In a recent NYT post, “I Would Do Anything for Stimulus But I Wouldn’t Do That (Wonkish)”, Paul Krugman writes:
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.
In this passage, Krugman misinterprets Modern Monetary Theory (MMT) from the outset. MMT does not say “deficits are never a problem”. It is unlikely that any economist would be so silly as to say that.
Rather, the theory suggests that the appropriate level of deficit expenditure is that amount just sufficient to sustain full-employment output given private-sector net saving intentions. According to MMT, if deficit expenditure falls short of this level, there will be a demand gap and unemployment. If it exceeds this level, there will be inflation.
Krugman also understates the importance of the debate when he suggests it is only of theoretical interest, not practical importance. Neoclassical theory, based on the inappropriate assumption of a ‘government budget constraint’, suggests that budget deficits require higher future taxes to pay for them, otherwise there will be severe inflationary consequences. If this were so, anybody who is against higher future taxes or inflation would have reason to oppose budget deficits, even if the deficits serve other positive purposes such as boosting employment. MMT shows clearly, however, that taxes do not fund budget deficits in a fiat-money system, and so are not required to pay for past deficits. In MMT, taxation serves other purposes. It underpins demand for the currency, provides a degree of business-cycle stabilization, and creates space for public-sector activity.
… I can’t go along with [Galbraith’s] view that
So long as US banks are required to accept US 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.
Krugman is correct to say that “the government must persuade the private sector to release real resources” in order for the government to spend. In MMT, this is the fundamental purpose of taxation. By imposing a tax obligation on the private sector, the government creates a demand for the currency. The private sector must sell some resources (including labor resources) to the government in exchange for the fiat money it needs to meet its tax obligation. The tax obligation provides space for public-sector activity by limiting the private sector’s command over real resources.
During periods such as the present one in which there is high unemployment and excess capacity, there is no shortage of resources. The tax burden is already more than sufficient to free up resources for public-sector use. If, on the other hand, the economy were operating at full employment and society still desired an expansion of public-sector activity, it would then be necessary for the government to increase taxes and restrict private demand. Otherwise the extra demand for fully utilized resources would cause inflation.
Krugman then presents a simple model to illustrate a way in which budget deficits could lead to runaway inflation. He employs, in part, the quantity theory. Also implicit in his model is the neoclassical ‘government budget constraint’. The framework is inapplicable to a monetary system in which the government is the monopoly issuer of its own flexible exchange-rate fiat currency. In any case, he uses his model to argue that “the higher the debt burden, the higher the required rate of inflation”. The whole argument is irrelevant in a flexible exchange-rate system because the terms on which debt is issued, including the interest rate and time to maturity, are at the discretion of the currency issuer.
Krugman’s article drew a response from Galbraith, which Krugman reproduces in a follow-up post, “More on Deficit Limits”:
[Krugman’s] argument is that infinite inflation is a theoretical possibility. Well, yes. It happened in Germany in 1923.
There is no reason to cut Social Security benefits or Medicare now, with effect in the future, in order to avoid the theoretical possibility that some combination of policies might at some time in the future give us the economic conditions of post World War I Germany.
Those conditions were desperately resource-constrained.
From an MMT perspective, this is the correct explanation of hyperinflation. It is always preceded by a massive contraction in potential supply.
In the actual world we live in, government does not have to “persuade the private sector to release real resources.” In the actual world, the private sector has already released those resources by the tens of millions of people.
This statement is accurate whenever there is unemployment and excess capacity, which has been the normal state under capitalism. If, however, the economy were operating at full capacity and government intended to expand its activity, it would then be necessary to “persuade the private sector to release real resources”. But Galbraith (and also Krugman) are correct to observe that this is not at all the situation faced at the moment.
Under current circumstances, Galbraith points out:
All the government has to do, in the actual world, is mobilize those resources, which it does by issuing checks, preferably to pay people to do useful things.
It is the availability of unemployed labor and unutilized capacity that makes such expenditure feasible and hence “affordable”. That is the only real meaning of “affordability” when it comes to government expenditure in a fiat-money system. If the resources are idle, they can be put to productive use through government expenditure. If and when resources are fully utilized, there can be no non-inflationary expansion of government expenditure without a corresponding increase in taxes. At that point the budgetary limits have been reached. Again, the true limits are real, not financial.
