There was an interesting if not ego-centric interchange last week involving the New Keynesian economist Paul Krugman and others about whether the sort of macroeconomic policy positions one takes is more motivated by ideological motives (about the desirable size of government) rather than being evidence-based. Apparently, if you support austerity it is because you really just want smaller government and vice versa. This is an oft-stated claim made by conservatives. That if you support fiscal stimulus and government regulation that you are automatically in favour of big (intrusive) government. The point is not valid. Whether one supports a larger proportional government or smaller is a separate matter to understanding how the monetary system functions and the capacities and options available to the government. Modern Monetary Theory (MMT) provides the basis for that understanding but not a prescription for a particular size of government.



To begin, there is no necessary correspondence between support for fiscal stimulus and one’s perception of how large the government sector should be as a proportion of the overall economy.

Continuous fiscal deficits of some proportion may be necessary irrespective of the size of government. To argue otherwise is to misunderstand the role of fiscal deficits in the monetary system.

The dispute between Krugman and Austrian School economist Russ Roberts started a while ago. Roberts, from Stanford cites his influences as Gary Becker, Friedrich Hayek and Milton Friedman, an unsavoury trio if there ever was.

He wrote in an article (October 11, 2011) – The evidence for Keynesian economics – that:

Krugman is a Keynesian because he wants bigger government. I’m an anti-Keynesian because I want smaller government.

Now, clearly one’s perspective on the size of government cannot be prescribed by any body of theory. It is a misconception to think that mainstream textbook economic theory proves the government should be ‘small’. There is no proof to that end.

Orthodox economic theory, in fact, has nothing to say about the optimal size of government.

Further, there is nothing “Keynesian” that dictates a preference for a particular size of government.

I discuss the vexed use of the term ‘Keynesian’ in this blog – Those bad Keynesians are to blame.

Paul Krugman has defined the term to suit himself. In his New York Times article (November 3, 2009) –

On not listening – he had claimed that:

The position held by Keynesians … is that fiscal stimulus is necessary only under certain special conditions. Namely, when you’re up against the zero lower bound, and conventional monetary policy is useless, fiscal stimulus may be your best option.

In his latest entreaty into the subject (June 6, 2015) – Why Am I A Keynesian? – he repeats that construction in a defensive way to disabuse readers of any notion that he supports “bigger governnment”:

If I were, shouldn’t I be advocating permanent expansion rather than temporary measures? Shouldn’t I be for stimulus all the time, not only when we’re at the zero lower bound? When I do call for bigger government — universal health care, higher Social Security benefits — shouldn’t I be pushing these things as job-creation measures? (I don’t think I ever have). I think if you look at the record, I’ve always argued for temporary fiscal expansion, and only when monetary policy is constrained.

The essential point that Paul Krugman has been making about his own conception of what constitutes Keynesian thinking is that “recessions … [result from] … failures of aggregate demand” and that there is a role for governments to reverse those failures using monetary or fiscal policy.

But, in his view, “when the slump pushes rates down to zero, and that’s still not enough, any simple model I can think of says that fiscal expansion can be a useful supplement, while fiscal austerity makes a bad situation worse”.

So fiscal policy is only to be preferred when monetary policy is ineffective and that happens according to Krugman when there is a zero interest rate policy (ZIRP).

At times, Krugman has equated the ZIRP with the notion of a ‘liquidity trap’ to reinforce his Keynesian credentials.

I have written about the issue of the liquidity trap before. Please see the blogs – The on-going crisis has nothing to do with a supposed liquidity trap and Whether there is a liquidity trap or not is irrelevant – for further discussion.

Paul Krugman abuses the meaning of the ‘liquidity trap’ and his version is not rooted in the work of Keynes. He is among a group of economists that articulated the same position during the early months of the GFC that the economy was presenting a special case which they deemed to be – the “liquidity trap” case.

Accordingly, they argued, that when an economy enters a liquidity trap monetary policy loses its capacity to influence aggregate demand via interest rate changes and only fiscal policy (deficits) can be effective in reviving real GDP growth.

It is this association that allows these economists to identify themselves as Keynesian or New Keynesian and many so-called ‘progressive’ economists fit into this category, however ill-defined it might be.

I explain in detail in this blog – Whether there is a liquidity trap or not is irrelevant – why this appeal to Keynes is invalid.

In summary (you should read the whole blog if you are curious), the liquidity trap does not require a zero interest rate to become operational.

The Keynesian link is usually made by appealing to a section in Keynes’ 1936 book – The General Theory of Employment, Interest and Money – specifically Chapter 15, Section II.

Keynes talked about liquidity preference in Chapter 13 of the General Theory where he introduced the transactions-motive for holding cash balances. That is, people will hold cash to allow them to purchases goods and services on a daily basis.

