
Do banks need reserves to lend? The mainstream view is that reserves are deposits that haven’t been lend yet. All the standard macroeoconomics textbooks speak in those terms.
But banks do not lend reserves. The role of bank reserves is different. The commercial banks are required to keep reserve accounts at the central bank. These reserves are liabilities of the central bank and function to ensure the payments (or settlements) system functions smoothly. That system relates to the millions of transactions that occur daily between banks as cheques are tendered by citizens and firms and more.
Without a coherent system of reserves, banks could easily find themselves unable to fund another bank’s demands relating to cheques drawn on customer accounts for example.
Depending on the institutional arrangements (which relate to timing), all central banks stand by to provide any reserves that are required by the system to ensure that all the payments settle. The central bank charges a rate on their lending in this case which may penalise banks that continually draw on the so-called “discount window”.
Banks thus will have a reserve management area within their organisations to monitor on a daily basis their status and to seek ways to minimise the costs of maintaining the reserves that are necessary to ensure a smooth payments system.
The interbank market (say the federal funds market in the US) functions to shuffle the reserve balances that the member (private) banks keep with the central bank to ensure that each of these banks can meet their reserve targets which might be simply zero balances at the end of the “day”. I have put “day” in inverted commas because we should think that the central bank polices its reserve requirements per day. They requirements are usually expressed over some period of weeks rather than days and are averages. But that is a complication we can avoid here.
So we might qualify the statement that banks do not lend reserves. In a sense, they can trade them between themselves on a commercial basis but in doing so cannot increase or reduce the volume of reserves in the system. Only government-non-government transactions (which in MMT are termed vertical transactions) can change the net reserve position. All transactions between non-government entities net to zero (and so cannot alter the volume of overall reserves). I explain that in deficit suite referred to above.
This is how the actual system operates. And it helps to understand why budget deficits place downward pressure on interest rates – which is contrary to the mainstream macroeconomics textbook depiction captured by “crowding out”. I will come back to that below.
The important point that when a bank originates a loan to a firm or a household it is not lending reserves. Bank lending is not easier if there are more reserves just as it is not harder if there are less. Bank reserves do not fund money creation in the way that the money multiplier and fractional-reserve deposit story has it.
MMT notes that bank loans create deposits not the other way around. Reserve balances have nothing to do with this – they are part of the banking system that ensure financial stability.
These loans are made independent of their reserve positions. So while the bank organisation will include a reserve management division it also will have a loan division. The two are functionally separate and the latter does not correspond with the former prior to making loans to appropriate credit-worthy customers.
Depending on the way the central bank accounts for commercial bank reserves, the banks will seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds.
At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.
So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.
The other point which is related to this is that total bank reserves do not fall when a loan is made which also should disabuse you of the mainstream notion that reserves are loaned out.
Please read my blog – The role of bank deposits in Modern Monetary Theory – for more discussion on this point.
I covered the argument pertaining to the inflation risk embodied in deficit spending in my response to Paul Krugman’s blog last week. Please see – To challenge something you have to represent it correctly.
Any spending that pushes nominal aggregate demand (spending) more quickly than the growth in real capacity will be inflation. That is the risk in all spending. There is nothing special about government spending in this regard.
So, yes, under certain circumstances, government deficits could be inflationary but that begs the question as to why a prudent government would want to expand its deficit beyond full employment. It might want to if it wanted to increase the public mix of total output. But if it seriously sought that outcome it would not do it via deficit expansion but rather would squeeze private spending capacity by increasing taxes.
Taxes in this context – consistent with functional finance – are a means of depriving the private sector of purchasing power. If a government increases taxes it must want the private sector to have less purchasing power.
Repeating Krugman’s point:
I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue. For it is.
No it isn’t.
The fact he is not clear means that he hasn’t read the academic literature that MMT proponents have provided over many years. His one link in this blog to a MMT article is a blog written by a non-academic who is a recent (but welcome) addition to the “school of thought”. So once again we have an academic waxing lyrical about what is right and wrong about a school of thought and it seems he hasn’t read the primary literature carefully.
That is a very un-academic approach.
The point is that we have been at pains to outline that the monetary operations that accompany deficit spending (in this case, debt issuance) do not alter the inflation risk of the spending. The inflation risk is embodied in the spending not subsequent monetary manouevres.
But here we can reflect on the last several paragraphs and really understand why the two scenarios are mainstream depictions and not akin to a MMT perspective.
In this blog – Understanding central bank operations – we learn about the parameters which pertain to the conduct of monetary policy. Another excellent source for readers is the paper by Scott Fullwiler – Modern Monetary Theory – A Primer on the Operational Realities of the Monetary System.
The reality is very clear. If the central bank has a positive interest rate target – that is, the policy rate that it sets as an expression of its monetary stance – then it cannot “monetise” deficit spending by the treasury – which Krugman calls printing money. Such a central bank has no option – it either has to issue debt to drain the reserves that are boosted by the deficit spending (on a daily basis) or it has to pay a return on the reserves that are held with it by the private banks.
The two options – debt-issuance or paying a support rate – are from an operational perspective equivalent.
