Wednesday , March 27 2019
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Wrong in a very confusing way

Summary:
There are lots of macro models out there: old monetarism, market monetarism, old Keynesianism, new Keynesianism, supply-side economics, Fiscal Theory of the Price Level, NeoFisherism, Austrian, Real Business Cycle, etc., etc. People who believe in one tend to view the others as being at least partly wrong. But where they disagree, it’s usually possible to pin down some specific points of disagreement. MMT is not like that. In his Twitter account, Paul Krugman again tries to show what’s wrong with MMT, by pointing to a specific example of how very little of the national debt is financed by printing money. I’ve made similar arguments on a number of occasions, as has Nick Rowe and many other people. But I’m increasingly coming to the view that none of this will work.

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There are lots of macro models out there: old monetarism, market monetarism, old Keynesianism, new Keynesianism, supply-side economics, Fiscal Theory of the Price Level, NeoFisherism, Austrian, Real Business Cycle, etc., etc. People who believe in one tend to view the others as being at least partly wrong. But where they disagree, it’s usually possible to pin down some specific points of disagreement.

MMT is not like that.

In his Twitter account, Paul Krugman again tries to show what’s wrong with MMT, by pointing to a specific example of how very little of the national debt is financed by printing money.

I’ve made similar arguments on a number of occasions, as has Nick Rowe and many other people. But I’m increasingly coming to the view that none of this will work. MMT has constructed such a bizarre, illogical, convoluted way of thinking about macro that it’s almost impervious to attack. Krugman’s right that a reasonable person would view his evidence as demolishing their claims about fiscal policy—but it won’t be seen that way.

As far as I can tell, MMT created this monster by combining the following:

  1. Bizarre (and unconventional) definitions of terms.
  2. The tendency to confuse accounting relationships with causal relationships.
  3. Being wrong about basic questions of causality.

If it was just one problem, it would be easy to figure out how to attack the model. Thus Krugman is trying to present evidence that they are wrong about certain causal relationships. But because they define terms differently than the rest of us, this evidence will have no effect on their views.

For instance, normal economists would think about government spending being financed by a mixture of taxes, debt and money creation. AFAIK, MMTers think spending is paid for with money creation. When they describe their views in detail, however, it looks like they believe that spending is paid for with taxes, debt and money creation, not just money creation. They simply characterize that fact differently. So how to attack this view?

If you say, “You’re wrong, spending is paid for with some mix of money creation, debt and taxes,” they’ll respond, “no, it’s just paid for by money creation.”

If you bring to bear all sorts of evidence that implies that spending is paid for by all three, they’ll respond, “We know all that, it’s in our model. Taxes are used to drain money from the system to prevent inflation.”

I’m struggling to think of an analogy from everyday life—perhaps someone can help me. But try this:

I ask my friend, “Did you pay for that new car out of your savings, or did you have to borrow the money? And your friend responds, “Neither, I paid for it with a check”. You say, “I get that, but where did the money for the check come from?” And the conversation keeps going around in circles.

So one problem is their weird definitions, insisting that government spending creates money that pays for the spending, which is based (AFAIK) on a misinterpretation of the implications of an accounting relationship involving the Treasury account on the Fed’s balance sheet.

But there are substantive problems too. They seem to not understand that when nominal rates are positive, high-powered money is several orders of magnitude more inflationary than T-securities. (High-powered money is zero interest base money in a positive interest rate environment). They don’t seem to understand the Fisher effect, and instead assume that flooding the economy with base money drives interest rates to zero. While it’s true that you can flood the economy with high-powered money when the equilibrium nominal rate is zero, if it isn’t zero then you’ll create lots of inflation and thus much higher interest rates—as the UK discovered in the 1970s. Thus here is Stephanie Kelton, ignoring the Fisher effect:

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.

If you foolishly follow the “As I explained” link, you will find no explanation at all, merely a repetition of the bizarre claim that deficits lead to a massive injection of new reserves. (I think she is assuming a money financed deficit, but who knows?) And here is Kelton misrepresenting the views of Krugman:

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. 

I have often criticized Krugman, but I don’t think I have ever misrepresented his views so egregiously. Look how the QE quotation is taken out of context. Implying that Krugman was a QE/inflation scaremonger doesn’t even pass the laugh test. He’s probably the world’s most famous QE skeptic. He was merely pointing out that inflation was the goal of QE. Perhaps he thought it would produce a tiny amount of inflation, but it did!

So don’t tell me she’s just quoting Krugman. Her snarky “No economist is going to get everything right” tips her hand. She’s accusing Krugman of making lots of false predictions, in areas where MMT is “correct”.

MMTers would say that Krugman doesn’t understand the distinction between Italy using the euro and Japan having its own currency (with zero default risk.) In fact, it’s the MMTers that don’t understand that having your own currency doesn’t guarantee low rates if investors believe that the only way you’ll be able to handle your debt is via inflation.

FWIW, I suspect one difference is that Japan has far lower government spending than Italy, and thus more room (fiscal space) to raise taxes before relying on money creation. And Japan has less to worry about in terms of their best people moving to better run eurozone countries. But having fiat money is no cure-all. The UK discovered this in the late 1970s, when the IMF bailed them out. So Krugman’s puzzlement was not completely unjustified.

The quotes provided by Kelton don’t provide specific dates, and thus one can’t really say that Krugman was “wrong”. In fairness to Kelton, Krugman probably did think the day of reckoning was coming sooner than it has, but then during the 1990s very few people predicted the super low interest rates of the post-2008 period. That sort of mistake is hardly indicative of a flawed model.

PS. In the US, I expect the day of reckoning to take the form of higher taxes, not high interest rates/high inflation.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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