I read an interesting report this morning, which resonated with some other work I had…
This is the second part of my response to an article posted by American political analyst Jared Berstein (January 7, 2018) – Questions for the MMTers. Part 1 considered the thorny issue of the capacity of fiscal policy to be an effective counter-stabilising force over the economic cycle, in particular to be able to prevent an economy from ‘overheating’ (whatever that is in fact). Jared Berstein prescribes some sort of Monetarist solution where all the counter-stabilising functions are embedded in the central bank which he erroneously thinks can “take money out of the economy” at will. It cannot and its main policy tool – interest rate setting – is a very ineffective tool for influencing the state of nominal demand. In Part 2, I consider his other claims which draw on draw on the flawed analysis of Paul Krugman about bond issuance. An understanding of MMT shows that none of these claims carry weight. It is likely that continuous deficits will be required even at full employment given the leakages from the income-spending cycle in the non-government sector. Jared Bernstein represents a typical ‘progressive’ view of macroeconomics but the gap between that (neoliberal oriented) view and Modern Monetary Theory (MMT) is wide. For space reasons, I have decided to make this a three-part response. I will post Part 3 tomorrow or Thursday. I hope this three-part series might help the (neoliberal) progressives to abandon some of these erroneous macroeconomic notions and move towards the MMT position, which will give them much more latitude to actually implement their progressive policy agenda.
Question about Krugman’s “finance-ability” claims
The issue raised by Jared Bernstein draws on an August 15, 2011 article by Paul Krugman – MMT, again.
In that article, Krugman claims that:
1. “a deficit financed by money issue is more inflationary than a deficit financed by bond issue” – which is clearly false. More later.
2. “the money-financed deficit would lead to hyperinflation” – clearly false as a general rule.
3. “When people expect inflation, they become reluctant to hold cash, which drive prices up and means that the government has to print more money to extract a given amount of real resources, which means higher inflation” – clearly ridiculous. If people are reluctant to save and spend instead then the fiscal deficit will be smaller.
If the government wishes to retain the same hold over real resources then it will have to deprive the non-government sector of purchasing power in these cases. Please read Part 1 – for the discussion about this.
4. If the government tries to spend without issuing bonds “the currency is destroyed. This would not happen, even with the same deficit, if the government can still sell bonds” – clearly false.
5. “the MMT people are just wrong in believing that the only question you need to ask about the budget deficit is whether it supplies the right amount of aggregate demand; financeability matters too, even with fiat money” – clearly, it is Krugman that is in error not the MMT economists.
I will, of course, explain the annotations after each of the above quotes.
The basic response is that if Krugman’s claims “that self-financing is more inflationary that bond issuance” were true then the sequence of quantitative easing episodes in Japan, the US, Britain, Eurozone over several decades would have resulted in very high inflation rates.
That hasn’t happened which really tells you everything.
But the myths that Krugman perpetuates still underpin Jared Bernstein’s questions in this context.
One could argue that the government doesn’t have to sell bonds – it can just print money – but it does sell bonds, it always has and probably always will. Moreover, it doesn’t just sell them to itself. It sells them to open markets of investors who could, under conditions triggered by printing-press reliance, decide not to buy them without an exorbitant risk premium. A model that assumes otherwise may raise interesting ideas, but, like discounting the role of the Fed and interest rate policy, risks being of limited real-world utility.
This is a very confused question in fact.
The government does not spend by ‘printing money’. It credits bank accounts, irrespective of any other monetary operations that might be performed in an accompanying manner (such as issuing bonds).
The US government does not really sell debt to “open markets” but rather via a selective ‘sealed-bid single price auction’ process where the authorised primary government security dealers (which have special accounts with the Federal Reserve Bank of New York) dominate the auction.
So within that context (bond issuance) how might we get “conditions trigger by printing-press reliance”? Not logical.
Further, it is true that the US government or any government for that matter can make itself hostage to the private bond dealers – by which I mean allow the private bond markets to set whatever yields on the debt they desire at the primary auction process and embody those yields into the liability the government assumes.
