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.