In Chapter 15, he expounded on this in more detail and came up with several distinct motives for holding cash. One such motive – the Speculative-motive – was central to the way he thought about uncertainty.

In the Classical theory, money was just a transactional commodity with no special characteristics other than to ease exchange. People exchange in real terms (based on perceptions of real use values) and the introduction of money was of no particular import to those valuations. It just eased the so-called problem of barter where the double-coincidence of wants might be absent (the baker doesn’t want her plumbing fixed and the plumber prefers fruit!).

But for Keynes, money was special and “plays a part of its own and affects motives and decisions and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted, either in the long period or in the short period, without a knowledge of the behaviour of money ebtween the first state and the last” (taken from his book “On the Theory of a Monetary Economy”, page 216).

What that means for our purposes here is that money serves as a temporal link between present and the unknowable future.

What does that mean? Keynes said that money can act to “lull our disquietude” about the uncertainty of the future. By holding money we do not commit to purchase. Instead we hold liquidity until we are more certain of things.

So when there is rising unemployment or other sources of uncertainty, more people will hold money as a safety measure and refrain from spending.

In the Chapter 17 (Section III) of the General Theory, Keynes wrote:

Unemployment develops, that is to say, because people want the moon; — men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control.

In other words, the increased demand for money to ease uncertainty doesn’t produce any real goods and services which would employ people, unlike, say, the increased demand for motor cars.

So money is a special commodity.

It is the most liquid asset available but because it earns no interest (unlike a bond) there is an opportunity cost in holding it. So people will hold more cash when interest rates fall rather than when they rise.

Central banks influence interest rates by conducting ‘open market operations’ – they exchange government bonds with the private sector.

Keynes argued that monetary authorities can normally:

… purchase (or sell) bonds in exchange for cash by bidding the price of bonds up (or down) in the market by a modest amount; and the larger the quantity of cash which they seek to create (or cancel) by purchasing (or selling) bonds and debts, the greater must be the fall (or rise) in the rate of interest.

He is referring to ‘open market operations’ here which have been normal liquidity management operations of central banks. Please read my blog – Budget deficits do not cause higher interest rates – for more discussion on this point.

But there is a point where people will only wish to hold cash and will eschew the purchase of bonds, thus rendering the capacity of the central bank to modify the interest rate ineffective.

And in that sense, monetary policy becomes ineffective as a means of altering the level of total spending in the economy.

This leads to our understanding of the liquidity trap as developed by Keynes. At some point, people form the expectation that the future prices of all income-earning assets (stores of wealth) are at their maximum and that any purchases of those assets would result in a capital losses.

This coincides with a situation where interest rates reach some low point (not necessarily zero). The expectation of capital loss is based on the inverse relationship between interest rates and bond prices explained in the blog cited above.

So everyone holds cash rather than bonds because they consider interest rates are so low they can only rise which means that purchasing bonds at existing market prices would guarantee a capital loss as their prices fell.

The central bank then cannot push rates lower and if aggregate demand is deficient at that level of rates they allegedly lose their capacity to increase spending.

This is what Keynes call the ‘liquidity trap’.

You can see that this is not the same thing as a ZIRP chosen by the central bank. Krugman’s liquidity trap does not arise in the same way that Keynes’ trap does and it is wrong to claim an association with the latter concept.

Paul Krugman also argued that a Keynesian position is for “temporary” rather than “permanent” stimulus. The fiscal stimulus should only come at the zero interest rate. Which implies that normally he considers monetary policy should be given primacy and fiscal policy is a special case

Did Keynes have a preference for monetary policy?

Keynes’ earlier interests were associated with his perception that he was somehow directly extending the work of Alfred Marshall who had taught him about ‘money’ at Cambridge. Keynes sat in Marshall’s monetary classes in 1905.

He developed his monetary economics within a firm view that central banks should cooperate to maintain fixed exchange rates, a position he held until his death and which influenced the development of the Post World War II Bretton Woods system that operated until 1971.

In the early days of the Great Depression (around 1931) he firmly advocated the Bank of England to cut the discount rate (the rate it lends reserves to the commercial banks) to stimulate credit creation in the banking system.

The so-called ‘cheap-money’ policy suggested that he favoured monetary policy as the principle weapon for counter-stabilisation.

He also advocated controlling longer term investment rates to ensure they were low enough to stimulate spending. He celebrated the British government’s decision in 1932, for example, to cut the interest rate on outstanding War Bonds, which allowed the Bank of England to reduce long-term interest rates generally.

