I read an article in the Financial Times earlier this week (September 23, 2023) -…
In his latest New York Times article (December 10, 2009) – Bernanke’s Unfinished Mission – Paul Krugman reveals that he doesn’t really understand much about macroeconomics. Sometimes you read a columnist and try to find extra meaning that is not in the words to give them the benefit of the doubt. At times, Krugman like other columnists sounds positively reasonable and advances arguments that are consistent with modern monetary theory (MMT). But then there is always a give-away article that appears eventually that makes it clear – this analyst really doesn’t get it. In Krugman’s case, he doesn’t seem to have learned from his disastrous foray into Japan’s “lost decade” policy debate.
In the late 1990s, Paul Krugman joined a number of academic economists in urging the Bank of Japan to introduce large-scale quantitative easing to kick start the economy. The Bank, reluctantly, heeded their advice and in 2001 they increased bank reserves from ¥5 trillion to ¥30 trillion. This action had very little impact – real economic activity and asset prices continued their downward spiral and inflation headed below the zero line.
Many economists had also claimed that the huge increase in bank reserves would be inflationary. They were also wrong. Please read my blog – Balance sheet recessions and democracy – for more discussion on this point.
In this 1998 article on Japan’s trap, Krugman claimed that Japan was “in the dreaded “liquidity trap”, in which monetary policy becomes ineffective because you can’t push interest rates below zero”. This is similar to the argument he is making about the US at present.
He said that when the nominal interest rate is at zero and therefore stimulatory interest rate adjustments can no longer be made, the real rate of interst that is required to “match saving and investment may well be negative” (as an aside – this sort of reasoning is derived from the highly flawed loanable funds doctrine).
As a Keynesian, he recognised that there was a spending gap in Japan at the time and while fiscal policy would possibly work it is constrained by “a government fiscal constraint” and further that the Japanese Government would only be wasting its spending on “roads to nowhere”.
So he then considers monetary policy as the best way forward. In that context, Krugman says that the nation needs a dose of expected inflation so that the real interest rate becomes negative (and flexible). He concluded 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.
So he was completely wrong in this diagnosis. The only thing that got Japan moving again in the early part of this Century was a dramatic expansion of fiscal policy.
In another related article Krugman elaborated on quantitative easing. He said:
The Bank of Japan has repeatedly argued against such easing, arguing that it will be ineffective – that the excess liquidity will simply be held by banks or possibly individuals, with no effect on spending – and has often seemed to convey the impression that this is an argument against any kind of monetary solution.
It is, or should be, immediately obvious from our analysis that in a direct sense the BOJ argument is quite correct. No matter how much the monetary base increases, as long as expectations are not affected it will simply be a swap of one zero-interest asset for another, with no real effects. A side implication of this analysis … is that the central bank may literally be unable to affect broader monetary aggregates: since the volume of credit is a real variable, and like everything else will be unaffected by a swap that does not change expectations, aggregates that consist mainly of inside money that is the counterpart of credit may be as immune to monetary expansion as everything else.
But this argument against the effectiveness of quantitative easing is simply irrelevant to arguments that focus on the expectational effects of monetary policy. And quantitative easing could play an important role in changing expectations; a central bank that tries to promise future inflation will be more credible if it puts its (freshly printed) money where its mouth is.
So once again he is claiming that an expansion of reserves will increase bank loans because he asserts it will be inflationary and alter the drive the real interest rate into the negative domain.
More recently, Krugman wrote – It’s the stupidity economy. Once again when you read this article you appreciate how far Krugman is from understanding modern monetary theory (MMT), which means he really doesn’t get the way the fiat monetary system works.
His options of how to deal with the ineffectiveness of monetary policy are, in his order of preference, which just rehearse his earlier work in relation to Japan:
- First best: “… credibly commit to higher inflation, so as to reduce real interest rates”. So he is still thinking monetary policy is the best way to proceed.
- Second best: “… a really big fiscal expansion, sufficient to mostly close the output gap. The economic case for doing that is really clear. But Washington is caught up in deficit phobia, and there doesn’t seem to be any chance of getting a big enough push.”
- Third best: “… subsidizing jobs and promoting work-sharing.”
