It was always going to happen. Several prominent New Keynesians both in the US and the UK have been hiding behind a smokescreen they erected during the Global Financial Crisis to allow their readers to form the view that they were not part of the problem. That they were different from the more rabid anti-deficit economists and that they had a deep understanding of why the crisis occurred and what the solutions were. For a while they masqueraded under the aegis of promoting the discretionary use of fiscal deficits (increasing them nonetheless) to stimulate growth in output and employment. They were seen by many who have a lesser understanding of economics as being progressive economists. The British Labour leader even had some of them on his inner advisory team. But the masks can only stay on so long. Yesterday, one of the most prominent of these characters, Paul Krugman came out! He is not progressive at all. He is a New Keynesian with all the IS-LM baggage that they cannot let go of. In his New York Times article (January 9, 2016) – Deficits Matter Again – he well and truly shows his colours. And they (to speak American) ain’t pretty!
Just the title – Deficits Matter Again – is enough to tell you that he doesn’t know much outside of his textbook narratives.
Deficits always matter as they are intrinsic to ensuring full employment. There isn’t a point (threshold) where the deficit suddenly becomes an issue and otherwise is not a concern.
In Modern Monetary Theory (MMT), if the deficit is too small then there is mass unemployment. If the deficit is too large then there is inflation.
The ‘too small’ and the ‘too large’ are relative not absolute terms and have to be assessed in the context of what the other two macroeconomic sectors – the private domestic (firms and households) and external (foreign trade and net income flows) – are doing.
The idea of a danger threshold is typical of New Keynesians who think fiscal rules have to be specified in terms of a particular fiscal limit (defined self-referentially, say 3 per cent of GDP) or as a ‘balanced budget over the cycle’ rule independent of what these other sectors are doing.
I will return discussion to that presently.
Paul Krugman is correct to castigate the American Republican politicians who like “to warn in apocalyptic terms about the dangers of budget deficits, declaring that a Greek-style crisis was just around the corner” but then “are perfectly happy with the prospect of deficits swollen by tax cuts” under the incoming Trump Administration.
Clearly, the Republicans are liars – they are happy with deficits if they are helping their vested interests (including the military – remember the scream when austerity cuts were proposed to the military in Virginia) but feign fear and loathing when they might be trickling out a dollar or two to the most disadvantaged Americans.
They are charlatans and I am surprised any American takes them seriously.
But I wouldn’t be too eager to talk about a “Greek-style crisis” if I was Paul Krugman. It could easily be interpreted as a case of the Pot calling the Kettle Black.
Not that long ago, March 24, 2011 to be exact – he wrote a New York Times article The Austerity Delusion where he ran the same line about the Republicans (about the US ending up like Greece) and wrote:
But couldn’t America still end up like Greece? Yes, of course. If investors decide that we’re a banana republic whose politicians can’t or won’t come to grips with long-term problems, they will indeed stop buying our debt.
Which tells us that he is not on top of the subtleties of monetary systems. In fact, he should have answered his own rhetorical question with an emphatic no – never!.
It only takes a moment’s reflection on what would happen if the bond markets stopped tendering for Treasury debt issues in the US to no that the answer is NO, THE US WILL NEVER END UP LIKE GREECE.
What exactly would happen if the bond tenders started to fail? The US central bank would start buying up more of the Treasury issues and start making statements they needed more bonds for its ‘liquidity management’ operations.
That is exactly what the ECB has been saying since 2010 when it launched its Securities Markets Program which effectively meant it was funding Eurozone nation deficits in contravention of the ‘no bailout’ rules under the Treaty.
Several high ranking ECB Board members toured around Europe saying “Oh, but we are just maintaining the viability of our liquidity management capacity” (by which they meant their open market operations capacity).
Billions of Euros of debt purchases later (when only a fraction of that amount would normally be required for daily liquidity management) and the ECB honchos expected us to believe that they weren’t violating the Treaty. The European Commission, as it regularly does when its rules become inconvenient, turned a blind eye reinforcing the farce.
But they still didn’t take their boots of the Greek throat! But then Greece was small and bullies like to pick on defenseless targets.
And to make it more comical, at the same time, the ECB was offering interest payments on excess reserves through their standing facilities which meant they no longer needed to conduct open market operations to sustain a positive interest rate anyway.
