In “What are Taxes For?”, Paul Krugman chooses to mention MMT again, though only in passing on this occasion. Krugman’s post follows recent consideration of MMT by Brad DeLong, Nick Rowe and Steve Randy Waldman. Much of the disagreement expressed by these economists appears to stem from misunderstandings of monetary operations, but implicit assumptions over long-run employment determination and the nature of interest also seem to contribute to the differences in perspective. In this post, I want to explore these points a little, using Krugman’s brief remarks as a springboard for the discussion.
Operational Aspects of Deficit Spending
Krugman’s remarks seem to reflect a simple misunderstanding of monetary operations. Bill Mitchell has already provided a response at billy blog, as has Tom Hickey here. I haven’t had a chance to check everywhere yet, so apologize if I’ve missed others.
So taxes are, first and foremost, about paying for what the government buys (duh). It’s true that they can also affect aggregate demand, and that may be something you want to do. But that really is a secondary issue.
Krugman seems stuck on the notion that taxes “fund” government expenditure, when it is clear that this is operationally impossible for a sovereign currency issuer. The act of government spending results in a net increase in financial assets held by the non-government. The government subtracts back out some of the net financial assets it has already created through taxation.
If this point is all that is preventing Krugman from “getting” MMT, simply reading Warren Mosler and Mathew Forstater’s A General Analytical Framework for the Analysis of Currencies and Other Commodities would presumably clarify the matter.
For a currency issuer, taxes are not first and foremost (in fact, not at all) about funding but about ensuring a demand for the currency. If there were no tax obligation, there would be no imperative for the non-government to get hold of the currency and little reason for the non-government to part with real goods or services in exchange for seemingly worthless pieces of paper or credits in bank accounts. In short, without the tax obligation, there would be no compelling reason for the non-government to transact with government. Once a tax-driven demand for the currency is established, taxes can then function as a moderator of demand (but never a source of funding).
Appropriate Level of Deficit Spending
Upon noting that a currency user such as a state government in a federal system must fund its spending, Krugman writes:
Does the same thing hold true for the federal government? Well, the feds have the Fed, which can print money. But there are constraints on that, too — they’re not as sharp as the constraints on governments that can’t print money, but too much reliance on the printing press leads to unacceptable inflation.
The operative words here are “too much reliance”. Nobody – certainly not MMT economists – argues for excessive government net spending. Rather, they argue that the budget deficit should be consistent with full employment and price stability. (See Krugman and Galbraith on Deficits.)
When the government spends on real goods and services, the act of spending is at the same time a transferral of real resources to the public domain. This transfer of real resources is independent of tax measures (provided there is already a tax-driven demand for the currency) and occurs even if government tax revenues remain constant. The question then becomes, will this transfer of real resources be inflationary? After all, some resources that might have been purchased by the private sector have been purchased by the government.
The answer, of course, as both MMT economists and Krugman would agree, is that the spending will only be inflationary if the additional demand exceeds the capacity of the economy to respond at current prices. At full employment and full capacity, the transfer of real resources to the public sector would leave less resources available for purchase by the non-government. If there was no extra taxing alongside the additional expenditure to subtract non-government spending power, inflation would occur.
But if, instead, as is currently the case, there is unemployment and excess capacity, it is more likely that the additional government expenditure will simply induce greater output at current prices. Under competitive conditions, firms with excess capacity will tend to respond in this way. The transfer of some resources to the public sector, in these circumstances, will not prevent the non-government from obtaining what it demands.
Now, as noted, Krugman would agree with this. He has consistently argued for stimulus to make up for weak private demand, and also recognizes the fallacy of composition in expecting wage reductions to generate employment, although in orthodox fashion he links this to a so-called liquidity trap in which interest rates have reached a lower bound.
Controversy Over Long-run Employment Determination
So what is the source of disagreement when it comes to the long-run effects of budget deficits? On one level, it may just be a matter of Krugman being unfamiliar with the monetary operations. But there are also other fundamental differences between Post Keynesianism (including MMT) and the orthodoxy that might be impeding understanding.
Most notably, as has recently been emphasized by John T. Harvey, the presence or otherwise of a long-run automatic tendency to full employment is a central point of contention. The orthodoxy implicitly assumes that the economy gravitates to the level of real output associated with the so-called NAIRU in the long run. In this view, the price mechanism will eventually ensure full employment irrespective of non-government net saving decisions. In particular, it is implied that once the economy escapes the liquidity trap, private investment will respond to price signals and real interest rates in such a way as to ensure this gravitation.
Now, if the economy were really predestined to return to full employment in the long run, as the orthodoxy implicitly supposes, then any budget deficit would merely be delivering the same employment outcome that would eventually be achieved without fiscal stimulus, only with a higher proportion of public-sector demand. In the absence of this deficit expenditure, the orthodoxy implicitly assumes that interest-rate adjustments would eventually induce sufficient private investment to generate full employment. But if deficit expenditure were used to establish full employment instead, there would be less room for private investment and a need to raise taxes to avoid inflation.