Krugman clearly still believes that monetary policy is the preferred counter-stabilisation tool despite the evidence that it is relatively ineffective in this regard and relies on difficult to determine distributional assumptions about the spending propensities of creditors and debtors.
He also thinks that quantitative easing will expand resources to borrowers by creating an inflationary adjustment to real interest rates. So in this case he wants to tweak monetary policy into action by creating inflation – to move the real interest rate below zero.
Now to the most recent article. Krugman’s record is stuck in the groove it seems.
In the context of the forecasts from Federal Reserve chairman Bernanke that the US can only look forward to “modest economic growth next year – sufficient to bring down the unemployment rate, but at a pace slower than we would like”, Krugman explores the policy options to stimulate faster growth.
He is also more pessimistic than Bernanke and thinks that unemployment might in fact rise. He is correct when he says:
I don’t think many people grasp just how much job creation we need to climb out of the hole we’re in. You can’t just look at the eight million jobs that America has lost since the recession began, because the nation needs to keep adding jobs – more than 100,000 a month – to keep up with a growing population. And that means that we need really big job gains, month after month, if we want to see America return to anything that feels like full employment.
Given this challenge he says that “the political reality is that the president – faced with total obstruction from Republicans, while receiving only lukewarm support from some in his own party – probably can’t get enough votes in Congress to do more than tinker at the edges of the employment problem.”
So he is asserting that fiscal policy has reached the end of the road in the US. This is consistent with claims by the President that the US has run out of money. Please read my blog – The US government has run short of money – for more discussion on this point.
In this context, Krugman says that the US Federal reserve “can do more”. He says that:
The most specific, persuasive case I’ve seen for more Fed action comes from Joseph Gagnon, a former Fed staffer now at the Peterson Institute for International Economics. Basing his analysis on the prior work of none other than Mr. Bernanke himself, in his previous incarnation as an economic researcher, Mr. Gagnon urges the Fed to expand credit by buying a further $2 trillion in assets. Such a program could do a lot to promote faster growth, while having hardly any downside.
So we are back to quantitative easing, which failed to stimulate lending in Japan and is currently failing to stimulate lending in the UK, for example. Please read my blog – Quantitative easing 101 – for more discussion on this point.
The point is that quantitative easing is not really capable of stimulating lending. Krugman clearly doesn’t understand the banking operations that link monetary policy to bank reserves. Developing this understanding is a core differentiating feature of MMT.
But banking professionals also understand it. This recent working paper from the Bank of International Settlements – Unconventional monetary policies: an appraisal is very useful in advancing this understanding.
It argues that mainstream economists have not really thought much about the unconventional monetary policies that have been used in this downturn by central banks.
In relation to these policies, their:
… distinguishing feature is that the central bank actively uses its balance sheet to affect directly market prices and conditions beyond a short-term, typically overnight, interest rate. We thus refer to such policies as “balance sheet policies”, and distinguish them from “interest rate policy”.
In making this distinction, they show that these policies are intended to work by altering “the structure of private sector balance sheets” and targetting “specific” markets. The major points they make are as follows:
First they say that:
… rather paradoxically, some of these policies would have been regarded as “canonical” in academic work on the transmission mechanism of monetary policy done in the 1960s-1970s, given its emphasis on changes in the composition of private sector balance sheets.
That is, the recent history of macroeconomics has attempted to obliterate insights that were well understood during the “Keynesian” period. If you look at a recent macroeconomics textbook, for example, you will struggle to find any reference to liquidity trap (I just searched Barro, Mankiw and Blanchard).
The feature of the “new” textbook era in macroeconomics which began in the 1980s and has intensified in recent years is that students are confronted with one highly stylised “model” of the economy without competing views being presented. The historical debates (like those between Keynes and Pigou – the so-called “Keynes and the Classics” debates – are rarely presented in any coherent form yet remain relevant today.
Students have no scope within these books to dispute the paradigm being presented. It is a take it or leave it approach. The problem is that the stylised models presented have very little relevance for the macroeconomic behaviour they purport to study.
All these books fail to present an accurate rendition of the modern monetary system and so students leave their studies with a wrong-headed understanding of how the monetary system operates and how it interacts with the real economy.
