Paul Krugman has set off a storm of debate in the US blogosphere this week, with a post in the New York Times that raised the possibility of hyperinflation in the US.
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 (MMT) 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.
The key thing to remember is that current conditions — lots of excess capacity in the economy, and a liquidity trap in which short-term government debt carries a roughly zero interest rate — won’t always prevail. As long as those conditions DO prevail, it doesn’t matter how much the Fed increases the monetary base, and it therefore doesn’t matter how much of the deficit is monetized. But this too shall pass, and when it does, things will be very different.
So suppose that we eventually go back to a situation in which interest rates are positive, so that monetary base and T-bills are once again imperfect substitutes; also, we’re close enough to full employment that rapid economic expansion will once again lead to inflation. The last time we were in that situation, the monetary base was around $800 billion.
Suppose, now, that we were to find ourselves back in that situation with the government 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 — nobody is willing to buy U.S. debt except at exorbitant rates….
once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation. And no amount of talk about actual financial flows, about who buys what from whom, can make that point disappear: if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base.
This post has not surprisingly enraged the “modern monetary theory”, or MMT people, whose views Krugman is attacking. In response, Bill Mitchell of Billy Blog fired off a (slightly unhinged) public letter to Krugman, accusing him of “poor scholarship.” Dear Paul Krugman, You Do Not Understand MMT, wrote Cullen Roche at Pragmatic Capitalism. Scott Fulwiller wrote a similar post at Naked Capitalism.
What are they so upset about? Well, the people Krugman is accusing of arguing that deficits never matter, have never actually argued that deficits never matter.
What they do argue is that for sovereign nations that issue their own currency, such as the US, there is no “solvency risk” of the sort that is faced by a private company, a state like California, or a member of a currency union like Greece. This is fairly self evident. If you are the monopoly issuer of the currency that your debt is denominated in, there is no reason to ever have to default on your debt because you can always print more currency. However, that doesn’t mean that you can just spend recklessly without consequences. This is also fairly self evident, because under certain conditions, rising government deficits will lead to inflation. Here’s what Randall Wray, one of the leading figures in the MMT crowd says about deficit spending in one paper:
Government deficits might place two kinds of pressures on prices, one coming from the demand side and one coming from the supply side. If resources are fully employed, any extra demand would cause input prices to rise, which could be expected to be passed on in the form of higher prices. If the government’s budget were essentially unconstrained because it could run deficits, then it would continue to compete with the private sector as the economy moved beyond full employment, leading to continuous inflation.
We can also identify two kinds of supply side price pressures. If the government spending led to bottlenecks for particular inputs (highly skilled engineers, certain natural resources), this could increase the cost of these inputs at least temporarily… Another supply side source could result if fiscal deficits did lead to crowding out of private investment, leading to lower growth of capacity and productivity; if demand continued to grow so that it outpaced the growth in supply, inflation could result.
So to demolish Krugman’s first straw man, nobody is making the argument that deficits never matter. The point is that they are generally not inflationary when an economy is suffering from high unemployment and there is plenty of spare capacity.
Krugman’s next argument that the US could run into hyperinflation if it kept running $1 trillion deficits is just as bizarre, as it is based on a totally implausible set of hypotheticals, which he acknowledges himself by stating “at this point I have to say that I DON’T EXPECT THIS TO HAPPEN.” Still, given Krugman’s influence as a columnist for the New York Times, you would think he would be a little more cautious about dishing up unrealistic hypothetical scenarios which are likely to be misunderstood.
Without even getting into any monetary theory (see some of the links above if you are interested), what is the point of setting up a hypothetical scenario in which the deficit doesn’t fall from the current $1 trillion a year even as the economy approaches full unemployment? After all, a large portion of the current deficit is attributable simply to the collapse in tax revenues (and a corresponding rise in automatic stabilisers such as unemployment benefits) caused by the weak economy.
As the economy grows faster and approaches full employment, tax revenues will automatically rise, welfare payments will automatically fall, and the deficit will fall accordingly. This automatic process will happen even without any change in current policy. Furthermore, given the rise of the Tea Party and heated debate about the public deficit leading up to the 2012 Presidential elections, further spending cuts are inevitable.
In any case, let’s take a look at how close the US economy is to full capacity today. This chart from the Hamilton Project shows that to reverse the job losses of the recent recession would take another decade, even if the monthly rate of job creation returned to the fastest annual rate seen in the 2000s. In a more realistic scenario in which jobs growth is slower than that, we’re looking at longer than a decade. The other two lines on the graph below are basically pie in the sky stuff. In other words, the economy is not going to be anywhere near full capacity any time soon.
