The debates between the deficit doves and the deficit owls continued at New Deal 2.0 (ND20) today. Jeff Madrick, a dove, gives us a post entitled: “Stimulate Now: On Inflation and Deficits.” In this post, I’ll evaluate Jeff’s views paragraph by paragraph.
”Some have suggested that if a country nears the point that it must consider default, that is, it can’t generate enough tax revenues to pay debt and meet other minimal commitments, then all it need do is create reserves if it has a sovereign (aka ‘fiat’) currency.”
Maybe Jeff is right that “some have suggested . . .” the above, but I’ve never seen anyone do that. The economists I read who write about the capabilities of Governments sovereign in their own currencies say that such countries can’t be forced to default, that they can only do so voluntarily, and that if they do, it’s only because their decision makers don’t understand that they can’t be forced into default by international markets any external authorities.
In addition, these same economists disagree that tax revenues are used to pay debts, or to meet any commitments of the Government, minimal or otherwise. They would say that as a purely operational matter the Government creates money every time it spends, including when it pay debts, and that its revenue gathering activities, both taxation, and sales of debt instruments or anything else, are, as a matter of its operations, entirely separate from its spending, and also happen after spending has already occurred.
In short, they say the Government’s power to spend is in no way dependent on either its taxing or borrowing activities, and so it can never be nearer to default because it “can’t generate enough revenue” to match these spending activities. Now, Jeff Madrick may disagree with this description of the economic facts of the situation, and if so, he ought to present a counter-narrative about how Government spending actually occurs. But it is simply wrong to suggest that the deficit owls opposing his position believe that a country can ever get nearer to insolvency because its tax collections don’t match its spending. What they believe is that whatever its tax revenues are, they are equally far away from forced insolvency, i.e. the loss of their capability to pay debts and obligations denominated in their own sovereign fiat currency. Jeff continues:
”But in most such circumstances, such a thing will incur inflation. Now, the level of inflation is part of the issue, if is high enough. But the direction of the level of inflation is more important. That is, does it suggest ever higher inflation? Paying back the debt in devalued dollars amounts to a de facto default. The government might not incur trouble from a legal standpoint, but if the financial squeeze of the country is great, the markets will react as if it is a default and creditors will demand higher rates for the next round of debt and a tragic spiral of further money printing and inflation could ensue.”
Why will “such a thing. .. incur inflation"? As a consequence of the quantity theory of money? I’m afraid that theory is long discredited. I think there will be no demand-pull inflation if the Government spends without incurring debt as long as there is excess unused productive capacity as measured by less than full employment. If Jeff doubts this, I’d like to see some evidence from fiat monetary systems sovereign in their own currency. Why doesn’t Jeff cite some cases of demand-pull inflation at less than full employment if he has any? If he hasn’t any such cases, then I think he needs to withdraw that statement.
Jeff also says that not only the level of inflation is an issue, but also whether price increases suggest ever higher inflation. If this occurred it would certainly be an issue. But we need to be careful of terminology here. Price rises and “inflation” are not the same thing from the economist’s viewpoint. One-time price increases are not inflation, but just price adjustments to shocks. Increasing prices over time are not “inflation” either, if the pattern of increase shows a declining increase over time. “Inflation” is a condition in which prices show an accelerating increase over time. And hyperinflation is “inflation” at a very fast rate of acceleration of price increases. These different patterns of rising prices are very different, and to claim that there is a danger of either inflation or hyperinflation, I think an economist has to tell a reasonable story about how different factors in the economy would feed back upon one another over time, producing accelerated price increases and also present some facts testing such a model. But what do we have from Jeff? Just his assertion, and the narrative that repaying debts in a currency that has less value is a “. . . de facto default . . . “ and “. . . . if the financial squeeze of the country is great, the markets will react as if it is a default and creditors will demand higher rates for the next round of debt and a tragic spiral of further money printing and inflation could ensue.”
However, since the premise of his narrative is that a government sovereign in its own currency begins to spend without incurring debt or raising enough in taxes to fund its spending, then why would such a government have to worry about creditors in the international market raising interest rates, since it’s no longer incurring new debt and the interest rates on its old debt are already fixed by contract? Moreover, spending by such a Government would flood the banking system with excess reserves and have the effect of driving short term interest rates down close to zero. So, who would be determining interest rates, the international markets or the sovereign government involved? Jeff goes on:
”To believe that creating of reserves can work if a country is nearing default requires a belief that nations in such circumstances will retain confidence in their currencies and not incur inflation. How do we know that? Paul Krugman’s response to James Galbraith on this point is, in my view, basically correct. Galbraith has expressed concern that those who do not subscribe to the view that long-term big deficits will almost never be a problem are potentially threatening Social Security. But the real issue is whether the US will get close to default threats. In my view, it only will if we do not stimulate now. Our energies should be focused on that, and I would like to see more macro models with various Keynesian multipliers and accelerators to show how much growth we need to reduce long-term debt, and not just rely on the CBO model.”