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.
A strength of MMT is that it clearly identifies the real constraints to policy. A shortage of real resources, including labor resources, limits policy options. But a shortage of fiat money is a nonsensical notion. In deciding what can be done as a society, we should be looking at whether we have the necessary resources, not the necessary money. The money is created out of thin air, the real resources are not.
Galbraith also recognizes the inessential nature of government borrowing in a modern monetary system (meaning a fiat-money system in which the exchange rate is allowed to float):
If the government spent but declined to “borrow,” what would happen? Nothing much. Banks would hold their reserves as cash rather than bonds, and their earnings would be a bit lower.
Neoclassicals have traditionally supposed this build up in reserves to be inflationary, but as Galbraith points out, the argument is based on the:
… monetarist (quantity-theory) simplification, that the increase in money flows directly into prices. But this is just a modeling error. In the real world, especially in broadly deflationary conditions, people — and banks — simply hang on to cash.
Krugman responds to Galbraith’s comment in the remainder of his article. He begins by agreeing that deficit expenditure creates no problem under current circumstances in which there is high unemployment and idle capacity. He then continues:
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.
We have come full circle. MMT is not saying that deficits are never a problem. It is Krugman who incorrectly attributes this conclusion to the theory.
If and when the economy happens to be at full employment, “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.”
True, but this point is not in dispute.
From an MMT perspective, the aim of policy should (and can) be to maintain full employment at all times, for instance, through implementation of a job guarantee program. There is no inherent tendency for the economy to “return” to full employment, even in the long run, as Krugman and other neoclassical macroeconomists typically suppose. There is no foundation for such a belief in view of the Capital Debates and later work uncovering aggregation problems by neoclassical general equilibrium theorists themselves. Nevertheless, if and when full employment is achieved, whether by a confluence of fortuitous circumstances or deliberate and informed government policy, appropriate tax levels become dependent on the socially desired private-public mix of economic activity, which is a political question. A more dominant private sector requires lower taxes and government spending – smaller government – to provide space for the private sector. A more dominant public sector requires the opposite. MMT in itself makes no judgment on which is the preferable course for a society to follow.
Having acknowledged that there are real limits to budget deficits (it was never denied), MMT nevertheless makes clear that budget deficits are the norm, not the exception. This does not mean that budget deficits of any size are okay. They must be consistent with private-sector net-saving intentions. It simply means that ongoing budget deficits of some size will be the appropriate policy under normal circumstances. The reason for this is that the non-government sector typically desires to net save. This means, as a matter of accounting, that the government sector must be in deficit.
For a closed economy, such as the global economy as a whole:
Government Deficit = Non-government Surplus
This is an identity, true by definition. The net saving of the non-government sector matches the government’s deficit expenditure dollar for dollar. The net financial wealth of the non-government sector is nothing other than the accumulated deficits of the government sector.
For an open economy, such as an individual trading nation, the non-government sector can be disaggregated into the domestic private sector and external sector. As a matter of accounting:
Budget Deficit = Private Net Saving – Net Exports
The majority of nations run trade deficits (net exports are negative). For these economies, budget deficits are the normal requirement. Ongoing budget surpluses are only sustainable in a few small trade-surplus nations, and even then only to the extent that net exports more than offset the net-saving intentions of the private sector.
Whenever the non-government sector net saves, it is spending less of the monetary unit than it earns. The result is unsold output and a signal to firms to cut back output unless the government fills the demand gap through deficit expenditure. By doing so, the government is in a position to ensure all output is sold at current prices and the non-government sector satisfies its net saving desires. If, instead, the government allows the demand shortfall to persist by not injecting sufficient expenditure of its own, firms will respond by cutting back production. There will be a contraction in output and income, thwarting non-government net saving intentions. If the non-government sector responds by redoubling its efforts to net save, the result is a further shortfall in demand, further contraction of income (as well as tax revenue), more frustration of non-government saving plans, etc. There is no end to the process until either the non-government sector accepts a smaller net-saving position or the government accepts a bigger deficit.