An economics, investment, trading and policy blog with a focus on Modern Monetary Theory (MMT). We seek the truth, avoid the mainstream and are virulently anti-neoliberalism.
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Wednesday, February 13, 2019
Alexander Douglas — Paul Krugman on Functional Finance (UPDATED)
I don't link to the NYT since it stopped being a newspaper. Alex Douglas explains Paul Krugman's criticism there of MMT based on r > g.
This is not a new criticism. It is a neoclassically based argument. It was raised when Thomas Piketty's Capital in the 21st Century made r > g famous.
The expression r > g itself was criticized at the time, and I won't repeat it. Suffice it to say that that is a monetarist view that suffers from the insufficiency of neoclassical assumptions about monetarism, in particular the assumption that interest rates are determinative economically, upon which monetarism is based. Brad DeLong raise this issue, too, if I recall correctly. It also prioritizes interest rates as an economic factor (cause) and policy instrument much higher than the data justifies, and it ignores the difference between currency users that must obtain the currency and the currency issuer, especially when the issuer is sovereign in its currency.
While the model is perfectly logical based on the assumptions, that it is wrong as shown by its being useless other than perhaps in special cases. Of course, it could matter in the special case that Paul Krugman and other conventional economists are chiefly concerned with, inflation. But the monetarist solution involving interest rate setting (NAIRU) works through economic contraction that idles workers to reduce wage pressure. This results in a buffer stock of unemployed.
The idling of real resources amounts to waste that cannot be recaptured, and economic inefficiency is the big sin in neoclassical economics, which leaves economic effectiveness to "market forces" and spontaneous natural order. MMT proposes a solution for that in terms of the MMT JG that maintains full employment (less transitional) while providing a price anchor in the guaranteed wage.
Abba Lerner proposed functional finance in contrast to so-called sound finance, which manifests as fiscal conserativism, for example. It is grounded monetarist thinking, the idea being that fiscal imprudence will generate inflation that will result in the bond vigilantes driving up the interest rate they demand to lend money, assuming loanable funds and crowding out. Government, having lost control of the interest on its debt will be driven to insolvency if it doesn't adopt draconian measures that "restore confidence" to financial markets. "Sound finance" is has therefore been a cornerstone of finance capitalism in addition to neoclassical economics, which serves as its academic justification.
One of the foundations of functional finance in its rejection of "sound finance" is that monetarism upon which sound finance is based is not only ineffective but also based on false assumption (which is a reason it doesn't work). This is revealed by a correct operational understanding of government finance built on a correct theory of money. Neoclassical (conventional) economics miss the target here. Even the Fed recently admitted that it has no good theory of inflation. This implies that monetary policy is discretionary rather than rule-based, since a rule-based policy requires a good theory articulated in a model.
Hint: Mono-causal theories are generally insufficient at explanation in complicated simple systems and a fortiori in complex adaptive systems. The reliance on "expectations" shows that the Fed understand that the finance and the economy are aspects of a complex adaptive system. Any mono-causal explanation is likely to be inadequate to the task of predicting, and monetary policy is based on the ability to forecast. Barking up the wrong tree.
The good news though is that Paul Krugman continues to move toward the MMT position. Progress!
Alexander Douglas at Medium
Paul Krugman on Functional Finance
Alexander Douglas | Lecturer in Philosophy, University of St. Andrews
UPDATE
Paul Krugman is out with a follow-up piece at the NYT, to which I don't link, calling for "spend and tax" rather than interest rate setting.
Identical with the MMT position, if Krugman understood it, or was even aware of the exchanges on Twitter these days.
The MMT position as Stephanie Kelton stated in succinctly on Twitter is that spending must be offset as the economy reached optimal capacity as indicated by approaching full employment. Taxation is one offset. Others are available.
See also
Angry Bear
I actually disagree with Paul Krugman for once
'The MMT position as Stephanie Kelton stated in succinctly on Twitter is that spending must be offset as the economy reached optimal capacity as indicated by approaching full employment."
ReplyDeleteTom, if MMTs position is that government spending isn't paid for with taxes when the economy below full employment but at full employment taxes *effectively* have to pay for any additional spending without inflation, isn't that a rather conventional economic view? I understand that MMT disconnects the operations of taxes and spending and the logic of why they're not connected. But if at full employment they are effectively connected, then Krugman and other mainstream economists don't seem to me as wrong as people like to say when they claim that there isn't much new in what MMT is saying. In other words MMT is mostly Keynesian recessionary economic? Conventional mainstream economics is back in play at full employment, which is precisely what MMT aims achieve via a job guarantee. Thus will MMT lead us to a Neoclassical Economics environment via a JG? Where policy debates are all about taxes funding spending. etc.
Krugman and other mainstream economists don't appear to take into account Keynes's argument that demand is very rarely optimal:-
ReplyDeletehttps://rucforsk.ruc.dk/ws/portalfiles/portal/32845977/Jespersen_General_Theory_becoming_75_years.pdf
"Never touch the money system!" Paul Krugman
ReplyDeleteBesides being corrupt, he has crazy eyes. Guilt?
