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More Musings on Modern Monetary Theory

Written by Dean Baker   
Monday, 09 April 2012 16:15

I had several people ask me in comments or e-mails whether I agreed with Modern Monetary Theory (MMT) that the government doesn't need to raise taxes to pay for spending or whether I agreed with Paul Krugman that it does. I won’t claim to know exactly Paul Krugman’s view on the topic, but let me reframe the issue somewhat in a way that may cause people to see differently what is in dispute.

I think that all MMTers believe that the government cannot literally spend without limits. In other words, we can push the economy to the point where inflation is a real problem. The MMT answer is to raise taxes to prevent inflation from getting out of control.

Now suppose we are in the world where we have pushed the economy to the point where inflation is a problem and we decide we want the government to spend more money on some great project. At that point, it would seem that MMTers would have to agree that we need tax increases to offset the impact of government spending in boosting the economy.

We don’t literally need the tax increases to pay for the spending. The Fed could simply create more money to finance the spending. However if we don’t want the spending to be inflationary, then it must be offset by a tax increase.

I think the difference between the MMTers and Krugman is largely on the frequency with which they believe that the economy is up against its capacity constraints so that inflation is a real issue. I don’t want to put words in Krugman’s blog, but my guess is that he believes that the U.S. economy is typically operating near its capacity, so that the story of needing tax increases to offset spending would in general apply.

The current situation is an exception in this respect. Krugman has been as loud and clear as possible about the need for spending to boost demand in the current context, without any offsetting increase in taxes.

For my part, I think the cases where the economy has been near its constraints have been the exception. I think the economy was arguably facing supply constraints at the end of the 90s when the unemployment rate fell to a 4.0 percent year-round average in 2000.

I don’t think we hit supply constraints at any point in the following decade, which is why I could not get all that upset about the Bush tax cuts. It was not a good idea from the standpoint of either economics or equity to focus tax breaks on high income taxpayers, but if we had the same spending policy in the years 2001-2007 without the tax breaks I think the recovery would have been weaker and unemployment would have been higher. In other words, the tax breaks were better than no tax breaks, but had they been structured to be more progressive, they would have provided more boost to the economy. And, spending on infrastructure, education, and research and development would have been even better.

So I don’t know if this puts me in the MMT camp on this one, but I think the differences between Krugman and the MMTers may not be as large as some have claimed. Or at least they may take a different form.

Tags: inflation | mmt | taxes

Comments (14)Add Comment
Dean Baker gets it !
written by Dan Lynch, April 09, 2012 4:44
I'm pleased to see that you mostly understand MMT on the issue of taxation and spending and inflation.

There are nuances, however . . .

Not all inflation is caused by US fiscal and monetary policy. If the Sauds decide to raise the price of oil, or if the Chinese bid up the price of copper, or if the Russian wheat harvest fails, that will likely cause "cost-push" inflation in the US. We had that in the 70's due to oil, and we have experienced a bit of it lately, even though the US economy is far below capacity.

So . . . I suggest that when setting US monetary & fiscal policy, we should distinguish between inflation that is caused by external shocks to commodities vs. inflation that is due to the US economy running at 100% capacity. Unfortunately, the Fed does not seem to make that distinction.
Dean Baker is even handed
written by Tschäff, April 09, 2012 4:54
The MMTers respect you Dean for good reason. If other economists had half the intellectual integrity you do, we'd be in much better shape today.
Permanent deficits and sectoral balances
written by Dan Lynch, April 09, 2012 5:01
Another difference between MMT and Krugman is that MMT emphasizes sectoral balances, as derived from the national income equation. Particularly:

Federal Deficit = Net Private Savings + Trade Deficit

That equation tells us that the only way to sustain a balanced budget is to have a large trade surplus, and maybe not even then. In the short run, you can balance the budget by forcing the private sector into debt, which is essentially what happened during the Clinton years.

Krugman is a "deficit dove," believing it is good to run a deficit during a recession, but you should attempt to balance the budget when the economy is good.

MMTer's are "deficit owls," believing that perpetual deficits may be necessary and desirable (depending on the trade balance). The trick is to make the deficit just the right size -- not so big as to cause excessive inflation, but not so small as to allow unemployment.

MMT believes that paying the national debt will never be a problem providing the debt is issued in our own floating currency. We can continue to roll over the debt.

MMT believes that interest rates are set by the Fed, not by the free market, so the interest on the debt will never be beyond our control.

The European debt mess is completely different because they gave up their monetary sovereignty, and instead the Euro functions similar to a gold standard, requiring balanced budgets in the long run -- which means it is doomed.

Thank you for taking the time to consider MMT, Dean. Whether you agree with all aspects of it or not, it is to your credit that you are trying to understand the MMT model.
another comment on MMT and inflation
written by Dan Lynch, April 09, 2012 5:09
Warren Mosler has some unique ideas about inflation, that aren't necessarily part of the MMT model, but some people associate them with MMT since Mosler has written about them.

Mosler believes that the Sauds effectively control the price of oil, and has suggested that the US government could use its massive purchasing power to negotiate the price of oil if it so desired, similar to how the VA negotiates for better drug prices. Instead, we buy oil on the spot market (unlike other countries that negotiate long term purchase agreements), and allow wild swings in the price of oil to play havoc with our economy.

The government purchasing power model might be applied to other commodities, if we so desired.

Mosler also believes that a Minsky-style job guarantee program could serve to stabilize the price of labor.