In the The Collected Writings of John Maynard Keynes XXI, which covered “Activities 1931–9: World Crises and Policies in Britain and America”, he wrote (Page 395):

The Bank of England and the Treasury had a great success at the time of the conversion of the War Loan. But it is possible that they still underrate the extent of their powers. With the existing control over the exchanges which has revolutionised the technical position, and with the vast resources at the disposal of the authorities through the Bank of England, the Exchange Equalisation Fund, and other funds under the control of the Treasury, it lies within their power, by the exercise of the moderation, the gradualness, and the discreet handling of the market of which they have shown themselves to be masters, to make the long- term rate of interest what they choose within reason.

He also advocated the use of “tap issue” system of debt issuance, which dominated public debt management until the neo-liberal era began. Accordingly, the government would announce the yield (interest rate) it was prepared to pay on different debt maturities and then the private market could buy whatever volume of bonds they chose, the central bank filling any shortfalls in desired revenue.

This system effectively allowed the government to control all yields. This system was abandoned in the 1980s in Australia when the Government decided that it would move to a full auction system whereby the government would set the volume of cash desired from the bond issue and the private sector would determine the interest it required to earn to supply that much cash.

This new system gave the impression that the private bond markets were in charge. But it was just a voluntary choice to provide corporate welfare.

Keynes was important because he broke with the Classical tradition by advocating a central role for a central bank which was to advance general well-being and demonstrated how ‘money’ was a crucial commodity in its own right in an environment of endemic uncertainty.

So there is some merit in considering that Keynes’ early work was focused not on counter-stabilising policies in a crisis but rather setting in place an institutional structure that would provide for stability in domestic and international monetary conditions.

He also believed that large-scale public works, for example, were an important policy intervention that governments could use to break a recession arising from a deficiency of private spending.

He clearly showed that the capitalist monetary system could become trapped at production levels which generated mass unemployment and required an external spending intervention from government.

Does this mean that he was supporting fiscal deficits in the same way as Modern Monetary Theory (MMT)? Not really, he considered that the expansion on the public expenditure side would via the multiplier expand output and employment and tax revenue.

In his Essays in Persuasion (1933), he discusses the impact of the automatic stabilisers on tax receipts and spending.

He writes that “We have reached a point where a considerable proportion of every further decline in the national income is visited on the Exchequer through the agency of the dole and the decline in the yield of the taxes. it is natural, therefore, that the benefit of measures to increase the national income should largely accrue to the Exchequer”.

He then wrote:

If we apply this reasoning to the projects for loan-expenditure which are receiving support today in responsible quarters, we see that it is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the Budget, – that we must go slowly and cautiously with the former for fear of injuring the latter. Quite the contrary. There is no possibility of balancing the Budget except by increasing the national income, which is much the same thing as increasing employment.

So he thought austerity was bad if the government wanted to “balance the budget” but that fiscal stimulus would not undermine that aim.

So there is some truth in Paul Krugman’s notion that being “Keynesian” meant that you advocated temporary fiscal deficits.

That, of-course, sets his position apart from the Functional Finance principles developed by Abba Lerner which Modern Monetary Theory (MMT) is more closely aligned with.

Functional finance says that government should always be guided in its policy choices by how effective they in influencing national income and employment.

The concept of a ‘balanced budget’ becomes irrelevant and should never be a goal of the government.

Please read my blog – Functional finance and modern monetary theory – for more discussion on this point.

In this conception, permanent fiscal stimulus may be the most appropriate policy action if non-government spending (and saving) decisions leave a spending gap – defined in terms of the level of spending required to produce enough employment to satisfy the desires of the available labour supply.

There is every reason to believe that continuous fiscal deficits are required, especially when external deficits are the norm.

It might be argued that these continuous deficits are not stimulus measures. That is, a fiscal stimulus might only mean a discretionary increase in the deficit.

That would be a difficult argument to maintain. Stimulus just means adding to expenditure and a continuous deficit continuously supports spending – preferably at desirable full employment levels.

Paul Krugman is in the ‘balanced budget over the cycle’ camp which is at odds with functional finance (and MMT) but not necessary at odds with the early writings of Keynes.

Where Krugman fall foul of Keynes though is in his New Keynesian belief that it is the rigidity of wages and prices that separates Classical from Keynesian theory. That is another blog – but I touch on it in this blog – Those bad Keynesians are to blame – among others.

Conclusion

A ZIRP situation may, by definition, reduce the capacity of the central bank to influence effective demand in the economy any further. But it is not the same state that Keynes considered rendered monetary policy ineffective.

I should add that MMT also does not automatically bias one to thinking that government should be relatively large. Small government advocates would be wise to understand MMT principles given they apply to monetary economies irrespective of the size of government.

Some MMT proponents that I know support larger public sector provision, while others support a greater role for the private sector. But we all agree on the way that the monetary system operates and the capacities that the currency-issuer holds in that system to further the well-being of the population.

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.