Paul Krugman has a write-up on VoxEU about a new paper with Gauti Eggertsson, “Debt, Deleveraging, and the Liquidity Trap.” This paper is vintage Krugman (I say that having known about the man for 4 whole years)- he comes up with a simple and elegant model, and derives salient insights. I think he moves his arrow closer to Modern Monetary Theory here, in that he begins to probe the distribution of debt. In particular, he writes,
Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.
I wrote about attending part of the MMT teach-in back in March. Randy Wray brought up this asset/liability idea as a way to express MMT to skeptical parties, particularly non-economists. Rather than thinking of our economy as a household, he said, realize that every asset is a liability. If one wants the non-government sector be net savers, the government sector must be a net borrower.
Now, recall that back in July, Krugman and Jamie Galbraith had a friendly skirmish over whether deficits ever matter. Krugman wrote,
And there are limits to all three. Even a country with its own fiat currency can go bankrupt, if it tries hard enough…
Since the price level is, by assumption, proportional to M, this tells us that the higher the debt burden, the higher the required rate of inflation — and, crucially, that as D-S heads toward a critical level, this implied inflation heads off to infinity…
So there is a maximum level of debt you can handle.
Then, Galbraith argued that by talking about future inflation, Krugman assumed the consequent, etc. I’m not here to rehash that. I do want to point out that in this paper, Krugman seems more concerned about the distribution of debt.
It follows that the level of debt matters only because the distribution of that debt matters, because highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. This becomes very clear in our analysis. In the model, deficit-financed government spending can, at least in principle, allow the economy to avoid unemployment and deflation while highly indebted private-sector agents repair their balance sheets, and the government can pay down its debts once the deleveraging crisis is past.
I believe MMTers would argue that this need for non-government deleveraging is necessary in cases other than a liquidity trap. I think this point is where we see the divergence, and Krugman’s eventual caution against high levels of government debt (it’s the inflation at full employment, stupid, he would say). While I side with MMT on this front, I think Krugman can move the discussion in a positive direction by encouraging folks to think clearly about debt distribution. When calling for the government sector to dissave, do conservatives and neoclassical economists really want the private sector to be saving more? In a vacuum of aggregate demand? I’m sure they will reject his model out of hand, which isn’t surprising, because much of center and right economics seems politically and not intellectually motivated. Boo on them.
As for Krugman, I’d love to see his insights on what happens when we’re not in a liquidity trap, but household debt remains a crippling burden. Remember, much of his discussion of depression economics is around this idea of a liquidity trap, Nipponization, etc. If the liquidity trap ends, and unemployment remains high and resources underutilized, does Krugman have a model for that? Because I know MMT does. Somehow I think that Krugman will sound a lot more like Galbraith in 2 or 3 years.
As with so many terms lightly tossed about in economics, “Liquidity trap” means different things to different people. The most popular definition boils down to: “The point at which adding money to the economy doesn’t lower interest rates.”
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But, contrary to popular faith, the Fed determines most interest rates by fiat (i.e. by lending at specified rates) and low rates do not stimulate the economy (See: http://rodgermmitchell.wordpress.com/2009/09/09/low-interest-rates-do-not-help-the-economy/ ). So what kind of “trap” are we talking about?
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I, for one, feel the term “liquidity trap” either is misleading or meaningless, I haven’t decided which, but in either case it is not a constraint on economic growth.
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Krugman loves to use non-specific terms. For instance he says, highly indebted players face different constraints from players with low debt.” Who are these “players.” Are they monetarily non-sovereign governments like Greece, Italy, California, Illinois or Chicago? Or are they monetarily sovereign governments like the U.S., Canada, Australia and China?
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The meaning of debt is dramatically different for sovereign vs. non-sovereign monetary systems, but Krugman doesn’t seem to address that. In fact, I never have seen him discuss monetary sovereignty, despite it being the very foundation of modern economics.
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Then, to facilitate further confusion, Krugman substitutes “actors” for “players.” Huh? What next, “thespians”?
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Finally, Krugman says, “. . . government can pay down its debts once the deleveraging crisis is past. . .”
I assume by “crisis” he means inflation, which is the only constraint on federal deficit spending. But think of what “paying down debts” means. It means the government will buy back T-securities, and that means pump liquid dollars into the economy in exchange for less liquid T-securities. This is supposed to cure inflation???
