Dear Paul Krugman: You Do Not Understand Modern Monetary Theory

by: Cullen Roche

Paul Krugman came out Friday with another misrepresentation of MMT. For some reason, he has come to the false conclusion that MMTers believe deficits don’t matter. He says:

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.

This is an absurd misrepresentation of the MMT position and proves that he has not taken the time to fully understand MMT. In my treatise on the subject, I specifically say this is not the case:

Some people claim that MMTers say deficits don’t matter. That is a vast misrepresentation of MMT. No MMTer would ever say such a thing. Deficits most certainly do matter. Maintaining the correct level of deficit spending is, in many ways, a balancing act performed by the government. It is best to think of the government’s maintenance of the deficit like a thermostat for the economy. When the economy is running cold the deficit can afford to be higher. When it is hot the deficit should be lower. Because there is no solvency concern in the USA (as there is in the revenue constrained European nations) the only concern is inflation and with record low inflation rates there is no fear of the deficit resulting in hyperinflation which would be a pseudo form of default.

I have maintained that the size of the deficit matters greatly in the current environment because of the uniqueness of this recession. It matters because we are in a balance sheet recession (a description that Mr. Krugman has himself written about). Because the United States is running a current account deficit and the private sector is paying down debt (as opposed to borrowing and spending as they might do in a healthy economic environment) the government sector MUST maintain a higher than normal deficit. This is best understood by visualizing the sectoral balances approach. Currently, the Federal government is running a 10% budget deficit so the private sector is able to save in excess of 7% of GDP (we are running a -3% Current Account (CA) deficit so the math can be no other way).

As time goes on and labor markets improve and the US economy reaches something resembling full employment we will require a much smaller deficit and in fact the automatic stabilizers will do much in resolving this on their own. So, my position on the current environment is really no different than Mr. Krugman’s prescription although he appears intent on misrepresenting this position. Deficits most certainly do matter. I don’t know if I can make that much clearer.

As for the whole “funding” idea, well, perhaps Mr. Krugman would like to explain how a sovereign issuer of currency just “runs out” of money. There is simply no such thing as the USA not being able to “fund” itself in the currency that it alone can create. He appears to be stuck in his gold standard world where currency issuers are always constrained in their ability to spend.

Funding is never an issue for the USA, which is the monopoly supplier of currency in a floating exchange rate system. The issue is maintaining a level of inflation that does not devolve into a hyperinflationary environment and thus maintaining the right size deficit given the economic environment is vital to ensuring that demand for the sovereign currency does not collapse. Mr. Krugman appears to agree with much of this, but has clearly not taken the time to appreciate even the most basic premise of MMT.

The comments from the original piece are illuminating and 99:1 against Krugman. On Saturday, Krugman posted his response. He wrote:

A followup on my printing press post: I think one way to clarify my difference with, say, Jamie Galbraith is this: imagine that at some future date, say in 2017, we’re more or less at full employment and have a federal deficit equal to 6 percent of GDP. Does it matter whether the United States can still sell bonds on international markets?

As I understand the MMT position, it is that the only thing we need to consider is whether the deficit creates excess demand to such an extent to be inflationary. The perceived future solvency of the government is not an issue.

I disagree. A 6 percent deficit would, under normal conditions, be very expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary. But if the U.S. government has lost access to the bond market, the Fed can’t pursue a tight-money policy — on the contrary, it has to increase the monetary base fast enough to finance the revenue hole. And so a deficit that would be manageable with capital-market access becomes disastrous without.”

This is a classic retort (and honestly, one I expect from someone just learning MMT). If you skip the logical sequence of events in any economic reality you can discredit anything. What Professor Krugman fails to address is why the USA will lose “access to the bond market”. This is a crucial step in the progression here. Why will savers suddenly lose their desire to save in $USD? Why will the Primary Dealers stop purchasing the bonds? Why will the buyers strike?

If it is due to high inflation then it is safe to say that the US economy has either rebounded sharply (in which case the buyers strike argument is bunk to begin with) or output has utterly collapsed (in which case you need to elaborate on the reasons why there is going to be some collapse in US economic output).

If his 2017 scenario involves a much stronger economy and something resembling full employment then a 6% budget deficit would be inappropriate and as previously stated, would not be recommended by any MMTer. Interestingly, the budget deficit could fall to 6% in an environment in which the government begins a form of austerity measures, but as Professor Krugman has often said, this will likely lead to a Japan scenario and a more deflationary outcome (in which case the collapse of the US government bond market is nonsensical).

He doesn’t explain the sequence of events so we have no way of knowing (I believe he has intentionally left out the details because his scenario is not realistic).

Either way, we appear to be making a one way argument down the nonsensical hyperinflation route which requires a great deal more analysis and explanation than just “the USA will lose access to the bond market”. Professor Krugman does no such thing, so while his comments may appear valid at first glance, they are in fact highly misleading.

None of this even touches on the operational realities that MMT discusses (the fact that bond markets fund nothing in the USA – a fact that Professor Krugman clearly doesn’t even begin to understand), but the sequence of events is important nonetheless. If you skip this crucial step you are merely creating a strawman argument and Professor Krugman is using his heavyweight stature in the field of economics to blow right thru that strawman with the assumption that his opinion is enough to validate the argument in the first place.

Unfortunately, his argument is the logical equivalent of debating with someone about the potential decline in oxygen levels in the atmosphere and concluding with the absurd statement that “if the oxygen runs out tomorrow we will all die”.

Of course this is true, but one must first explain what will lead to the lack of oxygen and the specific sequence of events. If you fail to do so you have failed to prove a point in the first place….Professor Krugman fails to connect the dots in a rational and logical sequence of events and it entirely discredits his conclusions.