There's actually quite a bit of difference between MMT and Krugman, though at the moment both agree that the economy needs massive fiscal stimulus.

Thanks again for discussing MMT.
MMT requires a job guarantee
written by Peter, April 09, 2012 6:08
The thing that makes MMT really unique is that it's a macro theory encompassing price stability and full employment through the job guarantee. When people discuss MMT they need to discuss the job guarantee. Otherwise, you're missing the whole point of MMT. The point with the job guarantee is that the government can sustain full employment without having to lose control of prices. The bigger problem is whether the job guarantee is politically sustainable because it would have to employ millions of people all the time. But that's a different question. So Krugman might differ on this point also. James Galbraith has been a proponent of many MMT concepts, but doesn't support the job guarantee so that probably leaves Krugman somewhere just outside of yourself and Galbraith on this issue.

Thanks for taking on MMT.

Sounds about right!
written by wh10, April 09, 2012 6:17
You got this one right, Dean!

There are many more differences though. I think a lot of it has to do with the existence of a natural rate of interest (which MMT does not believe in). Did you see the recent squabble between Krugman and Rowe vs. Keen and MMT on bank lending, loanable funds, etc? There seem to be many disagreements about the proper way to understand monetary policy, bank lending, etc.
CEO, Knowledge Management Consortium International
written by Joe Firestone, April 09, 2012 6:23
Good post and comments. I think you've gotten both MMT and PK right.

To Dan Lynch: I don't know any MMTer who disagrees with Warren about how to handle the Saudis, and I think his view is consistent with how MMT views monopoly. The JG of course is a central policy prescription of MMT, and Warren's view on it is shared by most MMTers. There's disagreement on the JG wage level however.
written by Dan Kervick, April 09, 2012 7:49
It's interesting to think about alternative operational procedures that the government could adopt to make its deficit spending more pellucid and less susceptible to demagogic exploitation.

Suppose as part of each annual budget cycle, Congress began by taking advice from economists on the optimal size of the deficit given current macroeconomic conditions. The economists recommend a deficit of $X, the size they deem appropriate for offsetting demand leakages and achieving full employment and full capacity, without creating serious inflationary pressures. Congress then debates and passes a spending and revenue package that targets a deficit of the recommended size of $X. After passing the budget package, Congress passes an additional piece of legislation directing the Fed to credit the Treasury Department account by $X. End of story. The Treasury issues no debt to cover the revenue gap, unless the $X Fed credit doesn't suffice, at which point Congress debates whether to direct the Treasury to issue debt or direct the Fed to credit the Treasury account by some additional amount.

In this way, we get no significant additions to the national debt, no debt hysterians pulling their hair out, no politicians claiming "we're out of money", no economy-crushing Bowles-Simpson commissions or austerity maniacs ruling the political roost.

We would still have to deal with the inflation hawks who see all government money creation as hyperinflationary "debasing" or "counterfeiting" of the currency. We just have to educate them to understand the fact that a growing economy always needs a growing money supply, and that the Congressionally-directed $X injection of new money would be aimed to correspond to the the % increase called for by the expected and targeted growth in GDP, minus any anticipated endogenous money growth from bank lending. But if lending is very sluggish, it is good to inject the financial assets directly via fiscal action, rather than continue to push lamely on the bank reserves channel, play psychological games with "expectations" and public ignorance about quantitative operations and their limited efficacy in hitting macroeconomic targets, or any of the other rather ineffective central bank policy measures that are so much the fad these days.

Direct fiscal injections have the added advantage of being credit-free, so they amount to a net increase in private sector financial assets rather than a mere balance sheet expansion where an additional bank liability is offset by an additional bank customer liability.
Milton Friedman supports Dan Kervick.
written by Ralph Musgrave, April 09, 2012 9:34

I agree with Dan Kervick. Re his point about “no significant additions to the national debt”, Milton Friedman also advocated a system under which the government / central bank issues no interest paying debt: it just issues cash. See paragraph starting “Under the proposal…” (p.250) here:


written by Dan Kervick, April 09, 2012 10:36
Where I wrote "full capacity" I should have said something like "production at full capacity."
written by y, April 10, 2012 8:05
"The economists recommend a deficit of $X, the size they deem appropriate for offsetting demand leakages and achieving full employment and full capacity, without creating serious inflationary pressures"

Isn't MMT largely about putting in place automatic spending programs such as the JG (with discretionary spending playing a smaller role), such that government spending is mainly 'endogenously determined'?

Then the size of the deficit comes down largely to how much is taxed OUT of the economy.(?)

p.s. could someone explain why MMTers are so resistant to the idea of using interest rate changes in any way whatsoever. Couldn't fiscal and monoetary policy work in parallel if need be?

Euro as gold standard? but a floating one?
written by Nichol Brummer, April 10, 2012 10:46
I don't understand the comment that the Euro is like a Gold standard. The ECB can in principle set the price of the Euro, it can loosen or tighten control on Euro's created by banks, and it can even create any quantity of Euros by itself, and lend them to banks. In principle, the ECB could even create Euros to subsidise infrastructure building in Euroland. But that last is against the current Euro rules.
written by wh10, April 10, 2012 12:58
Brummer- right. The ECB could be just like the US, but the key difference is that treaty rules prevent the ECB from being an unlimited purchaser of govt debt in the secondary markets.
also loanable funds
written by Diptherio, April 18, 2012 6:55
Krugman also disagrees with MMT on where bank loans come from. He is sticking to the loanable funds doctrine, which MMTers and practicing bankers continually discredit.

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