But, governments also know they effectively can control the process whenever they want – and set yields at any maturity they desire via central bank operations. So a government never has to accept an “exorbitant risk premium” on debt it issues.
Then, Krugman invokes the hyperinflation fear.
During the GFC, the US Federal Reserve, like many central banks bought large proportions of the outstanding debt (usually on secondary markets) with no inflationary consequences.
The reason? Adding reserves to the banking system is not intrinsically inflationary.
We will explore these concerns.
But first, Paul Krugman really disqualified himself from discussing macroeconomics in my view back when he tried to pull rank and give the Japanese government gratuitous advice in the 1990s on how to handle the difficulties their economy was in following the huge property market collapse in 1991.
The advice that Krugman gave the Bank of Japan was deeply flawed.
The economic decline in the 1990s in Japan was driven by the non-government debt build up that began in the 1970s and accelerated during the 1980s.
The asset price boom that was fuelled by the debt accumulation (primarily tied to land) was ultimately terminated by contractionary Bank of Japan monetary policy.
The subsequent crash in asset values and the resulting balance sheet adjustments that followed give rise to the term – “balance sheet recession”.
Japanese economist Richard Koo wrote in his 2003 book – Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications: that during the process of balance sheet restructuring within the non-government sector, the priority is to pay off debt rather than pursue profit.
In turn, this suppresses aggregate demand as investment and consumption spending plunges. The downturn reinforces the pessimism and credit-worthy borrowers dry up and bankruptcies rise.
Importantly, the lack of bank lending is not due to reserve constraints but because, even at low interest rates (zero), no-one worthy wants to borrow because the expectations of returns are ruled by pessimism.
Koo understood full well that in these situations the circuit breaker has to be fiscal policy
Monetary policy has no role to play in this context.
Krugman might have extolled the virtues of fiscal policy in the recent GFC (note below) but he was firmly Monetarist prior to that – a sort of economic chameleon – who runs with whatever idea he thinks will make him popular at the time.
If the Groupthink specifies a reliance on monetary policy – Krugman will be writing about that. If there is a swing towards fiscal policy – guess what?
Back in May 1998, when the conservatives had pressured the Japanese government into contracting net spending (via tax hike) which pushed the economy back into recession, Krugman wrote an Op Ed article – Japan’s Trap.
He noted that Japan was suffering from a spending gap and that fiscal policy solutions should be avoided because “there is a government fiscal constraint” and the Japanese Government would only be wasting its spending.
There was no fiscal constraint just an ideological preference against fiscal deficits.
He then said that monetary policy had been ineffective because:
… private actors view its … [Bank of Japan] … actions as temporary, because they believe that the central bank is committed to price stability as a long-run goal. And that is why monetary policy is ineffective! Japan has been unable to get its economy moving precisely because the market regards the central bank as being responsible, and expects it to rein in the money supply if the price level starts to rise.
The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.
This sounds funny as well as perverse. … [but] … the only way to expand the economy is to reduce the real interest rate; and the only way to do that is to create expectations of inflation.
History shows he was completely wrong in this diagnosis. The only thing that got Japan moving again in the early part of this Century was fiscal policy.
Koo wrote that:
Western academics like Paul Krugman advised the BOJ to administer quantitative easing to stop the deflation. Ultimately – and reluctantly – the BOJ took their advice, and in 2001 the Bank expanded bank reserves dramatically from ¥5 trillion to ¥30 trillion.
Nonetheless, both economic activity and asset prices continued to fall, and the inflation projected by Western academics never materialized.
The reason that quantitative easing did not work in Japan and has not achieved its aims since is elementary. MMT economists have been providing the answer for more than two decades now.
No-one in the private sector wanted to borrow and without borrowing and subsequent spending how will inflation evolve!
The likes of Krugman thought that by flooding the banks with reserves they would loan them out. But banks do not loan out reserves. They are special account balances that serve the purpose of clearing transactions.
In the 1990s, the firms were so indebted and their assets depleted by the collapse in property prices that their main focus was on restoring some sustainability to their financial positions rather than going further into debt.