They then say that a:
… key feature of balance sheet policies is that they can be entirely decoupled from the level of interest rates. Technically, all that is needed is for the central bank to have sufficient instruments at its disposal to neutralise the impact that these policies have on interest rates through any induced expansion of bank reserves (holdings of banks’ deposits with the central bank). Generally, central banks are in such a position or can gain the necessary means. This “decoupling principle” also implies that exiting from the current very low, or zero, interest rate policies can be done independently of balance sheet policies.
The “decoupling principle” is based on the way in which the central bank remunerates bank reserves relative to the policy rate, which is the rate it announces as its statement of monetary policy.
Consistent with MMT, there are two broad ways the central bank can manage bank reserves to maintain control over its target rate. First, central banks can buy or sell government debt to “adjust the quantity of reserves to bring about the desired short-term interest rate” a practice that has been “well known to practitioners for a long time” (page 3).
MMT posits exactly the same explanation for public debt issuance – it is not to finance net government spending (outlays above tax revenue) given that the national government does not need to raise revenue in order to spend. Debt issuance is, in fact, a monetary operation to deal with the banks reserves that deficits add and allow central banks to maintain a target rate.
Try finding this explanation for public sector debt issuance in a macroeconomics text book.
Second, “central banks may decide to remunerate excess reserve holdings at the policy rate” which “sets the opportunity cost of holding reserves for banks to zero”. The “central bank can then supply as much as it likes at that rate.” The important point is that the interest rate level set by the central bank is then “delinked from the amount of bank reserves in the system” just as in the first case when the central bank drains reserves by issuing public debt.
So the build-up of bank reserves has no implication for interest rates which are clearly set solely by the central bank. All the mainstream claims that budget deficits will drive interest rates up misunderstand their impact on reserves and the central bank’s capacity to manage these bank reserves in a “decoupled” fashion.
The BIS paper then addresses the issue of the implications of the current build-up in bank reserves. They say:
… we argue that the typical strong emphasis on the role of the expansion of bank reserves in discussions of unconventional monetary policies is misplaced. In our view, the effectiveness of such policies is not much affected by the extent to which they rely on bank reserves as opposed to alternative close substitutes, such as central bank short-term debt. In particular, changes in reserves associated with unconventional monetary policies do not in and of themselves loosen significantly the constraint on bank lending or act as a catalyst for inflation.
So all you Austrian School devotees and mainstream economists who claim that the build-up of bank reserves will be inflationary – take a break for a moment and read what the insiders are telling you.
All mainstream economists including Mark Thoma and others who claim that higher bank reserves make bank lending easier – take a break for a moment and read what the insiders are telling you.
The propositions being developed by the BIS staff in this paper are central to MMT but are absent in any understanding a macroeconomics student will get from a mainstream teaching program. Further, you will not read this sort of analysis in any of the mainstream monetary research articles that are published in all the top-tier journals by academic writers. They simply fail to understand any of these insights because they start with a model that is wrong.
The section of the BIS paper – Are bank reserves special? – which starts on page 16 is very rewarding reading although in places it uses language that is misleading (such as, crowding out) which could be misinterpreted by a reader who is imbued with mainstream concepts.
The BIS authors start by noting that bank reserves “may be seen as special … in their ability either to act as a catalyst for bank lending or to contribute to market stability and confidence”. In this context, they conclude that while “there may be plausible reasons for such a view, the underlying justification is sometimes premised on dubious grounds”.
They argue that:
… bank reserves are uniquely valued by financial institutions because they are the only acceptable means to achieve final settlement of all transactions. From this perspective, reserves may play a special role during times of financial stress, when their smooth distribution within the system can be disrupted. At such times, financial institutions may wish to hold larger reserve balances to manage their heightened illiquidity risk. Indeed, this was the case in the initial stages of the current crisis, when the precautionary demand for reserves increased materially …
They note that the need to maintain financial stability was one of the main reasons why the Bank of Japan expanded bank reserves between 2001 and 2006.
However, it is clear that the liquidity role can be accomplished when the central bank offers flexible arrangements to supply reserves on demand (via exchanges for near-reserve equivalents like short-term government paper).
In other words, there is nothing particularly special about bank reserves in this context.
