Paul Krugman, well-known for his opposition to the austerity concerns of the deficit terrorists and his advocacy of additional Government stimulus to lower unemployment and end the recession, just ignited a paradigm conflict which promises to clarify for many, the issues dividing “deficit doves” like Paul, from economists who take a Modern Monetary Theory (MMT) approach to economics, which holds, among other things, that Government deficits and surpluses are not, in themselves important, and that Government spending has to be evaluated relative to its impact on public purposes. Paul said:
”Right now, the real policy debate is whether we need fiscal austerity even with the economy deeply depressed. Obviously, I’m very much opposed — my view is that running deficits now is entirely appropriate.
“But here’s the thing: there’s a school of thought which says that deficits are never a problem, as long as a country can issue its own currency. The most prominent advocate of this view is probably Jamie Galbraith, but he’s not alone.”
I don’t think that’s quite what Jamie or the other Modern Monetary Theory (MMT) economists say either in his testimony, or elsewhere, and that the qualification in Jamie’s formulation that Paul neglects is an important one. What Jamie and the MMT school say is that as long as a Government can issue its own currency, and has not incurred debt in foreign currencies making it subject to its bankers, then it can never default on its debts, because it has “run out of money” (become insolvent). It can voluntarily decide to default, i.e. refuse to spend to fulfill its obligations, for various political reasons. But if it has an understanding of its real monetary powers and the will to persist, it can never be forced to default because of decisions made by banks, other nations which hold its debts, or international credit agencies which either foolishly or malevolently, downgrade its credit even though it cannot default. So, Governments sovereign in their own currency never present any solvency risk to investors, or to creditors they’ve made promises to, however great their deficits or national debts may be.
Paul goes on to say:
”Now, Jamie and I are, I think, in complete agreement about what we should be doing now. So we’re talking theory, not practice. But I can’t go along with his view that
So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system.
OK, I don’t think that’s right. To spend, the government must persuade the private sector to release real resources. It can do this by collecting taxes, borrowing, or collecting seignorage by printing money. And there are limits to all three. Even a country with its own fiat currency can go bankrupt, if it tries hard enough.”
I’m not sure what Paul means by “real resources.” But if he means non-financial resources, then I think the problem is one of getting the private sector to accept Government fiat money in return for those ‘real” resources. Why will the private sector go along with this “as long as the Republic exists . . .”? Because the private sector needs Government fiat money to pay its taxes, since that is the kind of payment the Government requires. As long as it needs Government money for this purpose, it can be “persuaded” to exchange it for resources.
If Paul includes financial resources in the category of “real resources,” then the Government can tax or borrow to get the private sector to release some of its financial resources. But when it creates money itself, it’s not persuading the private sector to release financial resources, only non-financial resources.
Here’s Paul again:
”Let’s think in terms of a two-period model, although I won’t need to say much about the first period. In period 1, the government borrows, issuing indexed bonds (I could make them nominal, but then I’d need to introduce expectations about inflation, and we’ll end up in the same place.) This means that in period 2 the government owes real debt service in the amount D.”
The Government doesn’t have to issue debt if it spends in period 1. If it chooses not to, it won’t owe real debt service in period 2. So any further argument based on the inference that Government must owe debt service in period 2 is questionable.
Paul goes on to talk about how that debt service may be fulfilled. He mentions that the Government can get a surplus of current revenue relative to current spending, but also asks us to imagine constraints on that possibility, and then brings up the “printing press.” He says:
”But the government also has a printing press. The real revenue it collects by using this press is [M(t) - M(t-1)]/P(t), where M is the money supply and P the price level.
”What determines the price level? Let’s assume a simple quantity theory, with the price level proportional to the money supply:
P(t) = V*M(t)”
I think there’s a little slipperiness here. First, there’s the assumption that there must be borrowing and debt service, and therefore “debt.” This assumption becomes very important to Paul’s argument later. Second, Paul shifts the ground by talking about “real revenue” and defining it as above. The debt service obligations of the Government are satisfied by nominal revenue, not “real revenue,” if by this Paul means revenue adjusted for price. Third, Paul’s expression for real revenue deflates the change in quantity of money by the price at time t, but why not by the change in price (P(t) – P(t-1)? In other words, why isn’t he looking at the change in real revenue, rather than a change expression biased toward time (t)? Fourth, he asserts that P(t) is determined by M(t) scaled by a proportionality constant “V.” But what is “V”? He doesn’t say. But another, more complete formulation of the Quantity Theory of Money by Bill Mitchell is:
”. . . MV = PY, where M is the stock of money, V is the velocity or the times the stock turns over per measurement period, P is the price level and Y is the real output level.”
Looking at this expression, and re-arranging so that we get: P/M = V/Y we see that Paul’s proportionality constant “V” = V(velocity)/Y(Real Output). As Bill Mitchell says, to work with the quantity theory, economists have to assume that velocity is constant at a particular point in time, and that Real Output refers to that value at full employment so that it too is a constant. Only then, is price a simple function of the money supply.
However, velocity is generally not constant but varies widely in any economic system. And, in addition, Real Output at full employment is not the condition assumed in the Modern Monetary Theory formulations Paul is criticizing. In formulations such as Jamie’s, Government spending is needed because the non-Government sector is running a surplus and this is causing low aggregate demand and unemployment. In short, the quantity theory, given its assumptions, is only applicable when an economy reaches full employment. Only then will its application predict price inflation if Government deficit spending continues.
However, MMT also predicts that inflation becomes a danger when the economy reaches full employment, so the question is, what is Paul trying to say that is different from what Jamie and other MMT economists would say? Well after presenting his model in a little more detail, and a graph showing the inflation rate increasing to infinity when debt gets too great, his conclusion is:
”So there is a maximum level of debt you can handle. In practice, if it makes sense to say such a thing with regard to a stylized model, at some point lower than the critical level implied by this model the government would decide that default was a better option than hyperinflation.