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Finally, not to be too picky, but there is a huge difference between deficits and debt. Contrary to popular faith, federal “debt” is not the total of federal “deficits.” Deficits are the difference between taxes collected in one year and spending in that year. Debt is the total of T-securities outstanding. Either can exist without the other
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The government can (and should) eliminate debt simply by not creating and selling T-securities, while it can (and should) continue to spend more than it taxes.
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If Krugman begins to sound more like Galbraith, will he have to give his Nobel to Galbraith?
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Rodger Malcolm Mitchell
Rodger, as I recall, Krugman defines “liquidity trap” as the point at which liquidity preference trumps consumption and investment at the zero bound. At this point, monetary policy has minimal effect. Bernanke has essentially admitted that at this point, fiscal policy is required.
Krugman is charging that the GOP knows this and is holding back on fiscal policy other than tax cuts in order to depress the economy for the ’12 general election — or, if the economy improves the GOP can claim that the liberal policies failed and tax cuts turned the economy around.
Nick, Krugman is not going to reverse position summarily. Look for him to make incremental adjustments in the direction of Galbraith/MMT, especially with Martin Wolf moving in that direction, too. It’s becoming clear to these folks that Wynne Godley had it right with his sectoral balance approach and stock-flow consistent economic models.
Tom- I think that’s a sensible prediction for how the shift would occur.
Rodger- interesting point about sovereign vs. non-sovereign. It’s surprising that he’s not clear on that, given how much he’s written about the unsustainability of the EU with diverse real economic situations.
Could you elaborate a little more on how the debt/deficit distinction affects his model? I think he’s basically saying that the government can afford to leverage further in the current situation, i.e. run deficits and increase the debt. At least as far as the future is concerned, is there much of a difference between deficit aggregates and debt increases (esp. with low Treasury bill rates)?
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Tom,
I’m not clear on what this means: “. . . liquidity preference trumps consumption and investment at the zero bound. . . “ Say a bit more.
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Nick,
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I suspect, though can’t be sure, that Krugman is using “debt” and “deficit” somewhat interchangeably. That is, by talking about the government “leveraging” further, does he mean running a larger deficit or accumulating a higher debt?
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The confusion comes from the fact that by current law the Treasury is required to “borrow,” i.e. to create and sell T-securities, in an amount to equal the deficit. But that law is unnecessary. If T-securities were decoupled from deficits, there would be no “debt,” as we know it.
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In that event, the total accumulation of deficits would be called something like “Net Money Created,” which would be a more correct description of what has happened.
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I do not know a mechanism by which large amounts of debt, i.e. outstanding T-securities, can cause inflation. In fact, the opposite seems true, since the sale of T-securities “de-liquifies” the economy (cash is replaced with T-securities), so I suspect debt growth actually may be anti-inflationary by pulling cash out of the economy.
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I do know a mechanism by which large deficits could cause inflation. Deficits increase the money supply, which the law of supply and demand says would reduce the value of money — unless the demand also were increased by reducing the risk or increasing the reward (interest rates).
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I’m not sure . . . did I answer your question?
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Rodger Malcolm Mitchell
Rodger: I’m not clear on what this means: “. . . liquidity preference trumps consumption and investment at the zero bound. . . “ Say a bit more.
The idea underlying monetary policy using interest rate setting is that raising rates increase the cost of borrowing and therefore decreases demand for loans, and vice versa. Hence, at very low interest rates borrowing should increase by both consumers and business, leading to increased consumption and investment. But when liquidity preference is greater, then even near zero interest rates do not create a demand for loans on the part of either business for investment or consumers for spending. Output and employment fall due to lack of demand.
According to Krugman liquidity traps are consequences of the paradox of thrift and can lead to depression due to debt deflation when consumers or business is leveraged. He cites Minsky and Fisher in this respect.
If exports don’t right the sectoral balances, which he thinks unlikely in the case of the US at present, then fiscal policy is needed, i.e., a budgetary deficit (government dissaving) is required to offset the domestic private sector’s desire to save with the country running a CAD.
Tom,
I touch on this at: http://rodgermmitchell.wordpress.com/2009/09/09/low-interest-rates-do-not-help-the-economy/.
The problem with the hypothesis you summarize is that it considers only the demand for loans and not the supply. It considers only the borrowers, not the lenders.
Low rates may increase demand but they decrease supply.
Rodger Malcolm Mitchell