If the central bank didn’t do either then it would immediately lose control over its target policy rate. Why? Because the private banks would seek to shed the excess reserves (over and above the balances they deemed necessary to ensure all cheques drawn on it cleared) via the interbank market. That is, to loan them to other banks which might need reserves.
But as noted above, when the system is in excess, this interbank lending does nothing other than shuffle the excess around. But the competition that accompanies this “shuffling” drives the overnight rate down to zero (in the case of no support rate being offered by the central bank) and so the central bank monetary policy stance is thwarted.
When the central bank pays a support rate on overnight reserves it is effectively making them equivalent to government bonds. Both provide a return to the bank which would be indifferent between them (in the jargon of economics, they become perfect subsitutes) .
So debt-issuance just allows the central bank to maintain a non-zero policy rate in the absence of a support rate being explicitly paid on reserves. Functionally, both can be seen as offering a support rate.
It is only when there is a Japanese-style zero interest rate policy target that the central bank can avoid selling government bonds or offering a support rate.
So then deficits will add to reserves and the private banks have no place to go. The deficits might be inflationary (depending on the overall state of the economy) but the reserve add is not.
To consider otherwise is to fall into the money multiplier myth which says that growth in bank reserves (the monetary base) will be inflationary. That mainstream textbook model does not explain how the system actually functions as noted above.
Paul Krugman however says:
The point is that under normal, non-liquidity-trap conditions, the direct effects of the deficit on aggregate demand are by no means the whole story; it matters whether the government can issue bonds or has to rely on the printing press. And while it may literally be true that a government with its own currency can’t go bankrupt, it can destroy that currency if it loses fiscal credibility.
Which means he hasn’t really come to grips with the way central bank and treasury operations work in liaison with the private banks.
The inflation risk is in the aggregate demand. The monetary operations that accompany the deficit spending are not the source of the inflation risk.
It is possible that holders of a particular currency will attempt to sell it off which drives its value down in foreign exchange markets. This may impart some cost pressures into the economy. But that is a finite process and with flexible exchange rates there is no necessity for the central bank to intervene nor is there a possibility of the nation running out of foreign exchange reserves. I discussed these option in this blog – To challenge something you have to represent it correctly.
I think it is way past the time that Paul Krugman updates his textbook. But MMT gets free advertising even though he hangs on to what are effectively classical Quantity Theory of Money views on inflation. So why should I complain.
Digression – extremism
I have been used to being labelled an extremist – radical leftist communist and all related terms. I have actually never advocated a radical overthrow of the state in any public statement I have made nor the abolition of private property. What my personal views are remain just that.
In public all I have really advocated is that if the private sector cannot see itself fit to provide enough work for all those wanting it so that they can have a stable income and bring up their families or support whatever arrangement they choose – then the state has to use its fiscal capacity to ensure those jobs are available.
I have also advocated regulating private market behaviour so that greed and corruption doesn’t get ahead of itself and cause crises such as we are enduring now.
But the current crop of US republican candidates seem to be outdoing themselves in a race to come up with the more radical – extreme – policies to tempt their constituencies with.
There is a site in the US – Think Progress – which is doing a sterling job of tracking the candidates and highlighting their views – which are often not covered by Fox News etc – because even they know how looney the positions are.
1. The US cannot continue to pay unemployment benefits “because we frankly don’t have the money” (Michele Bachmann – Source).
2. The poor should pay more taxes because “We’re dismayed at the injustice that nearly half of all Americans don’t even pay any income tax” (Rick Perry – Source).
3. One candidate now considers all Americans are less free than when the nation was founded – “Does anyone believe that our freedom is as whole as it was at the time of our founders? It is not” (Rick Santorum – Source).
5. Michele Bachmann does not consider gay families to be real (Source).
I could go on.
The funniest (and probably scariest) quote came from Perry during a rally in Iowa at the weekend just gone – referring to the Federal Reserve Chairman Ben Bernanke, Perry said:
If this guy prints more money between now and the election, I dunno what y’all would do to him in Iowa but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost is almost treacherous, er treasonous, in my opinion.
Under US law, treason carries the death sentence. Suggesting the central bank governor should be sentenced to death is extremism by any stretch.
Think Progress is also keeping track on propriety issues. For example, they have exposed Michele Bachmann for accepting federal government subsidies for their family farm and counselling clinic – then claiming “My husband and I have never gotten a penny of money from the farm” and then – disclosing tens of thousands of dollars on income from the farm in here financial disclosures statements. The word hypocrite comes to mind.
The confused language that these characters use as they race to better each other in the who can be more extreme stakes recalls the 1998 Simpson’s episode – King of the Hill – where a besieged Rainier Wolfcastle said:
McBain to base. Under attack by commie Nazis.
That sort of comment is downright intellectual compared to the recent utterances from the Republican hopefuls.
And I haven’t even considered their macroeconomics – which if implemented as a policy position would destroy millions of jobs, bankrupt a good percentage of US business, and impoverish a fair percentage of the US population.
And all I want to do is create some jobs.
That is enough for today!