Paul Krugman has some tweets harshly criticizing this article by Stephanie Kelton.

His claim appears to be that, as a Modern Monetary Theorists, she asserts that there are two schools of macroeconomics MMT and “the mainstream” which includes Paul Krugman. I am kicking myself for deciding to read the article to find if it is as horrible as he asserts. I think it is.

She wrote “There is a doctrine among mainstream economists holding that: (1) government deficits push interest rates higher and (2) rising interest rates crowd out private investment. The government can take more of the economy’s financial resources, but only at the expense of lost private investment. This means that running budget deficits has at least some downside.”

This proves that, by her definition Krugman isn’t a mainstream economist. He wrote this. For 20 years he has asserted that sometimes fiscal stimulus does Not cause higher interest rates and that, in those cases, it has no downside.

More generally, even when criticizing vulgar Keynesians (before the acronym MMT was coined) he stressed that the monetary authority can, and often will, cancel the effects of fiscal stimulus. Nothing about what must be true as in “at least some”. I don’s see how anyone who has read anything written by Krugman could type the quoted passage. I am extremely confident that Kelton has read almost exactly nothing Krugman has ever written on macroeconomics.

I don’t know what she means by federal funds, but I guess that would be loans on which the federal funds rate is paid. Since those are interbank loans, banks total demand for funds on which the federal funds rate is paid is always exactly zero. This is an accounting identity. I think she means banks borrowing at the discount window. I don’t think she knows that this was almost exactly zero until 2008 — it just isn’t important. Untill 2008 they borrowed from each other at the slightly lower federal funds rate.

Here I crop so you can see the numbers. An amount of money which it would be nice to have, but trivial compared to GDP, Bank assets, Fed liabilities or M1.

I have to pick up the pace and now flag every howler (after the jump)

“Leaving aside monetary and exchange rate policy … If the private sector wants to spend less and save more, the public sector will need to accommodate that desire by running a bigger deficit or the economy will be pushed away from full employment.”

This is false. It is possible to stimulate demand with a balanced budget increase in government consumption + investment financed by taxes. The government can alow the private sector to spend less and keep employment full by spending more. The spending increase does not have to be deficit spending. It can also convince the private sector to spend more by cutting taxes. The idea that the fiscal stance can be measured by the deficit is plain wrong. In theory it is totally wrong. The evidence (mostly from the balanced budget spending increase to finance the Korean war) shows it is wrong. Fiscal stimulus does not require deficits. It can work even if temporary tax cuts have no effect because there is Ricardian equivalance (see link to Krugman’s blog above). This is actually mainstream nonsense. It is standard to equate fiscal stimulus with deficit spending. But it is also nonsense. In the real world deficit financed spending has a larger effect on aggregate demand than tax financed spending. But tax financed spending should (in theory) and did in practice cause increased aggregate demand.

“He’s challenging that by asserting that you can have any size deficit and still have full employment because the central bank can always establish the “right size” interest rate to get you there.”

Of course Krugman does not assert this. Instead he asserted 20 years ago that the liquidity trap is “baaaaack”. It is insane to assert that Krugman asserted something when he has asserted the contrary innumerable times over the past 20 years.

My god. she asserts that interest rates don’t affect demand. What the hell happened in 1981 ? As Krugman notes, she looks at business investment. As he has explained many times, interest rates affect demand through residential investment. Has Kelton ever seen a house ? Has she asked home buyers whether interest rates matter to them ? Krugman explains this in a tweet.

I finally read the MMT argument that fiscal deficits automatically cause an increase in bank reserves. It is based on the assumption that deficits have no effect on the supply of treasury bonds (really)

“When you pay your taxes, your bank loses reserves, but with a trillion-dollar deficit, there is a huge net infusion of reserves into the banking system. If the central bank takes no action to prevent it from happening, the overnight lending rate — the federal funds rate — will fall to a zero bid.

Why? Because all banks are flush with non-interest-bearing reserves,”

I will complete this argument. So when you pay taxes, you can write a check and that reduces the banks reserves (the Treasury doesn’t use commercial banks so it doesn’t deposit your check). In contrast nothing like this happens if the Treasury prints a bond and you buy it by writing a check because …. uh well …

The story entirely relies on the assumption that the only asset is balances of checking accounts and that eithe we write a check to someone who deposits it in a bank (no effect on reserves) or we write it to the IRS (reducing reserves). But what if we buy a Treasury bond directly from the Treasury with it ?

The argument absolutely depends on the assumption that deficits don’t involve printing and selling Treasury securities. It would be valid if the Treasury covered deficits by printing money. It’s worse than I imagined possible.

“Yes, the Fed has a reaction function, and it can vote to raise rates in response to perceived inflationary pressures associated with deficit spending. But that is a different matter. That is fighting against the “natural” gravitation.” Note that this means that the argument above is irrelevant. This is exactly Krugman’s point. The interest rate is that chosen by the FOMC. The “natural” gravitation is not as she describes because there are assets other than deposits, and it is also irrelevant.

She looks at Krugman’s figure with 3 IS curves.

She assumes that there can’t be one half way between IS1 and IS2 which will give higher output and the same interest rate as IS1. Her argument “This framework shows that the government can expand its deficit and move the economy from a depressed condition at point A to full employment by shifting IS1 to IS2. The economy is now at full employment, but with higher interest rates and lower private investment.” must be completed with “because there is no IS curve between IS1 and IS2” She absolutely relies on assuming that Krugman drew 3 lines because he believes there are only 3 possibilities. I assert that no one who understands how graphs work could have written the quoted passage.

“his model assumes a fixed money supply, which paves the way for the crowding-out effect!”

In fact, his model does not assume a fixed money supply. If it did, then IS3 would give higher output than IS2 as the economy moves up the LM curve. He assumes that the monetary authority will reduce the money supply to keep unemployment at the target. Anyone who had any familiarity with the IS-LM model would see that Krugman assumes that the money supply is not fixed.

Krugman explains this in a tweet.

She asserts that fiscal policy is good because it increases private wealth. Here she assumes that fiscal policy is always expansionary. An actual Keynesian would say that ““The boom … is the right time for austerity at the Treasury ”
John Maynard Keynes (1937)

One might want a very high public debt, but even if one does, once the desired high level is reached, one might wisely turn to monetary policy to stabilize output (provided interest rates are above zero). Fiscal vs monetary stabilization is an issue entirely separate from the desired national debt. The assumption that fiscal policy is fiscal stimulus is crazy and very definitely un Keyenesian.

OK I sum up
1) Krugman’s tweets are immensely better than this post.
2) Kelton assumes that Krugman ignores the liquidity trap
3) she relies on the argument that if he drew 3 IS curves he asserts that they are the only 3 possible (this is absolutely critical to her argument)
4) she thinks that the fixed money supply fiscal multiplier in the IS-LM model is zero. She doesn’t seem to know that the LM curve slopes up in the standard IS-LM model.
5) she assumes that taxes are paid out of checking accounts and determine the balances of those accounts which can’t change when depositors buy bonds. She assumes that the supply of Treasury securities is not affected by budget deficits. She absolutely relies on this assumption. It is central to one of her arguments.