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DeLong (and Krugman) Smackdown Watch: Bill Black, Stephanie Kelton, and Randy Wray Are Justifiably Irate Modern Monetary Theory How Do Deficits Matter?: Monday Hoisted from Comments Weblogging

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Jeff Sachs is irate. He says that Paul Krugman says that deficits don't matter.

And that makes Paul Krugman irate:

Crude - I came into this crisis with what I think can be described as a pretty sophisticated view of liquidity-trap economics… [and] made some predictions — about interest rates, about the effect of large increases in the monetary base, and about the size of fiscal multipliers — that were very much at odds with what a lot of people were saying… [and that] have been overwhelmingly confirmed by recent experience. I guess I can understand some people not wanting to believe that evidence. But they don’t help their case by pretending that there is no evidence, and certainly not by pretending that people like me, Brad DeLong, Martin Wolf, Larry Summers etc. etc. are ignoramuses who unconditionally favor fiscal expansion under all conditions, as opposed to as a specific remedy under special conditions that happen to apply right now…

And Krugman points out that Sachs and Scarborough link to Krugman saying that deficits do matter:

Deficits and the Printing Press: Right now, deficits don’t matter — a point borne out by all the evidence. But there’s a school of thought — the modern monetary theory people — who say that deficits never matter, as long as you have your own currency. I wish I could agree with that view — and it’s not a fight I especially want, since the clear and present policy danger is from the deficit peacocks of the right. But for the record, it’s just not right…. [E]ventually [we will] go back to a situation in which interest rates are positive, so that monetary base and T-bills are once again imperfect substitutes…. Suppose... the government [were] still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers.... [T]he government would in effect be financing itself through creation of base money... the first month’s financing would increase the monetary base by around 12 percent. And in my hypothesized normal environment, you’d expect the overall price level to rise (with some lag, but that’s not crucial) roughly in proportion to the increase in monetary base. And rising prices would, to a first approximation, raise the deficit in proportion. So we’re talking about a monetary base that rises 12 percent a month, or about 400 percent a year. Does this mean 400 percent inflation? No, it means more…. [R]unning large deficits without access to bond markets is a recipe for very high inflation…. And no amount of talk about actual financial flows, about who buys what from whom, can make that point disappear…. At this point I have to say that I DON’T EXPECT THIS TO HAPPEN…

And this makes Bill Black irate:

For the record, Paul's description of MMT's position is incorrect, as we have repeatedly explained to him. This is a strawman claim. If Paul ever cites a work by academic MMT scholar (X) to support his claim (Y) that "MMT" argues that "deficits never matter" we will be able to show that the MMT scholar's work actually argues "not Y." Indeed, it is worse to make the claim without citation because it does not allow the reader to check the citation and realize that it actually argues "not Y."

And it makes Stephanie Kelton irate:

Well, what goes around…. Krugman characterizing MMT on March 25, 2011:

Right now, deficits don’t matter — a point borne out by all the evidence. But there’s a school of thought — the modern monetary theory people — who say that deficits never matter, as long as you have your own currency." ~Paul Krugman

Leading MMTer L. Randall Wray writes a blog entitled "Deficits DO Matter, But Not the Way You Think." July 20, 2010.

Awaiting scoring…

And Randy Wray:

Deficits Do Matter, But Not the Way You Think | Next New Deal: Our claim is that a sovereign government cannot be forced into involuntary default. We have never claimed that sovereign currencies are free from inflation. We have never claimed that currencies on a floating exchange rate regime are free from exchange rate fluctuations. Indeed, we have always said that if government tries to increase its spending beyond full employment, this can be inflationary… we have admitted that currency depreciation is a possible outcome of using government policy to stimulate the economy….

What if the economy runs up against a full employment constraint, but government stubbornly keeps spending more, driving up prices toward hyperinflation?… [W]e never claimed that a sovereign government will necessarily adopt good economic policy. The last time the US approached such a situation was in the over-full employment economy of WWII. Rather than bidding for resources against the private sector, the government adopted price controls, rationing, and patriotic savings. In that way, it kept inflation low, ran the budget deficit up to 25% of GDP, and stuffed banks and households full of safe sovereign debt…. After the war, private spending power was unleashed, GDP grew relatively quickly, and government debt ratios came down (not because the debt was retired but because the denominator -- GDP -- grew more quickly than the numerator -- debt; see here). In other words, [John Kenneth] Galbraith, senior, used rational policy to avoid the Zimbabwean fate. I do not understand why Krugman prefers to believe that our policymakers would choose hyperinflation over more rational policy….

If we can get beyond the fears of national insolvency then there are many issues that can be fruitfully discussed. While inflation will not be a problem for many years, price pressures could return… exchange rate instability…. Unemployment…. Aging…. Poverty and homelessness exist in the midst of relative abundance. Simply recognizing that our sovereign government cannot go bankrupt does not solve those problems, but it does make them easier to resolve. We may well need more government spending, and, yes, even budget deficits to tackle some of those problems. So, yes, deficits do matter, but not for solvency.

The closest I can come to meeting Bill Black's challenge is to go to Warren Mosler's Soft Currency Economics:

[D]eficit doves and deficit hawks… both accept traditional perceptions of federal borrowing… accept the premise that the federal government borrows money to fund expenditures…. [E]ven if [dovish] policymakers are convinced that the current deficit is a relatively minor problem, the possibility that a certain fiscal policy initiative might inadvertently result in a high deficit, or that we may owe the money to foreigners, imposes a high risk. It is believed that federal deficits undermine the financial integrity of the nation.

