Let’s get right to the point here. Paul Krugman is talking MMT again. And while it’s clear that he’s making a more concerted effort to understand MMT I still think he’s making some pretty seriously flawed assumptions in addition to working from a fundamentally flawed understanding of modern banking.
First of all, Dr. Krugman doesn’t particularly like my “manifesto” on MMT (which actually isn’t a MMT manifesto, but just a description of the monetary system from a market practitioner’s perspective. It happens to overlap with some MMT and Post-Keynesian economics in some segments such as the endogenous money section, but I would not call the paper a “MMT manifesto” since I disagree with MMT on several points). Now that that’s out of the way, I do think he’s misinterpreting MMT. He says:
“First of all, yes, I have read various MMT manifestos — this one is fairly clear as they go. I do dislike the style — the claims that fundamental principles of logic lead to a worldview that only fools would fail to understand has a sort of eerie resemblance to John Galt’s speech in Atlas Shrugged — but that shouldn’t matter.”
This reminds me a bit of Scott Sumner’s recent comments on MMT where he said he couldn’t quite understand MMT and that he believed it focused a bit too much on reality. I won’t rehash that conversation as we had a pretty lively discussion the first time around, but I think it’s pretty safe to say that one of the primary problems with economics these days is that we are relying largely on mythical beliefs that simply do not apply to our reality (much more on this below). The failures of the US economy are largely predicated on these myths that have been carried over from our days on the gold standard.
In building up his argument, Dr. Krugman creates a hypothetical scenario where bond buyers just disappear. He says:
“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.”
Okay, this is a lot like saying that life on Earth will end when the Earth stops orbiting the sun. This is probably true, but the key to understanding the demise of life on Earth is not the fact that Earth stops orbiting the sun. It’s discovering what causes the Earth to stop orbiting the sun. Dr. Krugman is just conveniently skipping a step in the sequence of events. It creates a convenient launching point for him to jump into the rest of his argument.
Unfortunately, his argument appears to me like a modified version of the hyperinflation environment (which he admits it is). We see this all the time when hyperinflationists say that interest rates will magically surge in the USA. In fact, Ken Rogoff said this exact point to Dr. Krugman in an interview on CNN this weekend. This argument is based on a fundamental misunderstanding of currency users and currency issuers and how the central bank sets its interest rates. Niall Ferguson has literally been making this argument for the entirety of a decade. Do you know how many fixed income hedge funds he could have imploded in that time? My guess is more than a few….The point is that you can’t just skip this essential step in the sequence without providing evidence for why it might occur. In addition, as I’ve covered quite thoroughly, there’s very little historical proof that shows hyperinflation to be a purely monetary event. In almost every case of developed market (or even emerging market) hyperinflation the trigger is an extreme exogenous event and not merely the printing of money.
The rest of his argument contains several other false assumptions though. His hypothetical assumes that MMTers would just run 10% budget deficits (or very high deficits) for eternity. This not only assumes automatic stabilizers wouldn’t function to help balance the budget, but it also assumes that MMTers are in favor of just running massive budget deficits regardless of the environment. Again, these are misrepresentations of the MMT position.
A few paragraphs later Dr. Krugman shows his fundamental misunderstanding of modern banking:
“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. “
Banks are never reserve constrained. The money multiplier that Dr. Krugman is referring to here is simply not the way a modern banking system works. This has been covered thoroughly by Fed officials AND the BIS. Banks lend to creditworthy customers. They do not lend based on the amount of reserves they carry at any time. Liquidity trap, balance sheet recession, booming economy – it doesn’t matter. This is simply a fact of modern banking. Banks are never reserve constrained.
Finally, Dr. Krugman assumes that bonds are necessary to “sterlilize” current spending. This falsely assumes that bonds are less inflationary than cash. This is a version of sorts of the QE2 argument that Ben Bernanke made (the same one that failed to fantastically). Dr. Scott Fullwiler explains the simple fact why this is false:
“no, a deficit financed by “money” is NOT more inflationary than a deficit financed by bonds. There’s a very simple reason for this–it is operationally impossible to finance a bond issue with “money” unless you have a zero interest rate target, in which case in your own paradigm you are in a liquidity trap. To achieve a positive interest rate target while printing “money”, the Fed would have to pay interest on reserve balances created by the deficit–which would leave the monetary base and t-bills as perfect substitute in your own paradigm. Please demonstrate how it is operationally possible for your scenario to occur.”
All in all, I think it’s fantastic that Dr. Krugman is taking the time to look into MMT and hash out his issues with it. There are many overlapping areas of agreement between Dr. Krugman’s work and my own (which is not technically MMT at all). But MMT is not the enemy he should be using his ammunition on. For instance, Dr. Krugman agrees that this economy can afford more stimulus and certainly needs it. But his purely left wing Keynesian position doesn’t provide him the flexibility to see that what we really need is higher budget deficits and hence, higher private sector net financial assets. How we get there is of little consequence given the political environment of late (which absolutely will not allow further spending). But Dr. Krugman rejects our pleas for lower taxes on grounds that the Republicans won’t allow it (I think there’s a more political argument underneath the surface there as tax cuts are a rather Republican policy, but that’s just one guy’s opinion).
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.