Second, Krugman is back at it in his latest New York Times column (January 9, 2017) – Deficits Matter Again.
After extolling the virtues of deficits a while ago, he is now trying to reverse direction to score points against Donald Trump and his tax policy.
In doing so he demonstrates how flawed his ‘mainstream textbook’ analysis is. The erroneous claims he makes in this article bear on Jared Bernstein’s seeming blind faith in following Krugman.
I agree with Krugman that the Republican Party claims that Obama deficits were shocking were just political point scoring. The deficits never mattered per se and were too low at the height of the crisis given the lost output that ensued.
He also states that “America, which borrows in its own currency and therefore can’t run out of cash”. So why did he say the Japanese government which is the same position as the US government was facing a fiscal constraint? You can answer that for yourselves – easily – chameleon.
But, of course, Krugman is trying to eviscerate Trump politically. After all he invested many New York Times’ columns trumpetting support for Hillary Clinton.
The New York Observer article (March 10, 2016) – Paul Krugman Throws Another Fit Over Clinton’s Lack of Support – described Krugman as the “New York Times’ Clinton puppet” who was “completely oblivious to the fact that Hillary is an awful candidate”.
Obviously the Observer is closely tied to Trump but its assessment of Krugman and Clinton in this regard was pretty accurate.
What is Krugman’s line on deficits now?
1. He claims the US economy is now close to full employment and that means:
… government borrowing once again competes with the private sector for a limited amount of money. This means that deficit spending no longer provides much if any economic boost, because it drives up interest rates and “crowds out” private investment.
2. “government borrowing can still be justified if it serves an important purpose: Interest rates are still very low, and borrowing at those low rates to invest in much-needed infrastructure is still a very good idea, both because it would raise productivity and because it would provide a bit of insurance against future downturns.”
3. The Trump increase in deficits will “by crowding out investment … reduce long-term economic growth”.
This is a very conventional view for a mainstream (neoliberal) economist. This sort of nonsense gets taught in universities around the world every day.
As a matter of logic, if Krugman thinks that the economy is close to full employment (meaning that there are few real resources available) then borrowing at low interest rates to spend on infrastructure projects will increase the demand for the available real resources and drive up prices.
But according to Krugman this would also drive up nominal interest rates because there are scarce funds available. Then the question is why interest rates are so low – because in Krugman’s mainstream framework – crowding out can only occur if the demand for funds outstrips the supply and drives up the price.
So even these twisted claims are very confused.
But confusion aside, they are also incorrect inferences to be drawn from the way the banking system operates.
The ‘financial crowding out’ story is deeply embedded in mainstream macroeconomics. It is one of the enduring myths to be found in the mainstream macroeconomics literature.
It is a central plank in the mainstream economics attack on government fiscal intervention. At the heart of this conception is the theory of loanable funds, which is an aggregate construction of the way financial markets are thought to work.
The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.
At the heart of this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.
Any external capital availability (from foreign sources) was ignored.
This is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times.
If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.
So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded.
The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.
So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.
Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.
According to this theory, if there is a rising fiscal deficit then there is increased demand placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to “clear” the loanable funds market. This chokes off investment spending.
This is exactly what Krugman (and implicitly Jared Bernstein) think.
So allegedly, when the government borrows to ‘finance’ its fiscal deficit, it crowds out private borrowers who are trying to finance investment.
The mainstream economists conceive of this as the government reducing national saving (by running a fiscal deficit) and pushing up interest rates which damage private investment.
The basic flaws in the mainstream story are that governments just borrow back the net financial assets that they create when they spend. Its a wash!
It is true that the private sector might wish to spread these financial assets across different portfolios. But then the implication is that the private spending component of total demand will rise and there will be a reduced need for net public spending (that is, deficits).
Further, they assume that savings are finite and the government spending is financially constrained which means it has to seek ‘funding’ in order to progress their fiscal plans.
But government spending by stimulating income also stimulates saving.
Additionally, and crucially, credit-worthy private borrowers can usually access credit from the banking system. Banks lend independent of their reserve position so government debt issuance does not impede this liquidity creation.
