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.
Paul Krugman is a believer in this doctrine. I’m not, and he’s asked me to explain why. He is responding to a column I wrote critiquing his view of modern monetary theory.
I’m going to respond directly to the questions he raised:
Are MMTers claiming, as Kelton seems to, that there is only one deficit level consistent with full employment, that there is no ability to substitute monetary for fiscal policy? Are they claiming that expansionary fiscal policy actually reduces interest rates? Yes or no answers, please, with explanations of how you got these answers and why the straightforward framework I laid out above is wrong.
Quick responses first, followed by explanations behind my thinking.
#1: Is there only one right deficit level? Answer: No. The right deficit depends on private behavior, which changes. MMT would set public spending always to the level required to achieve full employment, and then accept whatever deficit may result.
#2: Is there no ability to substitute monetary for fiscal policy? Answer: Little to none. In a slump, cutting interest rates is weak tea against depressed expectations of profits. In a boom, raising interest rates does little to quell new activity, and higher rates could even support the expansion via the interest income channel.
#3: Does expansionary fiscal policy reduce interest rates? Answer: Yes. Pumping money into the economy increases bank reserves and reduces banks' bids for federal funds. Any banker will tell you this.
#4: Does MMT accept Krugman’s “straightforward framework”? No. We can come back to this at the end.
Is there only one right deficit level? No, because for one thing, MMT would establish a public option in the labor market—a federally funded job guarantee—thereby ensuring full employment across the business cycle. The deficit, then, would rise and fall with the cycle, as the job guarantee becomes a new stabilizer, automatically moving toward the “right size” in response to changes in the level of aggregate spending.