And, further, the policy rate had already fallen to close to zero anyway, which meant that the reserve position of banks was irrelevant to the viability of the monetary policy stance.
It was tragically comical.
Paul Krugman might claim that there are rules in place that limit the spending capacity of the US national government and the bond markets rule, meaning that the US central bank would be precluded from directly funding treasury spending.
He might also claim that the Congress might refuse to change the rules and place artificial debt limits on that spending capacity, which override the lack of an intrinsic financial constraint on a currency-issuing government.
But we all know that is not the case. We will recall that when the conservatives in the US (including those on the Democrat side) were pretending that they would block raising the debt ceiling a few years ago it didn’t take long for them to cave in and then they pretended they hadn’t. It was a total farce and exposed them for the posturing liars that they are.
In that same article, Paul Krugman compared the US to Ireland which is another false comparison. Greece and Ireland are comparable because they are part of the same monetary system and both surrendered their currency sovereignty, which means they use a foreign currency.
That means they are dependent on bond markets to fund their deficits or the ECB as the currency issuer. Under the Treaty, the ECB is not meant to ‘fund’ deficits (although as noted above it does in a selective, dysfunctional way).
But the US retains full currency sovereignty and will do so until they agree to use, say, the Mexican peso or the Australian dollar as their currency.
Just a day before Paul Krugman wrote that 2011 article, the Governor of the Bank of Japan issued a statement to the Japanese Diet (Parliament)(March 23, 2011) which categorically confirmed that under Japanese law, the central bank only needs the permission of the Diet to push Japanese government bonds directly. That is the Ministry of Finance spends and the central bank credits relevant bank accounts. Bond markets – cold-shouldered.
This is why the private bond traders are happy to buy Japanese government debt at low yields – they know that if they don’t the central bank will and then they would miss out on their corporate welfare – the risk-free (guaranteed) annuity derived from the bonds.
The US bond market dealers share that knowledge and greed!
In yesterday’s New York Times article, Krugman now thinks “running big deficits is no longer harmless, let alone desirable”.
So what is the switch point – why were deficits okay back then but not now?
Eight years ago, with the economy in free fall, I wrote that we had entered an era of “depression economics,” in which the usual rules of economic policy no longer applied, in which virtue was vice and prudence was folly. In particular, deficit spending was essential to support the economy, and attempts to balance the budget would be destructive.
He said this conclusion was based on “well-established macroeconomic principles” and he links that statement to another of his articles on the so-called IS-LM framework.
As part of the drafting of our introductory MMT textbook – Modern Monetary Theory and Practice: an Introductory Text (published March 10, 2016) – I wrote a 7-part blog series on the IS-LM framework:
If you want chapter and verse then you should go back and read those blogs in chronological order.
In summary, the IS-LM approach is central to the bastardisation of Keynes’ work by John Hicks in the late 1930s and was consolidated into the main textbook macroeconomic exposition from then on.
This consolidation was termed the Neo-classical synthesis because it took Keynes’ damning critique of neo-classical macro (the dominant paradigm before the Great Depression), neutered it (rendered it a ‘special case’) and re-established the essential claims of the pre-General Theory dogma.
It leads to conclusions that increasing real wages will reduce employment (always), whereas in MMT, say, in terms faithful to the General Theory of Keynes, it might, but only if it squeezes the profit rate and investment expenditure falls.
So output and employment are determined by effective demand not what happens in the labour market, with demand adjusting through price flexibility.
The IS-LM framework brings together the ‘money market’, where the central bank is assumed to have control over the money supply and the demand for money is an inverse function of the interest rate and a positive function of income; and the ‘product market’, where total spending is the sum of the normal National Accounts components (consumption, investment, government, net exports) and investment is inversely related to interest rate movements.
So we get a nexus where ‘general equilibrium’ results at some unique combination of interest rates and national income (read the 7-parts to understand this better).
The point is that if governments increase their spending, this stimulates a rise in national income (output), the IS-LM framework tells us that this increases the demand for money (because there are more transactions going on), and with the money supply fixed, the only way the excess demand for money can be accommodated is through rising interest rates, which serve to choke of demand for money.
The rising interest rates feedback onto the ‘product market’ via there negative effect on investment spending.