Policy makers have been grossly misled by an obsolete and non-applicable fiscal and monetary understanding…. Once we realize that the deficit can present no financial risk, it will be evident that spending programs should be evaluated on their real economic benefits, and weighed against their real economic costs. Similarly, a meaningful analysis of tax changes evaluates their impact on the economy, not the impact on the deficit…. The imperative behind federal borrowing is to drain excess reserves…. It is not to fund untaxed spending…. Government borrowing… is actually an interest rate maintenance account…. Options over spending, taxation, and borrowing, however, are not limited by the process itself but by the desirability of the economic outcomes. The amount and nature of federal spending as well as the structure of the tax code and interest rate maintenance (borrowing) have major economic ramifications. The decision of how much money to borrow and how much to tax can be based on the economic effect of varying the mix, and need not focus solely on the mix itself (such as balancing the budget)…

The way Uncle Warren sees it:

  • The federal government spends: it write a check to somebody…
  • That somebody then takes that check and deposits it in their bank…
  • The bank credits them with a balance equal to the government check and presents the check to the Treasury's fiscal agent, the Federal Reserve…
  • The Federal Reserve then credits the bank with the amount of the check, crediting it to the bank's reserve deposit balance…
  • The Treasury and the Federal Reserve can debit the bank's reserve deposit balance by open-market operations--by selling Treasury bonds--and thus transform the liquid non interest-paying debt of the government that is high-powered money into interest-paying debt…
  • The Treasury can debit the bank's reserve deposit balance by imposing taxes and debiting the bank's reserve deposit by presenting check the taxpayer writes to the bank for payment…

Briefly: (a) federal government spending creates fiat money--liquid debt of the federal government. This money can then be uncreated by (b) levying taxes or by (c ) open-market operations that transform non-interest paying reserve deposits into interest-paying federal debt. Whether you do (b) or (c ), and how much you do of (b) or (c ), are technical financing decisions, but there is no such thing as "undermin[ing] the financial integrity of the nation". Federal spending is always funded by money creation, and the government then adjusts the money supply by levying taxes and conducting open-market operations.

From my perspective, Warren's way of putting it is both (i) completely, obviously, and tautologically correct; and yet (ii) somehow obtuse…

The problem is that Warren's claim that "the deficit can present no financial risk" is both right and wrong. it is right in that the government can never find itself in a situation in which it is forced to default on its interest-paying debt. How could it be? It amortizes its interest-paying debt by simply crediting the payee's reserve deposit account. The deficit and debt can present no nominal financial risk. But it is wrong in that the government can find itself unable to keep whatever commitments it has made on what the real return on government debt--both interest-paying and non-interest paying--will be. The inability to keep such commitments is also a kind of "financial risk", and deficit and debt accumulation can create it.

Are our deficits and debt accumulation currently creating such real financial risks? No. Simon Johnson:

America’s Latest Phony Fiscal Crisis: In most countries that experience a fiscal crisis, there is no ambiguity…. The government is unable to sell debt at a reasonable interest rate. This probably coincides with a broader shift out of domestic assets, as smart investors read the writing on the wall or in the newspapers. The currency collapses and, often, inflation accelerates. The government is forced to slash spending and, cap in hand, asks for help from the world’s least popular ambulance service: the International Monetary Fund.

No part of this description fits the modern U.S. Rates on government debt are very low, the currency isn’t depreciating rapidly and inflation seems stable. There is no imaginable circumstance under which the U.S. would need to borrow from the IMF. Yet this great land of innovation has undeniably invented its unique kind of fiscal crisis.

Or, to be more precise, we have reinvented the uniquely American way of ruining our fiscal affairs. At the beginning of the 19th century, Thomas Jefferson was obsessed with the idea that debt was bad and that the U.S.’s obligations -- inherited mostly from the War of Independence -- must be eliminated at all costs. (Jefferson himself had had some bad personal experiences with debt.)… In 1801, when Jefferson became president, the U.S. government embarked on a policy of cutting federal spending, including for the military. The Navy, in particular, suffered years of neglect or, in modern terminology, “lack of readiness preparation.”… Unfortunately, the American fiscal way -- then as now -- was to combine excessive expectations with inadequate revenue. As a result, the dominant war-hawks faction in Congress sought and achieved a confrontation with Great Britain. It pitted the world’s biggest navy against a depleted fleet in a sorry state of repair. The contest wasn’t even close. As a direct result, the British were able to trash Washington and burn the White House. The U.S. government didn’t default, or even come close. The fiscal crisis was a failure to deliver the public goods -- defense -- that the nation needed and expected.

Fast-forward to today. We have a budget deficit because revenue has been allowed to fall behind government commitments. This is the net result of the George W. Bush tax cuts, two foreign wars and the unfunded expansion of Medicare. Then, a financial crisis cratered the economy and further pushed down tax revenue while increasing unemployment and poverty. And, looking at decades ahead, health-care costs (not just Medicare) threaten to undermine competitiveness or even sink the economy. So how does the political system respond? Most recently, with a sequestration program of across-the-board spending reductions that undermine military readiness and cut essential programs that help poor children. And now, with a budget proposal from House Republicans that slashes Medicaid, about half of which goes to protect the health of poor children. Does this make any sense? No, but there is likely to be a lot more of this in our immediate future.

When will our deficits and debt accumulation start the process of beginning to create real financial risk we need to guard against? We don't know. But we do know that the bond market will be very happy to tell us when the process starts.

Until then, Uncle Warren is right.