Krugman and the natural rate again

Krugman again (re-channeling Hicks) restates his argument that the problem with the US economy is that the natural rate of interest is negative. Note that he also admits, as did recently Goldman Sachs or anybody that looks at data, that the accelerator is what determines investment. Not only his stance has serious logical problems, but also it weakens his own arguments about confidence fairies and so on. And there is no empirical evidence favoring the view that in any period, not just now, non residential investment is significantly affected by variations of the rate of interest. But yes we do need more fiscal expansion, even if lack of full employment is not simply a market failure.

PS: Note that Krugman's second graph, showing the equilibrium of I and S with a negative natural rate, implies that either we had a negative shock to I or a positive shock to S. That is, either a negative productivity shock or a change in preferences about present and future consumption. Real shocks. So what, now he is a Real Business Cycle (RBC) guy? Just drop the natural rate already. Evidence and logic require it.


  1. Right, this is an important point. Krugman has never, so far as I know, offered an explanation for *why* the natural rate is supposed to have fallen. The two obvious candidates would be (a) the natural rate was already negative from the early 2000s at least, but the housing bubble (and perhaps before that the tech bubble) obscured this; or (b) the natural rate is negative because the trade deficit (due, per PK, to an overvalued dollar) is depressing US investment demand (and demand for US output generally). Personally I doubt I could be convinced on either of these stories, but they're basically consistent with what he writes elsewhere (and with people like Dean baker, etc.), and at least they *are* stories. Right now there's nothing -- just an unmotivated fall in the IS curve.

    I guess a third possibility, consistent with the Eggerston paper, would be to say that the fall in IS is due to a tightening of credit constraints. Neither desired savings nor desired investment changed, but the ability of the financial system to intermediate between them fell.

    I agree with you that what we really need is to get away from the static IS-LM framework (which remains useful for simple short-run questions) and acknowledge a positive feedback loop between output and expenditure. Once income falls far enough and/or remains low long enough, desired expenditure falls as well. To a first approximation, output is low today because output has been low; if output had been high, it would continue to be high. There is not a unique equilibrium that can be read off of "fundamentals" and the interest rate.

    One implication of this is that changing the flow of demand for currently produced output will be more effective than changing the stocks of various financial assets. The monetarist/New Keynesian/MMT approach tends to conflate these two things.

    I really like Leijonhufvud on this stuff -- the corridor and so on. Do you?

    1. This makes pretty good sense to me except for the lumping of MMTites with monetarist/New Keynesians.

      From what I can see the MMT folks are constantly emphasizing the importance of the actual flow of deficit spending, at any given time, for ensuring full employment and capacity utilization, and dismissing attempts to do demand management, even in so-called 'normal' times, by means of interest rate adjustments, or the associated influencing of portfolio allocation decisions (e.g., QE).

      And unless I'm mistaken, there is no exogenously-controlled 'money supply', nor any market for 'loanable funds', nor any economic importance at all attached to the outstanding stock of reserves or bonds, as such, in MMT-land.

    2. MMTers advocate a jog guarantee. That would be an automatic flow of spending any time the economy took a dive. Also, they use the Sectoral Balances framework as their main analytical tool for short-run problems. That is a financial flows framework. I'd go as far as to say that if you think that the ISLM is a good short-run tool then you're more "into" stock-based analysis than the MMTers.

    3. JW Mason: "monetarist/New Keynesian/MMT approach"

      MMT economists are anti-monetarist, anti-neoclassical, and anti-neoclassical synthesis, and they reject ISLM as based on the erroneous assumption of loanable funds and exogenous money. MMT economists are fiscalists rather than monetarists, and they hold that money is endogenously determined rather than exogenously, although he interest rate is exogenously determined by the Fed in the US. Because money is endogenous and the Fed acts as LLR, the Fed can set the price (target rate, discount rate) but it cannot set the quantity, because in case of an overdraft it always provides a solvent bank the rb to settle as needed (at the penalty rate).

    4. A bit late to the deabte. Sorry about that. I think the trade deficit story is not what Krugman has in mind. Also, note that this would be something like the external deficit has caused a negative shock to I. I think he is more of a positive shock to S person. People decided to save more (consume less). Note that it is still about preferences and not their constraints associated with a collapse of credit. But no explanation of why the IS shock from him. Endogenous money is not necessarily MMT (see Wicksell), and perhaps some of the confusion in the deabte. Leijonhufvud is always interesting, and difficult to classify, but I ultimately think he remains within the mainstream camp. But he is perceptive and worth reading for sure.