“And going back to period 1, lenders would take this possibility into account. So there are real limits to deficits, even in countries that can print their own currency”
And comparing this to his earlier quote from Jamie above, we see that this conclusion postulates hyperinflation and voluntary default as issues that can come up, but not as Jamie says, “insolvency,” or “bankruptcy,” if by this one means running out of money rather than voluntary default. But what about “high interest rates” and the Government’s inability to borrow? Doesn’t Paul have a point here?
I think not. It’s Paul who constructs the situation as one in which the Government must borrow and perform debt service, and it is he who assumes that the interest rates the Government will pay will be determined by the market. Jamie and the MMT theorists make no such assumptions. That is why Jamie says: “. . . the government can and does spend without borrowing if it chooses to do so . . . “ and also that “ … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system.” In other words, to successfully meet this point of Jamie’s, Paul needs to discuss the situation of increasing deficits, rather than the situation of increasing debt, and then show that the hyperinflation that would accompany very high deficits could make the Government insolvent. Instead, however, he shifts the ground of the argument and ends up claiming that the money supply and the debt could reach levels high enough that the resulting price increases would induce the Government to voluntarily default even while it retained the authority to credit private sector accounts to pay obligations in its own currency.
This, of course, could very well happen, since leaders are free to do all sorts of things they are not forced to by actual constraints on their authority or capability. But it is the hyperinflation issue Paul is raising here, and not the issue of solvency risk which Jamie was speaking to and which Paul himself originally raised in his blog post.
After Jamie and others responded to Paul’s post, many claiming that Paul had distorted MMT, and Jamie showing that there were wide areas of agreement between them, and also that increases in the quantity of money would not flow directly into price increases in the absence of full employment, Jamie ends with:
”My position is that the government should focus on real problems: unemployment, care for the aging, energy, climate change, and the disaster in the Gulf of Mexico.
”The so-called long-term deficit is not a real problem. And the capital markets demonstrate every day that they agree with this judgment, by buying long-term Treasury bonds for historically-low interest rates.”
To which Paul responded:
”My response: there’s no question that right now there is no problem: if the Fed issues money, it will in fact just sit there. That’s what happens when you’re in a liquidity trap. And there’s also no question that right now, the proposition that the government can “create wealth by printing money”, which some other commenters call absurd, is the simple truth: deficit-financed government spending, paid for with either debt or newly created cash, will put resources that would otherwise be idle to work.
”But we won’t always be in this situation — or at least I hope not! Someday the private sector will see enough opportunities to want to invest its savings in plant and equipment, not leave them sitting idle, and the economy will return to more or less full employment without needing deficit spending to keep it there. At that point, money that the government prints won’t just sit there, it will feed inflation, and the government will indeed need to persuade the private sector to make resources available for government use.
”And that’s why I don’t accept the idea that deficits are never a problem.”
Of course, as Scott Fullwiler replied to Paul, this conclusion and also Paul’s first post both set up a “straw man,” because Jamie never claimed that deficits are never a problem, and even pointed to circumstances (conditions of full employment) where deficits could lead to inflation. Given the comments on Paul’s first blog, including a very clear comment by Marshall Auerback, it should have been clear to him that he was distorting the position of both Jamie and MMT. But evidently, Paul didn’t want to admit that.
Jamie himself responded to Paul by calling attention to their very close agreement on what ought to be done to end the Great Recession. But then he asks the key political question of the coming months: “Should we, or should we not, act *today* to cut *projected* deficits at some future date?” Say by cutting Medicare and/or Social Security or other valued programs. And Jamie answers that question with a resounding “no.” And adds that there’s no economic reason to cut these programs, that the forecasts suggesting large deficits and high interest rates after a full employment recovery are inconsistent, implausible, and contradictory, that good policy can’t be based on bad forecasts, and that we ought to solve the unemployment problem first and then, as in the 1990s tax revenues will rise and deficits will shrink. And then he ends with:
”Paul, I challenge you to drop the long-term deficit argument entirely — it will be used in a few months, in a dishonest way by unscrupulous people, to support cuts in Social Security and Medicare that cannot be justified by economic logic. These are cuts which, I am sure, you will oppose when they are proposed.
”Don’t set yourself up.”
Of course, here Jamie is referring to the deficit terrorist coalition in Washington, DC led by Peter G. Peterson, and his network of organizations, and now also encompassing CNN, The Washington Post, many in Congress and key elements in the Administration, apparently including President Obama. The deficit terrorists have been taking the line lately that now is not the time for spending cuts and perhaps even is a time for further stimulus, but that we must plan for reducing deficits now, and must establish a legislative framework to enact and implement cuts in future years that will keep us on an incremental course toward eventual surpluses. And they called for shared pain and even across the board spending cuts including entitlement programs to place us on a long-term path of deficit reduction without reference to the public purposes that Government needs to and ought to fulfill in the future.
Of course, Jamie and the MMT economists are opposed to the very idea, the very framing of Government’s role in the economy in a way that makes everything subject to deficits, national debts, and debt-to-GDP ratios. The position of MMT is that these numbers are just endogenous consequences of real economic activity including Government fiscal activity, and that it is this activity that ought to drive them and not the other way around. In their view, and in mine, as well, the role of Government in the economy is to spend to enable people to fulfill what Jamie’s father called “the public purpose.” As Jamie says: “. . . the government should focus on real problems: unemployment, care for the aging, energy, climate change, and the disaster in the Gulf of Mexico.” It should not be spending time and resources worrying about a long-term deficit crisis that is nothing but a fantasy.