Conclusion: depending on how strong these impacts are, the IS-LM framework leads economists to conclude that rising government spending crowds out private investment spending because it drives up interest rates.
Students then spend hours in excruciating exercises where the gains in output from the rise in government spending are partially, wholly, or more than wholly offset by the loss of output from private investment as interest rates rise.
They then have moral intonations forced upon them about the relative merits of public spending (which is not ‘disciplined’ by the market) and private investment spending (which is assumed to be always efficient and highly productive.
The morality play ends with students being told that fiscal deficits are bad, force out good private investment and lead to lower efficiency and degraded outcomes for all.
Then the IS-LM framework is married up to another illegitimate framework – AS-AD – which completes the horror story – fiscal deficits end in accelerating inflation.
It is really an amazing con.
There is no educational content in studying the IS-LM framework except from an history of economic thought perspective. It has very little correspondence with the real world.
But, for the likes of Paul Krugman, the IS-LM framework is still king and apparently allowed him to do a “vastly better … [job of] … tracking our current crisis” than those who do not understand it.
Well, I understand it, but found nothing in it to understand the GFC and its aftermath.
In his latest New York Times article, Krugman claims that statements that his lack of concern about the size of the fiscal deficit during the crisis were:
… always conditional applying only to an economy far from full employment.
Now, he claims “full employment has been more or less restored” in the US. To which I just laughed.
Please read my October 2016 blog – The US labour market is nowhere near full employment – for more discussion on this point.
The situation has deteriorated slightly since I wrote that blog three months ago.
But leaving aside the reality of his assumption, why does it matter that the economy is at full employment or not in terms of whether fiscal deficits matter or not?
… once we’re close to full employment? Basically, 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.
And then the usual ‘progressive’ (not!) dodge – well even then “government borrowing can still be justified if it serves an important purpose”.
And the partisan, the Republicans are “going to blow up the deficit mainly by cutting taxes on the wealthy”.
The substantive point is that Krugman is just channelling the simple-minded IS-LM textbook analysis here.
My response in point form:
1. Increased fiscal deficits do not force a competition for funds between the government and the private sector. There is no finite pool of savings that the government drains at the expense of private borrowing – this is the old, pre-Keynes ‘Loanable Funds’ doctrine that was categorically refuted by Keynes in the 1930s, but still rears its ugly head.
The fact that Krugman intones it tells you everything – he hasn’t a progressive macroeconomic bone in his body! He is a neo-liberal masquerading as someone who knows something about macroeconomics.
2. Interest rates are not driven up by on-going fiscal deficits.
3. On-going fiscal deficits at full employment do not “crowd out” private investment.
The loanable funds doctrine, which Krugman adheres to, is an aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.
It 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.
Thus, it was argued that aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality. A denial of the business cycle and mass unemployment no less!
Underpinning 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.
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 is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates up in order to ‘clear’ the loanable funds market. This chokes off investment spending.
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 budget deficit) and pushing up interest rates which damage private investment.
As noted above, this is the core IS-LM approach.
But the starting point for a sensible macroeconomics is that private saving is a positive function of national income.
A $X rise in net government spending (that is, the deficit) initially adds $X to national income. Why? Because
spending equals income. Therefore, saving must initially rise.
What happens next depends upon the size of the expenditure multiplier, which is the extra induced consumption spending that follows an initial rise in national income in response to an initial injection of aggregate demand.
The initial response to a spending stimulus is to increase output and income, which is then the basis for further rounds of consumption spending, given the latter is a positive function of income.
At each further round of spending, income rises as does private saving.
There are further reasons for eschewing the use of IS-LM as a central organising framework for analysis.
The central bank does not control the money supply. The reality is that the central bank sets the so-called official, policy or target interest rate. This is the rate at which they are prepared to provide funds to the banking system on an overnight basis.
This rate then determines the interbank rate that banks apply a margin to, which determines the cost of loans. The interbank rate is just the rate that banks lend to each other to ensure the payments system is stable on a daily basis.
The cost of loans influences the demand for them from private borrowers. Banks then lend to credit-worthy borrowers by creating deposits. The banks then seek the necessary reserves to ensure the withdrawals from the deposits are honoured by the payments system.
While the banks can get the necessary reserves from alternative sources, the central bank supplies reserves on demand to ensure there is financial stability and that they can maintain control of their policy interest rate.
