Krugman’s Monetary Mysteries

Here’s the latest from Paul Krugman:

The way it was: Eight years ago, with the economy in free fall, I wrote that we had entered an era of “depression economics,” in which the usual rules of economic policy no longer applied, in which virtue was vice and prudence was folly. In particular, deficit spending was essential to support the economy, and attempts to balance the budget would be destructive.
But these predictions were always conditional, applying only to an economy far from full employment. That was the kind of economy President Obama inherited; but the Trump-Putin administration will, instead, come into power at a time when full employment has been more or less restored.
What changes once we’re close to full employment? Basically, government borrowing once again competes with the private sector for a limited amount of money. This means that deficit spending no longer provides much if any economic boost, because it drives up interest rates and “crowds out” private investment.

When Government Borrowing is Bad

Let’s quickly review why, according to mainstream macroeconomics, government ‘borrowing’ competes with the private sector for a ‘limited amount of money’ at ‘full employment’ (I use the sneer quotes because none of these terms as used by economists have the sense that they intuitively should have).

At full employment, additional spending drives up the rate of inflation.

Deficit spending is additional spending. The government’s net spending is spending minus taxation (G-T), so that if G increases without T increasing, or T decreases without G decreasing, government net spending increases.

This additional spending and its expected inflationary effects drive the central bank to tighten monetary policy.

Tighter monetary policy dampens private borrowing, which might have been funding spending on better things than the new government borrowing will fund.

Misleading Metaphor

Krugman’s claim that government ‘borrowing’ competes with the private sector for a ‘limited amount of money’ is misleading.

Government ‘borrowing’ in itself doesn’t crowd out anything. Only if the central bank tightens monetary policy is private borrowing discouraged (and then only maybe). Krugman skips this step, presumably, because he takes central bank policy to be as inevitable as the tide.

But it isn’t. If monetary policy were changed — if the central bank’s mandate were changed — so that the interest rate could be simply fixed at a given level then the result would be different. High deficit spending at full employment could lead to inflation. But it wouldn’t ‘crowd out’ private borrowing at all. The effects of government spending would simply be added to those of private spending. Crowding out is always and everywhere a monetary phenomenon.

Under such a policy, the government could look at different ways to control inflation — e.g. changes to collective bargaining practices, policies to deal with monopoly, buffer stocks of raw materials, tighter regulation in asset markets, and, of course, taxation.

To go further: if the central bank let the interest rate run to zero — if it stopped sterilising the extra reserve balances created by government spending — then fiscal policy would have total control of the amount of money. Government borrowing would never crowd out private borrowing.

If the government wanted to restrict private spending in order to control inflation (without cutting its own net spending), then it could do so using a targeted tax policy and the sorts of measures mentioned above. These policies could be agreed to by elected representatives who would judge whether or not they were in the interests of their constituencies.

Also the government could aim its policies at discouraging the least socially necessary private spending, whereas monetary policy is entirely indiscriminate in what it discourages and encourages.

Mysterianism Crowds Out Debate

I find this a favourable policy for many reasons, including a moderate preference for representative democracy over a cabal of appointed hierophants. Also, monetary policy is deeply unfair: it massively favours those wealthy enough to adjust their spending in reaction to changes in the interest rate.

Fiscal policy is, in practice, usually unfair also. But at least we can vote out those who make it against our interests. And it would be much easier for voters to understand the choices involved if the sacred mysteries of monetary policy didn’t hang a veil over the whole matter — one that only experts can penetrate.

What annoys me is that we can’t even get a public debate going on the fiscalist alternative. That is partly, I suspect, because people like Krugman have been bizarrely successful at convincing the public to mistake a fairly recent policy for an immutable and eternal fact of nature.