But we jump ahead.
Most Post Keynesians (non-MMT heterodox economists) eschew the crowding out hypothesis by recourse to statements about the capacity of the government to ‘print money’ or the access global capital markets, which are outside of the direct influence of domestic interest rates, offers local borrowers.
In other words, they do not directly challenge the notion that fiscal deficits drive up interest rates per se. They just argue that interest rate rises can be mitigated by these other channels (money printing, global borrowing).
Where MMT departs from this literature is to explicitly integrate bank reserves into the analysis in a way that no previous Post Keynesian analysis had attempted.
The MMT framework shows that far from placing upward pressure on interest rates, fiscal deficits in fact, set in place dynamics that place pressure on interest rates in the opposite direction.
How does that occur?
The central bank operations aim to manage the liquidity in the banking system such that short-term interest rates match the official targets which define the current monetary policy stance.
In achieving this aim the central bank may: (a) Intervene into the interbank money market (for example, the Federal funds market in the US) to manage the daily supply of and demand for funds; (b) buy certain financial assets at discounted rates from commercial banks; (c) offer a return on excess bank reserves, and (d) impose penal lending rates on banks who require urgent funds.
In practice, most of the liquidity management is achieved through (a), although in recent times (as QE has become the norm) central banks are using option (c) more than in the past.
That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, but do not alter net financial asset position of the non-government sectors.
Money markets are where commercial banks (and other intermediaries) trade short-term financial instruments between themselves in order to meet reserve requirements or otherwise gain funds for commercial purposes. All these transactions net to zero.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly.
In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank. This support rate becomes the interest-rate floor for the economy. It may be zero.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.
Alternatively banks with excess reserves are faced with earning the support rate which may be below the current market rate of interest on overnight funds if they do nothing.
Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate.
When the system is in surplus overall this competition would drive the rate down to the support rate.
The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt.
In the absence of adjustments to the support rates offered on reserves, when the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt.
This open market intervention therefore will result in a higher value for the overnight rate.
The significant point for this discussion is to expose the myth of crowding out.
Net government spending (deficits) which is not taken into account by the central bank in its liquidity decision, will manifest as excess reserves (cash supplies) in the clearing balances (bank reserves) of the commercial banks at the central bank.
MMT refers to this a system-wide surplus.
In these circumstances, the commercial banks will be faced with earning the (possibly lower) support rate return on surplus reserve funds if they do not seek profitable trades with other banks, who may be deficient of reserve funds.
The ensuing competition to offload the excess reserves puts downward pressure on the overnight rate. However, because these transactions necessarily net to zero, the interbank trading cannot clear the system-wide surplus.
Accordingly, if the central bank desires to maintain the current target overnight rate, then it must drain this surplus liquidity by selling government debt or offer a competitive return on the excess reserves to choke off the competitive forces.
That is, the bond sales (debt issuance) allows the central bank to drain any excess reserves in the cash-system and therefore curtail the downward pressure on the interest rate. In doing so it maintains control of monetary policy.
- Fiscal deficits place downward pressure on interest rates;
- Bond sales maintain interest rates at the central bank target rate.
Accordingly, the concept of debt monetisation, which is a central part of mainstream thinking, is a non sequitur.
Milton Friedman claimed that to avoid ‘crowding out’ the government has to fund the whole deficit via money supply increases.
Which then, according to the likes of Krugman would lead to hyperinflation.
That assertion remains standard doctrine.
But when we understand how bank reserves are affected by fiscal deficits (an MMT insight), we quickly realise that once the overnight rate target is set by the central bank, the latter should only trade government securities if liquidity changes are required to support this target.
Given the central bank cannot control the reserves then debt monetisation is strictly impossible unless the central bank permits the excess reserves to rise indefinitely and pays a return to the banks for excess reserve holdings.
Imagine that the central bank traded government securities with the treasury, which then increased government spending. The excess reserves from the fiscal deficits would force the central bank to sell the same amount of government securities to the private market or allow the overnight rate to fall to the support level (which might be zero).