And if that’s the case, it’s virtually impossible to imagine any kind of scenario in which you could get hyperinflation in the US. The fact is, you need a very special set of conditions to get hyperinflation. Usually it requires not only completely incompetent fiscal and monetary policmaking, but in addition, some sort of supply side shock such as a massive destruction of productive capacity due to war (ie Weimar Germany).
In any case, right now the US looks a lot more like deflationary Japan than the hyperinflationary Weimar Germany.
Krugman strikes again.
- ASX at the close - April 23, 2013
- ASX at the close - April 22, 2013
- ASX at the close - April 12, 2013
YOU MAY ALSO BE INTERESTED IN
US property comes apart in that 70s show
It may be that US financial conditions are still
Albert Edwards: Everything bubble about to burst
Albert Edwards of Society General returns to
MOAR QE coming
Of course, MOAR is coming. But not before an epic
Another day, another US recession forecast
BofA joining the bears. It'll be mild only if the
Great article. Excellent stuff
Thanks.
Though I would add that hyperinflation is more of a psychologically-rooted phenomena, that it is a mechanical phenomena.
My 2c
Yes, it usually also involves a complete loss of confidence in the government/central bank, which in turn leads to difficulty collecting taxes, people shunning the currency in favor of hard assets, etc etc. Once again, hard to imagine any of this in the US today, no matter how incompetent you think the Bernank and the Treasury are.
The whole conversation from MMT is carried on as if there is no external account. Indeed Bill Mitchell stated the external account can be completely ignored because foreign debt never has to be repaid.
I realise that MMT is not alone in this and that ignoring the external account, its effects and any limits it might place on policy, has been part of the education in most universities (in Australia anyway)
The best summary I have seen of MMT thinking was from Eric Jansen at itulip
“I got into a lively email debate with Randall Wray who argues that a sovereign can print as much money and issue as much debt as it wants with impunity. An Austrian ideologue would dismiss the idea out of hand but I’m always interested in understanding the full range of ideas out there. After I got an introduction to him I sought an interview with him. He quickly dismissed my inflation argument as “video game economics” and then got rather abusive. For I presume ideological reasons he cannot enter currency depreciation into his calculus of sovereign debt and currency creation limitations, or I should say his theory of the unlimited power of sovereign debt and currency creation limitations does not include foreign exchange inputs. I walked away from the discussion concluding that there is no there there. Wray’s argument is ideological, rhetorical and stylistic. I decided not to bother to interview him.” Eric Jansen on itulip
You can keep issuing bits of paper. They are always worth one of your own dollars. MMT keep harping on this as if the rest of us are so stupid we don’t understand it. We aren’t and we DO! What MMT protagonists don’t understand is that in the wider world those dollars keep on being worth less and less. They buy less oil, iron ore, food! The Finster dollar index is worth a look
http://users.zoominternet.net/~fwuthering/FFF/FinsterDollarIndex
The US, has been printing for a long time and running the CAD now for a long time. It has been able to do so because it is the world’s reserve currency. It is the only nation in the world where the experience that it has so far had is possible. It thinks it has so far suffered NO ill-effects. Yet, it has high unemployment, a rapidly devaluing dollar, no growth in any way that matters. In addition the nation running the huge Current Account Surplus is busy around the world buying up every piece of in-ground resource, oil, and all the good agricultural land that it can. As a result the US, and the rest of us, may find its future much more difficult than it now envisages.
Further EVEN IF MMT could be made to operate in the US BECAUSE it is the reserve currency, this dopes not make it any more legitimate. It cannot be applied in any other case. The whole MMT is just “Magic Pudding” economics with Bill Barnacle the hero as usual.
From my understanding.
Deficits never require creating debt, modern governments just choose to issue debt that happens to be in equal amounts purely by choice.
A government can run a deficit as long as there is spare domestic capacity (i.e. things to buy) indefinitely. You only get inflationary effects from waste or by competing with the private sector for the same resources.
Foreign spending is another matter and I don’t think MMT ignores this. Any spending at all in foreign currency effects the CAD and lowers the relative value of the local currency increasing prices for imports. This only inflates the local currency where local alternatives are unavailable or highly uncompetitive, however this also makes domestic product more competitive in the process ideally evening out. Hyperinflation results when domestic production is thoroughly unable to respond as was the case in Germany and Zimbabwe. Zimbabwe couldn’t grow enough food domestically so the rising exchange pushed up pretty much everything as food prices soared. This takes serious mismanagement, not just a deficit even a large one.
