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 mischaracterizes Modern Monetary Theory (MMT) from the outset. MMT does not say “deficits are never a problem”. It is unlikely that any economic theory or economist would say that.
Rather, MMT suggests that the appropriate level of deficit expenditure is that level just sufficient to sustain full-employment output given private-sector net saving intentions.
Loosely speaking, MMT says that if deficit expenditure falls short of this level, there will be a demand gap and unemployment, whereas if it exceeds this level, there will be demand-pull inflation. More accurately, the theory also recognizes that there can be inflation before this point due to bottlenecks or supply-side factors, which in large part is why Modern Monetary Theorists call for a job guarantee as a means of achieving full employment alongside price stability. The theory suggests that a buffer stock of jobs (provided through a job-guarantee program) will be more effective than the buffer stock of unemployed workers that is maintained under the current NAIRU approach to inflation control. The job guarantee would function as an automatic stabilizer, with employment in the program varying countercyclically.
Krugman also understates the importance of the debate when he suggests that it is only of theoretical interest, not practical importance. Neoclassical theory, based on the inappropriate assumption of a ‘government budget constraint’ and the inapplicable ‘loanable funds’ doctrine, suggests that government deficits necessarily result in higher future tax rates, require higher interest rates and impose a debt burden on future generations. If this were so, anybody who is against higher future tax rates, higher interest rates and the burdening of future generations would have reason to oppose government deficits, even though the deficits serve other positive purposes such as boosting employment. MMT suggests, however, that none of these claims are true. A revival in private spending adds to income and boosts tax payments endogenously, automatically reducing the government deficit. If and when private spending strengthens to such an extent that demand-pull inflation is a risk, there may be reason to cut government spending or raise tax rates, but this eventuality is not inevitable. Nor do government deficits require higher interest rates. Government spending, far from drawing down a supposed finite pool of savings, adds net financial assets. As for future generations, the burden we risk imposing on them is not a public debt burden (the public debt, as a simple matter of accounting, is the non-government’s financial wealth and, as such, never needs paying down) but the ecological damage and shortfalls in knowledge, institutions and infrastructure that result when we tolerate unemployment and underutilization of resources on spurious financial grounds rather than investing in education, science and technology, the built environment, arts and culture and, above all, ecological regeneration.
… 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.
A currency-issuing government can never run out of what it alone issues at will (i.e. currency), and so can never be forced into bankruptcy. But Krugman is correct, and in complete agreement with MMT, when he writes that “the government must persuade the private sector to release real resources” in order for the government to spend. This is the appropriate focus when it comes to the currency issuer: real resources, not finance. And this is MMT’s focus. In MMT, the fundamental purpose of taxation is to transfer some real resources to the public sector. Imposition of a tax obligation that can only be extinguished (i.e. finally settled) in the government’s own money (in the form of reserves) ensures a demand for the currency. Non-government must sell some resources (which may include labor services) to the government in exchange for the funds 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.
At times such as the present 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 government 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 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 (this is discussed in the post ‘Hyperinflation‘).
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.
Galbraith’s basic point is sound. From an MMT perspective it would be more accurate to say that, in the actual world we live in, the private sector is already more than persuaded to release resources. A prevalence of unemployment and underutilized resources is an indication that the tax obligation is already more than sufficient to release resources for public-sector use. Resources that are idle have already been released. If, in contrast, the economy were operating at full employment 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 idle resources that makes such expenditure feasible and hence “affordable”. That is the only real meaning of “affordability” when it comes to government expenditure in a sovereign currency 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 no longer be a non-inflationary expansion of government expenditure without a corresponding increase in taxes. At that point the policy limits have been reached. As always, the currency issuer’s 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 sovereign currency is a nonsensical notion, since it can always be created at will by the currency issuer. 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 public borrowing in a sovereign currency system:
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 … 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 private spending strengthens sufficiently to sustain full employment without the need of a deficit, the fiscal deficit will shrink endogenously. This will occur without any change in tax rates as a result of the higher income. If it turns out, at some point, that demand-side inflationary pressures are an issue, there will be a need to raise tax rates or cut government spending. But there is no basis for supposing that the economy will necessarily reach such a point, under any time frame. No automatic tendency to full employment has been established in theory; nor is there convincing empirical support for the idea. It is quite possible that government deficits will be needed in the future, just as they are now. It will depend on non-government behavior.
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. There is no inherent (or monetary policy induced) tendency for the economy to “return” to full employment, even in the long run, as neoclassical macroeconomists implicitly suppose. There is no foundation for such a belief in view of the contributions of Keynes and Kalecki, the results of the Capital Debates, and later work uncovering aggregation problems by neoclassical general equilibrium theorists. Nevertheless, if and when full employment is achieved, whether by a confluence of fortuitous circumstances or through 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 government deficits (it was never denied), MMT nevertheless makes clear that government deficits are the norm, not the exception. This does not mean that government deficits of any size are okay. They must be consistent with private-sector net-saving intentions. It simply means that ongoing government 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 must run deficits.
Government Balance + Non-Government Balance = 0
This is an identity, true by definition. The financial balance of the non-government sector matches the government’s balance dollar for dollar. Non-government can only maintain a surplus (positive balance) if the government runs a deficit (negative balance). The financial wealth of non-government 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 foreign sector. As a matter of accounting:
Government Balance + Domestic Private Balance + Foreign Balance = 0
The majority of nations run current account deficits. For these nations, the foreign balance is positive and government deficits are required if non-government is to maintain a financial surplus. Ongoing government surpluses are only sustainable in a few small trade-surplus nations with current account surpluses sufficiently large to offset the net-saving intentions of domestic households and businesses.
Whenever the non-government sector net saves (maintains a surplus), it is spending less of the monetary unit than it earns. The result is unsold output and a signal to firms to cut back production 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 that 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.
This does not mean that government should necessarily accommodate whatever (full-employment) financial surplus the non-government sector desires. In view of the fact that high-income households and the wealthy save a much higher fraction of their income than other cohorts, the desired non-government surplus may partly reflect extreme income inequality. Fiscal policy that partially redresses this, such as steeply progressive taxation, may help to maintain healthy levels of private demand and so reduce the government deficit required to sustain strong employment outcomes. This is a political question to which MMT does not dictate a particular answer. It is still likely, however, even with a highly equal distribution of income, that non-government in aggregate will desire to spend somewhat less than its income as protection against future uncertainty. As such, ongoing government deficits of some size are likely to be appropriate under normal circumstances.