The Clock Runs Down on Mainstream Keynesianism

(Bloomberg Opinion) -- A couple of weeks ago, Paul Krugman decided to write about modern monetary theory. He didn’t cite the scholarly literature written by any of the academic MMT economists  (books, book chapters, published articles or an abundance of other writings).

Instead, he declared that MMT was pretty much just the economist Abba Lerner’s “Functional Finance” approach from the 1940s and offered a critique of Lerner that he maintained was effectively a critique of MMT. I pushed back, situating modern monetary theory in a broader intellectual history.

Krugman returned, accusing me of moving the goal posts and asking for straightforward answers to four questions. I responded with what I thought was a well-reasoned, respectful and direct set of answers.

So-called “finance twitter” buzzed as the tension between mainstream Keynesian analysis and MMT was put on display. Krugman then took to Twitter with a series of tweets calling my analysis “a mess” and declaring MMT to be “a losing game.” He also reminded us of his own record when it comes to “denouncing austerity policies.”

I want to address what Krugman claims I got wrong and also compare the record.

I argued that deficits put downward pressure on interest rates. Krugman says I got that wrong. The standard line – Krugman’s line – is that deficits normally lead to rising interest rates. I argued that deficits actually put downward pressure on the interest rate and that policymakers have to fight against this natural gravitation by doing something to prevent the overnight rate from dropping toward zero. This is really just basic supply and demand.

It helps to break the argument into a two-part thought experiment. First, think about what happens if the government is running huge budget deficits. As I explained, these deficits would result in a massive injection of reserves into the banking system. Unless something is done to prevent it, banks will scramble to offload the excess funds in the overnight market. But with massive supply and no demand for these balances, the overnight bid heads toward zero.

Krugman stops the story here and claims I’m wrong because we can see, empirically, that the monetary base doesn't increase with the debt. This is because he’s not recognizing that something is done to prevent the base from permanently increasing.

What is done? The government is coordinating its deficit spending with bond sales, thereby doing a reserve drain (selling bonds) along with a reserve add (deficit spending), so that the newly injected reserves are quickly transformed into newly added Treasuries. The bond sales are done to coordinate the impact so that the government’s fiscal operations don’t leave the banking system with a larger monetary base (and lower interest rates).

But this is fighting against the gravitational effects on the interest rate. Deficit spending pushes down on the overnight rate, and bond sales pull it back up. When bond sales are perfectly coordinated with deficit spending, the opposing forces cancel out, leaving the monetary base looking stable as Krugman’s graph shows.

To finish the thought experiment, consider what would happen if Congress decided to dispense with Treasury auctions and simply allow budget deficits to supply the system with base money instead of Treasuries. Clearly, that would drive the overnight rate to zero. If it wanted to, the Fed could still achieve a positive overnight rate, simply by paying “interest on reserve,” or IOR, balances. That, too, would be fighting against the natural tendency for rates to go to zero.

I understand why this makes no sense to Krugman. The crude, IS-LM interpretation of Keynes demonstrates that, under normal conditions, an increase in deficit spending will push up interest rates and lead to some crowding-out of investment spending. There is no room for a technical analysis of monetary operations in that framework. For Krugman, the model is simple but useful.

He used the same model to fight the deficit scolds, who were pushing austerity during the Great Recession. (And he deserves credit for being on the right side of that debate!) But his defense of deficits was always contingent on being in a depressed economy, where he argued that monetary policy had become largely powerless (a flat LM curve) due to the zero lower bound (ZLB) so fiscal policy needed to do more to help the economy recover. Now that the economy has escaped the ZLB, Krugman has returned to warning that “deficits matter again.” In his words:

What changes 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.

He then goes on to say that “by crowding out investment,” deficit spending “will somewhat reduce long-term economic growth.”

This follows directly from his model, and these are the arguments I disputed in my most recent reply. Our differences derive from our different analytical frameworks: Mainstream Keynesian versus MMT.

In the U.S. context, modern monetary theory begins with the observation that the currency itself is a simple public monopoly. From the earliest stages of the project (mid-1990s), MMT held that currency regimes matter. MMTers argued that governments cannot become insolvent when they borrow in their own non-convertible currencies and that the currency issuer never has to accept “market-determined” interest rates.

We explained that Social Security faces no long-term financial crisis and warned that the budget surpluses in the Bill Clinton administration were unsustainable. We warned of the housing bubble before it burst. We explained that quantitative easing wouldn’t be inflationary. We knew Reinhart and Rogoff were wrong about deficits and growth even before the Excel spreadsheet error was discovered.

We warned that the euro was susceptible to a debt crisis. And, once the crisis occurred, we insisted that the U.S. could never end up like Greece.

Krugman calls MMT “a losing game,” and he urges us to remember “all those articles I wrote” over the previous years.

I sampled those articles, and here’s some of what I found.

On Social Security, he asks, “Where is the crisis? Just over the horizon.” And then he warns, “While the present generation of retirees is doing very nicely, the [Social Security] promises that are being made to those now working cannot be honored.”

He called our nation’s finances “a fiscal train wreck” and confessed, “I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.”

He insisted that the U.S. faces, “a looming fiscal crisis,” adding, “the only question now is when foreign investors, who have financed our deficits so far, will decide to pull the plug.”

He mused about the potential for accelerating inflation under quantitative easing, writing that the Fed is, “printing $1 trillion of money, and using those funds to buy bonds. Is this inflationary? We hope so!”

He asked, “couldn’t America still end up like Greece?” answering, “Yes, of course. If investors decide 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.”

And he puzzled over the different interest rate environments in Japan and Italy, asking, “Why are the interest rates on Italian and Japanese debt so different?” confessing, “I actually don’t have a firm view. But it seems to be an important puzzle to solve.”

No economist is going to get everything right. But the odds of getting things right improve dramatically when you’re working with a macro framework that doesn’t lead you astray. The IS-LM framework is a gadget that will often align with sensible real-world analysis. It may perform better than a stopped clock, but it is no match for MMT.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephanie Kelton is a professor of public policy and economics at Stony Brook University. She was the Democrats' chief economist on the staff of the U.S. Senate Budget Committee and an economic adviser to the 2016 presidential campaign of Senator Bernie Sanders.

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