This is not monetisation but rather the central bank simply acting as broker in the context of the logic of the interest rate setting monetary policy.
Ultimately, private agents may refuse to hold any further stocks of cash or bonds.
With no debt issuance, the interest rates will fall to the central bank support limit (which may be zero).
It is then also clear that the private sector at the micro level can only dispense with unwanted cash balances in the absence of government paper by increasing their consumption levels.
Given the current tax structure, this reduced desire to net save would generate a private expansion and reduce the deficit, eventually restoring the portfolio balance at higher private employment levels and lower the required fiscal deficit as long as savings desires remain low.
Clearly, there would be no desire for the government to expand the economy beyond its real limit.
Whether this generates inflation depends on the ability of the economy to expand real output to meet rising nominal demand. That is not compromised by the size of the fiscal deficit.
Issuing bonds does not reduce the inflation risk associated with government spending
Building on that discussion, we can now understand why Krugman’s assertion that “a deficit financed by money issue is more inflationary than a deficit financed by bond issue” is plain nonsense.
The mainstream macroeconomic textbooks of which the likes of Krugman think are sound all have a chapter on fiscal policy.
The pedagogy (if you can call the dissemination of fake knowledge pedagogy) are often written in the context of the so-called IS-LM model but not always.
Krugman loves the IS-LM model – in his New York Times article (October 9, 2011) – IS-LMentary – he claimed the approach “has done what good economic models are supposed to do: make sense of what we see, and make highly useful predictions about what would happen in unusual circumstances.”
MMT economists reject the IS-LM model at the most elemental level. It is fraught with unsustainable constructs.
Please read my series on the topic for more explanation:
- The IS-LM Framework – Part 1
- The IS-LM Framework – Part 2
- The IS-LM Framework – Part 3
- The IS-LM Framework – Part 4
- The IS-LM Framework – Part 5
- The IS-LM Framework – Part 6
- The IS-LM Framework – Part 7
The fiscal policy chapters always introduces the so-called ‘Government Budget Constraint’ that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation.
But as noted above government spending is performed in the same way irrespective of the accompanying monetary operations – that is, by crediting bank accounts.
It is always claimed that “money creation” (borrowing from central bank) is inflationary while the private bond sales is less so.
This is a central contention of Paul Krugman and one that Jared Bernstein, unfortunately, seems to have mimicked.
These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.
All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.
So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a fiscal deficit without issuing debt.
Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.
The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.
This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management as noted above.
The point here is that deposits in the non-government sector rise as a result of the deficit without a corresponding increase in liabilities.
It is this result that leads to the conclusion that deficits increase net financial assets in the non-government sector.
What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered.
What is changed is the composition of the asset portfolio held in the non-government sector.
The funds to pay for the bonds came from financial asset balances which were not being spent.
The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).
There is no difference to the impact of the deficits on net worth in the non-government sector.
Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.
However, the reality is that:
- Building bank reserves does not increase the ability of the banks to lend.
- The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
- Inflation is typically caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.
So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.
This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.
It might be that a 6 per cent deficit with full employment might be too expansionary. But then it could be that a 1 per cent of GDP surplus might be too expansionary.
It all depends on the state of non-government spending and saving plans – which I will discuss in Part 3.
There is nothing intrinsically interesting about a 6 per cent deficit or a 2 per cent deficit or any deficit or surplus outcome. It all depends on the spending contributions from the three sectors (government, external and private domestic).
If a fiscal deficit – which is a flow of spending – was adding too much to aggregate demand (spending) at full employment and wasn’t just offsetting the demand drains coming from the external sector (trade deficit) and the private domestic sector (saving overall) – then MMT provides clear guidelines for policy.
As long as the government is politically happy with the private-public mix of economic activity, then it would cut back its deficit to avoid pushing demand into the inflation barrier. If it wanted more public activity and less private, it could do that by implementing fiscal measures to deprive the private sector of disposable income (see Part 1).
But the assertion that the private placement of debt reduces the inflation risk is totally fallacious. It does not.
The concluding Part 3 will follow next.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.