If there is a shortage of reserves, then the competition in the interbank market between the banks for funds will drive up the short-term interest rate above the policy rate and the central bank would lose control of its policy rate. In these cases, the central bank will always supply reserves at the policy rate to maintain control over its policy settings.
Alternatively if there are excess reserves, the banks will try to loan them to other banks at discounted rates and the short-term interest rate would drop to zero. Hence the central bank will either drain the excess by selling interest-bearing government debt or it will pay a return on the excess reserves that eliminates the interbank competition.
These operations tell us that:
- In a modern monetary system, loans create deposits and banks do not store up savings in reserve deposits to loan out. Banks will always provide loans (and hence deposits) on demand from credit-worthy borrowers and then accumulate the necessary reserves to ensure that all transactions will settle within the payments system (where reserve accounts banks hold at the central bank are adjusted to match all the cross bank transactions each day) – so that cheques do not bounce.
At any rate, total savings in the economy increase with national income, which leads to the insight that increasing spending (by government or non-government entities) not only increase income but also increase savings. Under these conditions, There is no finite pool of savings that increased government spending absorbs which then drives up interest rates to the detriment of private investment and there can be no crowding out.
- The demand for credit depends on the state of economic activity and the level of confidence in the future.
- Bank lending is not constrained by reserve holdings. The reserves are added on demand by the central bank where needed.
- Rather than driving the money supply, the monetary base responses to the expansion of credit by the banks.
- This process means the money supply is endogenously determined and the central bank has no real capacity to maintain any quantity-targets.
The fact that the money supply is endogenously determined means that one arm of the IS-LM framework (the ‘LM curve’) becomes horizontal at the policy interest rate.
Avoiding being technical, this just means that shifts in the ‘IS curve’ driven by rising government spending do not impact on interest rates, within that framework.
A central feature of the IS-LM framework, thus, has no application to the real world.
Why did Krugman think that at below full employment the deficits didn’t matter?
The answer is that he believed the LM curve to be flat in that range (horizontal) because of the presence of liquidity traps, which vanish at higher levels of employment.
I wrote about his misuse of the term ‘liquidity trap’ in these blogs:
1. Whether there is a liquidity trap or not is irrelevant (July 6, 2011).
2. The on-going crisis has nothing to do with a supposed liquidity trap (June 28, 2012).
Essentially, whether there was a liquidity trap or not – and there was no evidence of one given the strong demand for government bonds during the crisis – the failure of the central bank to control the money supply negates Krugman’s insight anyway.
Of further importance is that fact that the IS-LM framework leaves out issues relating to uncertainty and probability that Keynes saw as being crucial in the way long-term expectations were formed.
Investment, among other key economic decisions, is a forward-looking process, where firms form guesses about what the state of aggregate demand will be in the years to come.
So shifts in short-run interest rates are unlikely to impact on investment spending in the current period. Those decisions were made in past periods.
The 1990s Japanese debacle
Paul Krugman has history. Think back to the 1990s in the aftermath of the massive property market collapse in Japan, which started that nation’s long period of slower growth (but still low unemployment) and elevated fiscal deficits (with zero interest rates).
During the Japanese ‘lost decade’, Paul Krugman dramatically failed to understand the nature of the problem and recommended a reliance on monetary policy.
We know that during a liquidity trap monetary policy loses any effectiveness because no-one wants to borrow and everyone wants to hold cash. Cutting interest rates will not reverse the decline in aggregate demand (spending).
Back in 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 the following article.
When I read that back then, I realised that he didn’t understand what was going on in Japan at the time.
He clearly recognised then that a spending gap (in Japan) was responsible for the economic slowdown and that low nominal interest rates were not providing a stimulus.
However, in that article, he revealed his biases against fiscal policy by saying it would possibly work but that “there is a government fiscal constraint” and the Japanese Government would only be wasting its spending.
But there was no fiscal constraint in ‘financial’ terms (being able to get funds to spend).
At the time, Krugman said that monetary policy in Japan 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.
He was completely wrong at the time. The only thing that got Japan moving again in the early part of this century was fiscal policy, once the Japanese government rejected the neo-liberal advice it was receiving and reversed the 1997 austerity push.
As Richard Koo said in his 2003 book – Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications:
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.
