Paul Krugman first wrote about modern monetary theory on March 25, 2011. He last wrote about MMT in a two-part series on February 12–13, 2019. Although he’s had almost a decade to come to terms with the approach, he is still getting some of the basic ideas wrong.
This matters for two reasons: one, because people listen to Paul Krugman, who won the Nobel economics prize in 2008, and, two, because the approach he is discussing is at the heart of how to design economic policies that affect millions of Americans. I’d like to try to move the conversation forward by addressing his concerns.
He begins by saying, “MMT seems to be pretty much the same thing as Abba Lerner’s ‘functional finance’ doctrine from 1943.” Krugman then sets out to critique Lerner’s functional finance, which he says “applies to MMT as well.”
It’s actually not correct to say that modern monetary theory is pretty much the same thing as Lerner’s functional finance. MMT draws insights and inspiration from Lerner’s work — including his “Money as a Creature of the State” — but the American academics who are most associated with MMT would argue that the contributions of Hyman Minsky and Wynne Godley are at least as important to the project, and probably more so. So, a critique of functional finance is not a critique of MMT but a critique of one component part of the broader macro approach.
But let’s go ahead and examine what Krugman thinks MMT — er, Abba Lerner — gets wrong. For those who aren’t familiar with Lerner’s approach, here’s the thumbnail version: The government should use its fiscal powers (spending, taxing and borrowing) in whatever manner best enables it to maintain full employment and price stability. Basically, he’s saying Congress, not the Federal Reserve, should have the dual mandate.
Lerner abhorred the doctrine of “sound finance,” which held that deficits should be avoided, instead urging policymakers to focus on delivering a balanced economy rather than a balanced budget. That might require persistent deficits, but it might also require a balanced budget or even budget surpluses.
It all depends how close the private sector comes to delivering full employment on its own. In any case, the government should focus on inflation and not worry about deficits or debt, per se.
Krugman says there are two problems with Lerner’s thinking and, by extension, MMT. “First, Lerner neglected the tradeoff between monetary and fiscal policy.”
Specifically, Krugman complains that Lerner was too “cavalier” in his discussion of monetary policy since he called for the interest rate to be set at the level that produces “the most desirable level of investment” without saying exactly what that rate should be.
It’s an odd critique, since Krugman himself subscribes to the idea that monetary policy should target an invisible “neutral rate,” a so-called r-star that exists when the economy is neither depressed nor overheating. For what it’s worth, research suggests the neutral rate “may be flat-out wrong,” and Fed Chairman Jerome Powell has admitted that the Fed has been too cavalier in relying “on variables that cannot be measured directly and which can only be estimated with great uncertainty.”
But Lerner wasn’t trying to use interest rates to optimize the economy. That was a job for fiscal policy. He argued that the government should be prepared to spend whatever is necessary to sustain full employment without raising taxes or borrowing.
Unless it risked creating an inflation problem, Lerner wanted the government to cut taxes or spend newly issued money and just leave it in the economy. But he also understood that this could cause interest rates to “be reduced too low…and induce too much investment, thus bringing about inflation.”
For that reason, Lerner suggested that the government might want to sell bonds in order to mop up excess money (reserves) to the point that the short-term interest rate rose enough to prevent excessive investment. Otherwise, the low interest rates brought about by rising deficits might “crowd in” more investment spending and overheat the economy. In other words, Lerner had a completely different way of thinking about the relationship between deficits, interest rates and the purpose of ‘borrowing.’
He was worried about the potential crowding-in effects of fiscal policy, not the crowding-out effects Krugman believes are part of an inherent tension—tradeoff—between fiscal and monetary policy. Lerner understood that deficits could drive interest rates down and spur too much investment, thus his support of bond sales to maintain higher interest rates. In this way, borrowing was not about financing deficits but hitting some desired interest rate. MMT agrees and makes the same point.
Krugman’s other objection is that Lerner “didn’t fully address the limitations, both technical and political, on tax hikes/or spending cuts” as a means of fighting inflation.
In fact, Lerner actually had quite a lot to say about this. Here’s the opening sentence to an entire chapter on the subject in his 1951 book “The Economics of Employment”: “We have now concluded our treatment of the economics of employment, but a word or two must be added on the politicsand the administration of employment policies in general and of Functional Finance in particular” (emphasis in original).