SCB: Tom, if MMTs position is that government spending isn't paid for with taxes when the economy below full employment but at full employment taxes *effectively* have to pay for any additional spending without inflation, isn't that a rather conventional economic view? I understand that MMT disconnects the operations of taxes and spending and the logic of why they're not connected. But if at full employment they are effectively connected, then Krugman and other mainstream economists don't seem to me as wrong as people like to say when they claim that there isn't much new in what MMT is saying.
ReplyDeleteThe terms "offset" rather than "pay for" is a huge difference. They say the same thing in one respect but not in other key respects. What it means practically is that policy regarding spending is not directly related to policy regarding offsets. There are more offsets than taxation, too. Of course, there will be similarities among theories in economics, but the differences are stark, too, from understanding of institutions and operations to theoretical assumptions and technical definitions, and even what counts as relevant data.
Tom, if MMTs position is that government spending isn't paid for with taxes when the economy below full employment but at full employment taxes *effectively* have to pay for any additional spending without inflation, isn't that a rather conventional economic view? I understand that MMT disconnects the operations of taxes and spending and the logic of why they're not connected. But if at full employment they are effectively connected, then Krugman and other mainstream economists don't seem to me as wrong as people like to say when they claim that there isn't much new in what MMT is saying. In other words MMT is mostly Keynesian recessionary economic? Conventional mainstream economics is back in play at full employment, which is precisely what MMT aims achieve via a job guarantee. Thus will MMT lead us to a Neoclassical Economics environment via a JG? Where policy debates are all about taxes funding spending. etc.
In other words MMT is mostly Keynesian recessionary economic? Conventional mainstream economics is back in play at full employment, which is precisely what MMT aims achieve via a job guarantee. Thus will MMT lead us to a Neoclassical Economics environment via a JG? Where policy debates are all about taxes funding spending. etc.
For the above reasons, I don't see that happening. One might say that MMT corrects faulty economic understanding and unrealistic assumptions. MMT also provides a fresh perspective and updated methodology. Hopefully, previous theories of economics that don't incorporate the contributions of MMT (which includes many previous contributions by others) will be widely recognized as being obsolete and just be relegated to a museum.
Of course, this is not to claim that MMT has the last word or will have it. I would say that MMT provides the beginning words is a new approach to the debate by providing a new frame. And it's a long march to the horizon, which is ever receding owing to changing conditions in complex adaptive systems. A frame is not a theory. It is a framework in terns of which competing theories can be developed. One immediately result would be the ending of arid formalism, which has been a detour historically away from the issues and problems that occupied classical economics.
If Keynes made a serious mistake, it was working in the neoclassical framework to correct it. That compromise resulted in a set back, e.g., the neo-Keynesian "synthesis," which opened the door to Milton Friedman's monetarism and the New Classical school. The result was disaster. I don't see the MMT economists making the same mistake Keynes did
Good thread.
ReplyDeleteI'll add that in MMT there is no automatic tendency to a particular level of output, even if prices and expectations could be made fully flexible. In contrast, neoclassical theory suggests that, irrespective of fiscal policy, there would be an automatic tendency to a particular level of output (determined by supply-side factors) in the absence of rigidities. In the New Keynesian view, the main rigidity to blame in the aftermath of the GFC was the so-called liquidity trap.
The theoretical differences would not disappear with the introduction of a job guarantee. With a JG, there would be no involuntary unemployment, but in the MMT view there would still be demand-determined variations in the ratio of JG employment to total employment (the buffer employment ratio, or BER). There would be no automatic tendency for the economy to move to the lowest BER still consistent with price stability (what Bill Mitchell called the 'non-accelerating buffer employment ratio', or NAIBER).
A fundamental reason for this difference between MMT and neoclassical theory is that the latter's microfoundations imply the existence of a natural rate of interest. Following the GFC, the New Keynesian justification for fiscal policy was basically that the real interest rate was stuck above the natural rate. MMT rejects the notion of a natural rate. This conclusion makes sense in view of the capital debates, the 'Keynes versus Classics' arguments, MMTers' institutional analyses of monetary operations as well as the lack of empirical evidence for the neoclassical position.
One significance of this is that it is incorrect for New Keynesians to say that MMT's only novel feature is to switch the assignment of policy instruments. Yes, MMT does assign monetary policy to keeping r < g and fiscal policy to macro stabilization (the reverse of the New Keynesian policy assignment). But MMT cannot be said to amount to New Keynesianism with the policy instruments switched. This switch could not be viable in the long run if neoclassical microfoundations and the existence of a natural rate of interest were really operative. The MMT position depends on the interest rate being a matter of policy, including at full employment. The rationale for the MMT view is built upon non-neoclassical foundations (largely shared with other Kalecki and Keynes influenced macro approaches).
Another significance is that theoretical implications for the long run are not synonymous with implications of full employment (or NAIBER) in the case of MMT, whereas they are in the case of New Keynesian economics.
Here is the key sentence in Jesper Jespersen's paper (link above)that reveals how Neo-Classical economists fail to see the key factor of uncertainty embedded within it:-
ReplyDelete“…… it is the interaction between the sum of the individual firms’ sales expectations (aggregate demand) and their estimated production costs (aggregate supply) that together with a number of institutional conditions (bank credit, labour market organization, global competition and technology) determine the business sector decisions on output as a whole and employment.”