  2. I don't want to pick a fight with MMT folks, who I think are right on all the important substantive and policy questions. However, it is just true that prominent MMT proponents do assert, like Monetarists, that the economic effects of government deficits come through the change they produce in the stock of high-powered money held by the public. For instance, here is Randy Wray's 2001 article "Understanding Modern Money":

    "We would normally expect that the nongovernment sectors will want to accumulate some outside, or net wealth in the form of high-powered money, perhaps as a ratio to inside wealth, and/or as a ratio to income flows. ... Government deficit spending generates hoards of high-powered money to satisfy the nongovernment sector's desire to net save."

    If you go read that article, I think you'll agree it's fair to describe it as basically sharing the monetarist view that the economy always works as if there were binding reserve requirements. Note especially the suggestion that the private sector will likely want to hold outside money in a fixed proportion to income. That is equivalent to Milton Friedman's view that there is a stable, technologically determined velocity of money.

    The reason MMTers have to see outside money as special is because of the commitment to chartalism. But it really is not possible to believe in both chartalist and endogenous money without getting into all kinds of contradictions. I have no problem with what Tom Hickey writes above. But I don't think his story is compatible with the view that the value of money depends on its ability to satisfy tax obligations.

    1. "The reason MMTers have to see outside money as special is because of the commitment to chartalism. But it really is not possible to believe in both chartalist and endogenous money without getting into all kinds of contradictions. I have no problem with what Tom Hickey writes above. But I don't think his story is compatible with the view that the value of money depends on its ability to satisfy tax obligations."

      This is a very interesting critique of MMT, are there sources that go into this in a little more detail.

    2. I don't think this is right at all. And neither do the prominent endogenous money proponents (from Parguez to Lavoie) so far as I can see. The MMTers just say that all private debts and credits net out because the private sector is revenue/income constrained and so all debts (outside the atypical case of bankruptcy) will be repaid. So, the private money circuit will always close.

      The government money is "different", however, in that it is never returned from whence it came because the government is not revenue/income constrained. This is why the MMTers hypothesise that both deficits and debts are necessary to allow economic growth to take place.

      On the topic of monetarism, I don't think that you could be further from the truth. Wray and I have discussed the velocity of money in depth before and he thinks that its highly unstable.

    3. Hi JW,

      "The reason MMTers have to see outside money as special is because of the commitment to chartalism. But it really is not possible to believe in both chartalist and endogenous money without getting into all kinds of contradictions."

      Actually, there are no contradictions. If you think of the central bank as always accomodating, the whole process of money creation is endogenous in the sense that it is "demand driven" (someone needs to be willing to take on debt in order for money to be created).

      In other words, central banks only create reserves ex nihilo, if there is demand from the banks or if the goverment runs a deficit (note that in the current system reserves are the "real thing", bank (or other entities') liabilities are only obligations to "pay reserves"). Now, you may ask, when is there a demand for reserves on the part of commercial banks? Well, if somebody is borrowing from them. Borrowing from a bank implies using the bank's liability to pay somebody else. Now, in order for the liabilities of all banks to clear on par (which is just another way of saying "for the clearing system to operate", the central bank has to accomodate, otherwise the overnight interest rate will soar and if the central bank does not act, the system will eventually break down, huge bank run style).
      Clearing on par is what reserves are required for - the banks use them to settle debts to each other and to the government. They also need them for cash withdrawals. The required reserve ratio is not that important, and is certainly not something that limits lending (and prof. Wray would, I guess, definitely not argue from a money multiplier monetarist persepective). Yes, prof. Wray uses the term "leverage" in a way reminiscent of the money multiplayer, but he is always very clear that the causality actually runs the other way, i. e. the bank extends credit and only then does it seek to get the reserves it requires. This is clearly compatible with endogenous money as put forward by other post-keynesians.

      As far as the sectoral balance approach is concerned, it just spells out the implications of accounting: every financial asset has a financial liability. If the private sector as a whole wants to have a surplus, this is only possible if the governement runs a deficit.

      A government deficit also means that banks are, on aggregate, awash with reserves, which means the central bank (in the US system) needs to conduct open market operations (sell bonds) in order to hit a positive overnight interest rate. If it does nothing, the rate will just fall to zero. This is where Warren Mosler's idea of bonds as a "monetary operation" comes in. The central bank would eventually run out of bonds, and hence, if it still wanted to maintain a positive interest rate, it would have to ask the treasury to issue more debt.

      Anyway, let me also thank Matias Vernengo for running this excellent blog! I very much enjoy both the articles and the links.