This supposed automatic tendency to full employment is essentially Say’s Law for the long run, in which orthodox causation goes from saving to investment, leakages to injections and supply to demand, even though the orthodoxy does acknowledge Keynesian causation (the reverse) in the short run. In this view, full employment is guaranteed irrespective of fiscal policy, which will only influence prices. An implication is that the amount of real consumption that will be undertaken now and for all time is fixed and that all we are doing when the government increases net spending is altering the intertemporal pattern of that consumption through time.
But if, in reality, there is no automatic tendency to full employment, this is not the case. It becomes clear that there is unemployment now and quite possibly unemployment in the future, and therefore real consumption possibilities both now and in the future may be forgone because of insufficient demand. If there is no automatic tendency to full employment, restricting demand now through fiscal austerity will do nothing to increase future real consumption possibilities, and in fact will reduce them by causing missed investment opportunities in the present.
In contrast to the neoclassical orthodoxy, Post Keynesian (and MMT) economists do of course reject the notion of an automatic tendency to full employment, including in the long run. It is a fallacy of composition to think that the price mechanism can guarantee a particular level of output and employment, even with flexible real wages and interest rates. This was the position of Keynes and Kalecki. Their arguments did not depend on wage or price stickiness. Further, the capital debates made clear that real interest rates cannot be relied upon to induce private investment consistent with full employment, quite apart from any liquidity trap.
Instead, it is non-government net saving behavior that determines the appropriate level of the budget deficit. This behavior, in turn, primarily depends on political, institutional and distributive factors, not interest rates. From a Keynesian perspective, interest rates can influence the form in which savings are held but not the level of saving in any direct or predictable way. Institutional factors include properties of the welfare system – e.g., the presence or absence of universal pensions, unemployment benefits, health care services, etc. – which can all be expected to influence the desire to net save. Different propensities to spend among various income groups mean that distribution will also clearly impact on net saving desires. There are no grounds for expecting interest-rate movements to induce a net saving desire consistent with a particular deficit/GDP or debt/GDP ratio.
Over the long run, different societies will exhibit different saving behaviors, and the same society can exhibit different behavior under different institutional settings and political circumstances. On the demand side, what matters for employment and price stability is the size of the deficit in relation to non-government net saving behavior. If, as Post Keynesian and MMT economists suppose, there is no guarantee of full employment in the absence of appropriate fiscal policy, it makes no sense to claim discretionary fiscal actions today inevitably require reversal tomorrow. The appropriate level of taxes will vary over time with movements in private-sector demand and net saving behavior.
Controversy Over Interest
Related to the orthodox notion of an automatic tendency to full employment is a flawed conception of interest rates. For the orthodoxy, the interplay of real factors (productivity and thrift) is conceived to determine the real rate of interest in the long run. Excess saving will supposedly bring about lower real interest rates and induce stronger private investment. Post Keynesian and MMT economists, in contrast, point out that there is no mechanism in a modern monetary system akin to a ‘loanable funds market’ determining the real rate of interest on the basis of productivity (marginal product of ‘capital’, well known to be an invalid construct) and thrift. Rather, interest rates are a distributive variable and ultimately subject to policy control (see Scott Fullwiler’s Interest Rates and Fiscal Sustainability, or for an informal discussion Interest, Money and Crisis.)
MMT economists recognize that the short-term nominal interest rate is set exogenously as a matter of policy. Irrespective of the chosen interest-rate target, demand-pull inflation can result only if fiscal policy is too expansionary relative to the capacity of the real economy to respond to all demand at current prices. Since, in this view, inflation is controllable through the fiscal stance, and the short-term interest rate is set exogenously, the real short-term rate of interest is ultimately controllable by policymakers, not markets or real factors.
Rather than having a natural determination, the choice of interest rate is above all a distributive (political) decision. It concerns the degree to which income is to be transferred from producers (real economy) to non-producers (rentiers, pensioners, savers, etc.). For that matter, the existence of interest itself is purely a political choice. The transfer from producers to non-producers could be carried out in alternative ways that involve no creditor-debtor relationship, for instance through direct fiscal transfers carrying no interest obligation. Longer “investment rates” are also a function of a particular social arrangement in which the risk and benefits associated with innovation and economic development are not fully socialized.
The capital debates demonstrated that there is no basis for expecting interest rates to reflect productive contributions in the sense supposed in neoclassical theory. The very notion of the price mechanism providing a natural measure of productive contribution based on the marginal product of ‘capital’ is completely without basis (see Nobel-nomics). Ultimately, the rate of interest targeted by the central bank as part of the consolidated government sector over the long run reflects ideology and power. It does not determine the level of demand, output or employment independently of fiscal policy, if in fact it has much impact on these variables at all. Its impact is primarily distributive.