Well, again, Jeff assumes that “a country is nearing default, and that “confidence” would be lost. But why would that be the case? And whose “confidence” are we talking about? The hypothetical country involved would have met all its debt and other contractual obligations, right along. It would still be sovereign in its currency, so that its currency, and only its currency, could be used as legal tender, to do business, pay debts, make investments, pay taxes, which would still be a legal requirement, and so on. So, given that there is no solvency issue, where, exactly does “confidence” come into this process? What is Jeff’s narrative showing to make us accept that there would be a reflexive process driven by feedback effects involving “confidence” or lack of it, as a key factor driving an upward spiral of inflation?
Jeff says that he thinks that Paul Krugman’s reply to Jamie Galbraith on this point is basically correct. But as I’ve argued in more detail and in more formal terms, Paul’s answer to Jamie is based on the assumptions that the Government will continue to issue debt, on the quantity theory of money, and on the idea that the Government would choose to default on its obligations even if it doesn’t have to. All three assumptions are Paul’s and are not shared by the deficit owls, Paul, and now Jeff, are criticizing. In particular, the deficit owls believe that the Government doesn’t have to keep issuing debt, or that even if it does there are means open to it that would allow it to drive its interest costs down to near zero, so that there is no issue about markets raising interest rates. In short, Paul Krugman has modeled the wrong thing and bases his reasoning on the false quantity theory of money. He should have modeled the impact of increasing deficits, and not debts, on price increases, in order to address the views of the deficit owls, and he should have used an underlying theory of money different from the discredited quantity theory. Finally, Paul should have offered a theory about why we ought to expect the Government of the United States to default, when it has no external constraint forcing it to do so. Since he did not do any of these things, his argument fails to show that either inflation of hyperinflation is a more than an alarmist theory without any basis in fact or even in a coherent model suggesting that inflationary outcomes are plausible.
Finally, in raising the possibility of inflation both Jeff Madrick and Paul Krugman ignore the likely effect of automatic stabilizers in driving deficits down. The deficit owls contend that if short-term deficit spending is vigorous enough to end the recession and create full employment, a condition that the deficit doves also assume, then the consequence will be that the automatic stabilizers will end the deficits drive the Government sector towards surpluses. If that happens, GDP will increase at a more rapid rate than Government deficits, and any debt increases that the Government still allows to occur. The public debt-to-GDP ratio that both deficit hawks and doves are so fond of worrying about will then come down very quickly, and where will “our long-term” deficit problem be then? Gone with the wind and also, hopefully, gone from the fevered imaginations of both deficit hawks and deficit doves.
The truth is that the scenarios that the deficit doves, including Paul Krugman and Jeff Madrick, are appealing to, are more than a bit incoherent. One can’t postulate continued deficit spending once full employment is reached, without also assuming government stupidity, or a deliberate government attempt to create inflation. Given how paranoid about inflation our decision makers have been for the past 30 years, I hardly think excessive government spending once we’re at full employment is very much of a danger, and if, by some chance, it were to happen, there are, as Randy Wray recently pointed out, always price controls to manage any overheating while we’re draining any excess supply of money from the economy.
In view of this, the deficit dove expectation that we would have full employment and rapidly increasing deficits at the same time, seems incoherent. That is, what mechanism or confluence of forces can the doves or hawks point to that would overcome the automatic stabilizers driving the Government budget toward surpluses, and create the increasing Government deficits that might be the basis for inflation? I think they have no such mechanisms, and models that purport to show scenarios of this kind, such as the CBO projections of Government deficits between now and 2020 are based on these same incoherent assumptions. And because they are, CBO’s projections are just nonsense, and should not be used as the basis for any Government policy, much less policies cutting valued Government spending programs that are vital to most Americans. The problem with the deficit dove position is that it just accepts the deficit hawk notion that we have a deficit problem and that it does so without either any empirical evidence or any good theory showing that a problem exists. The problem is an imaginary one, and by claiming that it is real, the deficit doves are creating the political conditions that will lead to cuts in valued Government spending that people rely on. These cuts will come about because deficit hawks and deficit doves share the view that there is a problem. Since neither side will be able to agree on what to cut to end the problem; the inevitable result will be some genteel compromise that makes life a lot tougher for the middle class and older people; if not now, then in 10 years. But there is no need for such a compromise, because there is no problem. It is just not real. It is just a distraction from the real problem, which is how to bring government to bear to help us build America’s future by solving our current very challenging range of problems. When are going we going to stop talking about the deficit fantasy problem and start getting people back to work on all the things that need doing? Isn’t that what New Deal 2.0 is really about?