Blowing in the wind
We shouldn’t be surprised by anything Paul Krugman says – he blows with the wind.
An article published in the Economic Journal Watch in May 2010 – When the White House Changes Party, Do Economists Change Their Tune on Budget Deficits? – by Brett Barkely, studied “selected economists to see whether their tune on deficits changes when the party holding the White House changes”.
While the basic tenet of the writer is poor (“Large budget deficits represent a burden on the future, and debt acc- umulation eventually poses great problem”) his research strategy was not influenced by that.
He examined the writings of “17 prominent economists” spread across the political divide. They were all variously “U.S. recipients of the John Bates Clark Award … U.S. recipients of the Nobel Prize in Economics … members past and present of the Council of Economic Advisers”.
He conducted a textual analysis from 1981 to the end of 2009 (5 Presidencies) and sought to isolate comments made about fiscal deficits by these economists.
He then evaluated “whether each economist changed his or her position on the budget deficit” when the party of the President changes.
At the top of his list was Paul Krugman (99 unique commentaries about fiscal deficits) and the only economist of the 17 to “significantly” change his tune between political regimes.
The analysis of Krugman’s ‘political’ tune switching provided for in the article (I will leave it to you to read if interested) is hysterical – blows with the wind.
This analysis wasn’t the first time Paul Krugman had been accused of shifting position. A previous analysis – Left Out: A Critique of Paul Krugman Based on a Comprehensive Account of His New York Times Columns, 1997 through 2006 – found that in his 654 “New York Times columns 1997 through 2006”:
The pattern of policy positions and arguments do not square with his purported concern for general prosperity and the interests of the poor.
The authors of that article also display ideological biases towards neo-liberal views and attack Krugman for being in violation of those views, which is to his credit. But, they also convincingly demonstrate how Krugman shifts in his views to favour a “Democratic partisan” position at the expense of consistency.
Deficits always matter
The problem with the blogosphere and social media is that, in their enthusiasm, participants deal in half-truths. The discussions I get sent about MMT confirm that there is a lot of misinformation out there including the claim that MMT thinks that deficits do not matter.
Well unlike Paul Krugman, the MMT position (from its original exponents) is that DEFICITS ALWAYS MATTER.
I outline the reason in this blog – The full employment fiscal deficit condition.
1. Deficits have to fill spending gaps left by the saving overall of the non-government sector.
2. These spending gaps do not disappear at full employment without government action.
3. Depending on the spending decisions of the private domestic and external sector (a positive net saving desire), an on-going fiscal deficit of some size relative to GDP will always be required to avoid recession.
4. A nation running an external deficit, will always have to run fiscal deficits if the private domestic sector desires to save overall. National income adjustments will ensure that is the case and it is better that the deficits are discretionary and sustaining full employment rather than be ‘bad’ deficits that are driven by the automatic stabilisers are recessed levels of national income.
So, please – internalise it – deficits always matter. It is just a matter of choosing how large the deficit (or surplus in some rare occasions) should be.
In his own words, Paul Krugman’s latest article makes it clear where he stands within the economics profession.
He is part of the problem – adhering to a flawed, neo-liberal macroeconomics, that prevents full employment from being sustained.
To cover that, he also engages in the neo-liberal dodge that the US is at full employment already despite the majority of the jobs that have been created since the GFC being low-pay and precarious and despite the collapsed participation rate.
For those who follow my Twitter feed, know that yesterday I took the first step in creating a new educational organisation – the MMT University.
It is early days yet and I need to bring together a number of resources to make it happen. I have a good start already but we will see.
I do not intend at this stage to seek formal accreditation (from any national authority) as a degree-conferring educational institution.
Rather I plan to provide a vehicle to advance education in Modern Monetary Theory (MMT) by providing modular short-courses in theory and policy.
I will need to cover costs and we are working on a ‘business model’ right now, which will tell us how large tuition fees might have to be to make it sustainable. I expect they will be low and the aim is to make the access as inclusive as possible.
If anyone out there wants to pledge some funding as a capital injection please E-mail me. We need as much help as we can get.
More later on this project. I think it will be fun – sort of a return to Anarcho-Syndicalism – at least the worker education aspects of that.
That is enough for today!
(c) Copyright 2017 William Mitchell. All Rights Reserved.