Warning – This is going to be another nerdy one. I apologize in advance.
Paul Krugman and Stephanie Kelton are two very good economists. They’re also people I’ve had fights with over the years. Not physical fights. Make no mistake – I am a big wimp, but I could kick both of their asses at the same time with one arm tied behind my back. But as someone who leans somewhat towards Post-Keynesian economics and is critical of both MMT (Kelton’s camp) and New Keynesian economics (Krugman’s camp) I’ve found myself in the middle of disagreements with them. So that naturally makes me the perfect person to untangle the most recent disagreement between them.
Now, this all started a long time ago and I think Paul Krugman has been swayed by MMT and Post-Keynesian ideas over the years. For instance, in 2011 several of us had been engaging with Krugman in a series of debates about currency sovereignty and endogenous money. Krugman was unsure of why Italy’s interest rates were rising while Japan’s were remaining low. MMT and Post-Keynesians had been explaining the difference for years – Italy didn’t control its own currency so there was credit risk embedded in the price of their bonds. Then, in November of 2011 Krugman changed his mind on this and started saying exactly what MMT and PK economists had been saying all along.
The second big change occurred more covertly. Me, Steve Keen and Scott Fullwiler had engaged Krugman on a series of back and forths about the importance of endogenous money and the myth of the money multiplier. We regularly pointed out the flaw in Krugman’s use of the IS/LM model and the fixed money supply. As the debates unfolded Krugman started using David Romer’s IS/MP model which includes endogenous money. He basically changed his model after the debates to accept for the fact that the money supply is endogenous.
These were not small changes. They were bigly. So, in the long-run war between the Post-Keynesians and New Keynesians, the Post-Keynesians seem to be winning some important battles. More recently, the war has picked up again as MMT has gained some press due to AOC and the Green New Deal. People are starting to ask how MMT will not only pay for the huge price tag of the program, but how they might control inflation if the program causes it. But I am not sure that MMT has advanced the ball much here. In fact, I think Krugman might be gaining ground and that MMT might have hurt itself a bit.
First there was the FT article from Friday that basically said MMT’s theory for controlling a government induced surge in inflation would be a massive increase in government intervention via price controls, regulations and a Job Guarantee. As I said the other day, this smells a heckuvalot like the playbook of many South American countries during the last 20 years. It is not a good playbook. Actually, it is a very bad playbook.
Second, there were Stephanie Kelton’s responses which I think muddied the waters more than anything else. Specifically, she answered 4 questions from Krugman:
#1 – Is there only one right deficit level? Kelton gets this one right. The deficit is mostly endogenous and is the result of the economic activity that occurs at any given time rather than something that the government can set with discretion.
#2 – Is there no ability to substitute monetary for fiscal policy? Kelton misses the mark here. She says:
“In a slump, cutting interest rates is weak tea against depressed expectations of profits. In a boom, raising interest rates does little to quell new activity, and higher rates could even support the expansion via the interest income channel.”
We know this is incorrect. For a fact. After all, the Fed is undefeated in causing recessions when they invert the yield curve. If raising rates added to output then inverting the yield curve wouldn’t always cause a recession. So, what we have here is a case of overreach, which MMT engages in far too often. They hate Monetary Policy so much that they want to terminate it almost entirely. That is irrational in my view. Then again, I do tend to think that Krugman and New Keynesians rely too heavily on Monetary Policy which is why we end up with things like QE. This is unfortunate and I think MMT is right to try to bring the focus back to fiscal policy more. But they overreach when they claim that Monetary Policy is totally ineffective. The empirical evidence just doesn’t support such an extreme position.
# 3 – Does expansionary fiscal policy reduce interest rates? Kelton engages in a classic MMT deception here. They argue that a deficit causes rates to fall because the deficit floods the reserve system with excess reserves which banks try to lend out. Since they can’t lend them out in aggregate this drives the rate to zero. So the Fed has to respond. In the post-crisis era the Fed sets Interest On Reserves thereby establishing a floor under rates.
This is all correct in a narrow sense, but MMT misleads people on how this actually works and the impact of the deficit. The reason a deficit causes rates to drop (without IOR) is because the Treasury uses an account at the Fed called the Treasury General Account. That account clears via reserves. So banks lose some reserves when a tax is paid and banks gain back reserves when government spends. But the deficit is not the actual cause of the reserve creation. The cause of the reserve creation is the result of the reserve system being a thing in the first place. In other words, the TGA is a RESULT of the reserve system and so spending is not the cause of driving rates down. After all, the only reason we have the TGA in the first place is because we have private banks and a reserve system.If there was no reserve system there would be no TGA and no need for reserves.¹
This point is worth emphasizing because it’s a crucial MMT mistake. It is not the deficit that puts downward pressure on rates. Non-interest bearing excess reserves (whether it is part of monetary or fiscal policy) always put downward pressure on rates because banks want to rid themselves of non-interest bearing reserves. This says absolutely nothing about the “natural rate” of interest on government debt and only tells us that profit seeking banks don’t like assets that don’t earn a profit.
MMT plays dirty pool with their treatment of the reserve accounting and it doesn’t help their cause.
#4 – Does MMT accept Krugman’s “straightforward framework”? Kelton strawmans Krugman here. As I described above, and as Krugman clarified in a later Tweet, he is no longer assuming a fixed money supply. Kelton appears to have missed this change in Krugman’s thinking over the years so her point falls flat.
This battle goes to Krugman, but the war is far from over.
¹ – The best way to think about this is to consider an alternative banking system where the Federal Reserve’s clearing system is consolidated into the banking system as a private clearinghouse with one bank. In this case this one bank would clear its deposit liabilities directly with the US Treasury. There would be no need for reserves and the lending of reserves putting pressure on rates. Instead, the rate on deposits and the cost of selling liabilities to banks and non-banks would be whatever the counterparty demands in exchange for market making services and the real cost of funding.
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.