In a recent post, “Franc Thoughts On Long-Run Fiscal Issues”, Paul Krugman has once again engaged with Modern Monetary Theory (MMT). His main argument this time concerns the difference, if any, between issuing debt when the government net spends rather than simply allowing balances to mount in reserve accounts. He agrees that under current circumstances zero interest short-term debt and zero-interest reserves are close substitutes, but argues that issuing debt and allowing reserves to mount will have different macroeconomic implications when interest rates are positive.
The composition of public liabilities as between debt and monetary base does matter in normal times — hey, if it didn’t, the Fed would have no influence, ever. So if we try at that point to finance the deficit by money issue rather than bond sales, it will be inflationary.
It can be noted in passing that, according to MMT, bonds do not provide initial finance for government spending, and there is no choice between issuing or not issuing money when the government spends. All government spending involves the creation of government money in the form of reserves, irrespective of whether the reserves are left as reserves or swapped for bonds. These points are addressed at length in the previous post.
But turning to the central point of Krugman’s latest piece, the MMT position is that if the interest rate target were positive, short-term debt would remain a close substitute for reserves provided the Fed paid the equivalent interest rate on reserves. This would be the simplest approach to interest-setting monetary policy: to pay interest on reserves at the target rate rather than issue short-term debt.
Nevertheless, MMT is in agreement with Krugman that if the Fed targeted a positive interest rate and did not pay this rate on reserves, then allowing reserves to mount rather than issuing debt would have a somewhat different macroeconomic impact. Doing so would cause the interbank rate to fall to the rate paid on reserves (possibly zero). In that case, reserves would not be close substitutes for short-term debt, and the macroeconomic implications (including for inflation) would be somewhat different.
So, although MMT does suggest that monetary policy is less effective than fiscal policy, there is no suggestion that it “would have no influence, ever”. Rather, the MMT position is that any expansionary impact will work indirectly through interest-rate effects (and expectations) rather than through variations in the quantity of reserves. Since loans create deposits, expansion of the broader money supply is neither constrained nor driven by the base. The onus is therefore on interest-rate effects, and these are mixed, depending on the relative spending propensities of creditors and debtors, with the result that their overall impact on the real economy is likely to be small.
Relating this back to government net spending and the choice between leaving excess reserves in the system or selling bonds, the MMT view is that any difference in macroeconomic impact is likely to be modest and due to differences in the interest rates paid on reserves and short-term debt, not the quantity of reserves.
In any case, it is encouraging to see Krugman continue to engage with MMT. Right now, the public debate often seems to be bordering on insanity. Krugman is one of the few prominent voices advancing sensible policy responses to the crisis. As he mentions:
… for the time being the MMT people and yours truly are on the same side of the policy debate.
And, given the present circumstances, that is a significant point of agreement.