Unless your the USA running a permanent CAD is going to hurt. Usually export profits rise with import costs so you reach a balance point eventually. Sure the government can break that but it’d be a dumb thing to do whether under MMT or not.
What the government spends it’s money on is more important than how much. Wasteful spending will harm the economy whether in deficit or surplus, wise investment will improve the economy.
I echo Flawse here and had similar experience to Eric Jansen.
Last year I tried on numerous occasions to get MMTers, directly on Billy Blog, Steve Keen’s Debt Deflation and Naked Capitalism, to engage on how it can be applied anywhere else but in the US.
I don’t argue with the accounting side, that is irrefutable, but it is a dangerous theory ripe for abuse if extended to almost any other country. On that basis it merely entrenches the global wealth imbalances.
Furthermore, within the US it would also merely maintain the status quo in favour the banksters who are not forced to confront natural market forces in clearing up the black holes in their balance sheets.
I agree
Good article, RA. Some of the comments seem to be veering into straw man territory vis-a-vis MMT, though.
Would you care to expand on which comments your are referring to?
Just in case mine is one of them, would you explain how propounding a theory that governments can deficit spend almost as much as they want, because they issue currency, is any anyway fair and helpful to most emerging countries?
I don’t have too much time now, but my other grip is that they ignore the fact that at the top of the global balance sheet is “debit: man, credit: finite global resources”.
Why should they assume that global production and consumption levels of the past 30 years should be sustained by deficit spending, espcially since they have been driven by unprecedented global debt levels. Do you have a view on that?
“would you explain how propounding a theory that governments can deficit spend almost as much as they want, because they issue currency, is any anyway fair and helpful to most emerging countries?”
4D, you are making my case about straw men all over again. None of the significant MMT proponents have ever said that governments can deficit spend almost as much as they want.
PS, suggest you reread the extract from Randall Wray’s paper quoted in the original post.
PPS Most of MMT is in fact descriptive rather than prescriptive. MMT is just as applicable to right or left wing views of the world.
Its interesting to hear this from Paul Krugman especially after him spruiking the idea of further stimulus and continuing defecits for the forseeable future.
I recently watched an interview/debate between Niall Ferguson and Paul Krugman where Krugman said “Whats another couple of trillion dollars”. These words may be those that will echo through the ages as an example of a mistake from the past, just like Neville Chamberlains famous words “There will be peace in our time”.
The idea that the U.S is somehow going to grow out of its current fiscal doldrums without spending cuts or tax increases is unlikely at best. So another couple of trillion dollars matters a great deal especially if investors lose confidence in U.S Government bonds.
I agree that the much more likely scenario is deflation and an American economy that is largely stagnant. Although I wouldnt rule out stagflation with the current levels of growth and high food and oil prices.
I do not see any problem with Dr Krugman’s argument. He is merely stating the obvious. You can expand the monetary base when the country have excess production capacity. When the excess capacity is no more, then expanding monetary base will lead to inflation and hyperinflation.
Why is this even controversal?
As to the Tea Party, they have this weird theory that you can eliminate the deficit by cutting taxes..
Ronin – The controversy comes from the fact that Krugman is misrepresenting the views of his opponents and therefore setting up a straw man argument. It’s not the first time he has done this.
Indeed, my problem is not with Krugman’s current views but the fact he seemingly changes between opinions so effortlessly for someone of so much influence.
His previous position of defecits for the forseeable future is quite contrary to his current position of $1 trillion defecits possibly causing hyper inflation.
I dont doubt there is room for growth in the United States economy but far from enough to support this sort of national debt let alone a continuing defecit of close to 9% of GDP for the year of 2010.
The private credit markets are deflating. The public credit markets are inflating. It’s netting off to near zero. The problem is not whether we will have net inflation or not, it is the undisputed fact of public credit market inflation, because it is very hard to make public credit productive. One of the main ways in that today’s public credit is unproductive is that a fair proportion of it has gone on handouts to those who made bad private loans.
Re Ronin’s comment re expanding the monetary base as long as you have spare productive capacity.
Unfortunately expanding the monetary base in our hollowed out economies results not so much in more productive capacity as more imports, and more debt. In saying this I have no argument with RA and everyone else who argue that Govt spending needs to be better targeted than the injection we have had into the FIRE economy. That’s sure. Nevertheless, in executing policy, we should be fully aware of the outcomes and risks of what we are doing. In modern economics, in most of its various forms this seems to be sadly lacking.