The reason they consider bank reserves to be “special” lies in their operational significance for monetary policy. The central bank clearly sets the interest rate and generally aims to ensure that the overnight (interbank) rate is equal to it. In this context, bank reserves are:
… powerful and unique … [and] … obliges the central bank to meet the small demand for (excess) reserves very precisely, in order to avoid unwarranted extreme volatility in the rate … But in order to induce banks to accept a large expansion of such balances in the context of balance sheet policy, the central bank has to make bank reserves sufficiently attractive relative to other assets … In effect, this renders them almost perfect substitutes with other short-term sovereign paper. This means paying an equivalent interest rate. In the process, their specialness is lost. Bank reserves become simply another claim issued by the public sector. It is distinguished from others primarily by having an overnight maturity and a narrower base of potential investors.
That statement is not written by one of us (the MMT developers) – rather it comes from the BIS officials. It very clearly demonstrates how the reserve dynamics impact on monetary operations and require the central bank to issue debt or pay a return on reserves to maintain control over its monetary policy target rate.
It also demonstrates that bank reserves are near-equivalents to public debt issuance a point that is lost to mainstream economists.
Finally, the BIS paper considers the reserves – bank lending – inflation nexus. The authors say:
The preceding discussion casts doubt on two oft-heard propositions concerning the implications of the specialness of bank reserves. First, an expansion of bank reserves endows banks with additional resources to extend loans, adding power to balance sheet policy. Second, there is something uniquely inflationary about bank reserves financing.
They correctly point out that those who think that an expansion of bank reserves provides banks with additional resources to extend loans assumes that “bank reserves are needed for banks to make loans”. Accordingly, mainstream economists (such as Mark Thoma) think that the “bank lending is constrained by insufficient access to reserves or more reserves can somehow boost banks’ willingness to lend.”
The BIS authors go on to say that:
… an extreme version of this view is the text-book notion of a stable money multiplier: central banks are able, through exogenous variations in the supply of reserves, to exert a direct influence on the amount of loans and deposits in the banking system.
MMT outrightly rejects these propositions. Bank reserves are not required to make loans and there is no monetary multiplier mechanism at work as described in the text books.
The BIS authors concur and say that:
In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly.
It is obvious why this is the case. Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. Then, as the BIS paper says, “in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system.”
The loan desk of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit (a zero net financial asset transaction).
The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans.
The BIS authors then demonstrate that:
A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly
And during that time, Paul Krugman was urging the Bank of Japan to conduct quantitative easing to provide more resources to the banks which he claimed would allow them to lend more easily. It is clear that he didn’t get it then and still fails to understand basic banking operations.
I will examine the BIS arguments about reserves and inflation in another blog.
The reason that quantitative easing will not work is very simple – credit will be extended when there are demand for funds from the private sector. That was absent in Japan. Please read my blog – Balance sheet recessions and democracy – for more discussion on this point.
Richard Koo in his 2003 book Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications (John Wiley & Sons) said:
The reason why quantitative easing did not work in Japan is quite simple and has been frequently pointed out by BOJ officials and local market observers: there was no demand for funds in Japan’s private sector.
In order for funds supplied by the central bank to generate inflation, they must be borrowed and spent. That is the only way that money flows around the economy to increase demand. But during Japan’s long slump, businesses left with debt-ridden balance sheets after the bubble’s collapse were focused on restoring their financial health. Companies carrying excess debt refused to borrow even at zero interest rates. That is why neither zero interest rates nor quantitative easing were able to stimulate the economy for the next 15 years.
It may be true that the politics in the US are so destructive that its sovereign government is constrained from using its fiscal instruments to advance public purpose.
From my perspective – of understanding the intrinsic operations of the modern monetary economy – it is extraordinary that we allow ideological constraints to be imposed on our governments which conspire to prevent millions of disadvantaged workers from being able to work and force them and their families to live in poverty.
When there are insufficient jobs the answer is simple. Create more. The national government can always create enough jobs by expanding net public spending. The most direct way to ensure this is to create the jobs itself in the public sector.
But when influential economists like Paul Krugman avoid this reality and instead continually advance economic notions that misunderstand the operations of the monetary system and have been proven over and over again to be vacuous when converted into policy initiatives, you have to wonder what is going on.
The other point is that there has to be activism to bring the political system more in line with the extent of the opportunities that a national government has in a fiat monetary system.