    4. Franklin Serrano has said something, not sure if he published, on the fact that money is both endogenous and exogenous at the same time. Might be worth checking within this Chartalist/MMT discussion. My view, is that Chartalism does not necessarily mean exogenous money, and also the reason for accepting a currency can be other than taxation. The international use of the dollar is associated to the pricing of commodties, in particular energy ones, which make the economy move. And there is an army behind the power of determining in what currency oil is priced.

    5. Matias,

      I totally disagree with the "dollar is propped up because of oil being priced in dollars" theory. Dean Baker does a good job on it here:

      "It does matter slightly that the trade typically takes place in dollars. This means that those wishing to buy oil must acquire dollars to buy the oil, which increases the demand for dollars in world financial markets. However, the impact of the oil trade is likely to be a very small factor affecting the value of the dollar. Even today, not all oil is sold for dollars. Oil producers are free to construct whatever terms they wish for selling their oil, and many often agree to payment in other currencies. There is absolutely nothing to prevent Saudi Arabia, Venezuela, or any other oil producer – whether a member of OPEC or not – from signing contracts selling their oil for whatever currency is convenient for them to acquire.

      Even if all oil were sold for dollars, it would be a very small factor in the international demand for dollars, as can be seen with a bit of simple arithmetic. World oil production is a bit under 90 million barrels a day. If two-thirds of this oil is sold across national borders, then it implies a daily oil trade of 60 million barrels. If all of this oil is sold in dollars, then it means that oil consumers would have to collectively hold $4.2 billion to cover their daily oil tab.

      By comparison, China alone holds more than $1 trillion in currency reserves, more than 200 times the transaction demand for oil. In other words, if China reduced its holdings of dollars by just 0.5 percent, it would have more impact on the demand for dollars than if all oil exporters suddenly stopped accepting dollars for their oil."

    6. It's actually the Chartalist perspective. Dollars are the unit of account, and that includes the essential commodities without which the world economy does not work. See my paper with David Fields published in the Review of International Political Economy (it's also a working paper at the Levy).

  3. Matias, if you have time and patience, could you comment or do a post on this paper?

    1. Will do (probably merits a whole post). I did write something about Minsky's position on Sraffa and Keynes, which I ultimately think is misguided. I also think that Minsky's use of the term disequilibrium with respect to Keynes is a mistake. Keynes was very clear that his point was that the economy gets stuck at an unemployment equilibrium, and that is why it is radical. An equilibrium for neoclassical economics cannot be a sub-optimal position.

  4. Matias--great post!

    JWM--your misinterpretation of LRW there was common up to about 10 years ago. Since then, most everyone has come to understand that it was a far too literal one. As noted above, Lavoie and Parguez do understand this. At any rate, the key point is to recognize the paradigm LRW and Lerner build in terms of distinguishing b/n fiscal and monetary policy. In UMM, LRW sets monetary policy as accommodating the demand for reserves and setting an interest rate. Fiscal policy controls the qty of net financial assets--the national debt (obviously, this is somewhat endogenous through the automatic stabilizers). Given this division of labor, when there is a deficit the choice to issue bonds is part of setting the interest rate by draining reserves by monetary policy to accommodate the demand for reserves. For fiscal policy, it's just about printing the money for spending, HPM or reserves in this case (since spending is by key strokes, the part of HPM changing is reserves, not currency). So, when LRW discusses changing HPM in UMM, he's referring to a govt deficit, NOT a monetary aggregate in any sense like monetarists, new Keynesians, etc. Whether that deficit ends up as bonds instead of HPM is a separate monetary policy decision in UMM. So, we have changes to the deficit (changes to HPM) as exogenous (abstracting from automatic stabilizers) and the quantities of reserves (vs. bonds) and traditional monetary aggregates as endogenous (via the central bank and commercial banks, respectively). In the particular LRW quote you cite, he is simply saying that the non-govt sector desires to net save--i.e., a positive national debt--that's it. Again, this has NOTHING to do with monetarism or similar views of money demand, the money multiplier model, exogenous control over monetary aggregates or HPM in the neoclassical sense, and the like. Hopefully this clears things up for you--we say things differently now (though the meaning has not changed) precisely because some of the terminology there confused people. It's not uncommon for stuff like this to get hashed out after an important book is written and to determine that the same message and paradigm might be better understood if terminology is altered a bit.

    Scott Fullwiler

    1. As I said above I tend to agree that MMT (or endogenous money) is compatible with a Chartalist view. The other important distinction of the heterodox camp in general (and not just MMT) with the mainstream (even well intentioned guys like DeLong and Krugman, the best within the mainstream) is the absence of the natural rate. This should be emphasized.


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