Kelton and Krugman on IS-LM and MMT

The MMT debates continue apace. New critiques — the good, the bad and the ugly — appear daily. Amidst the chaos, a guest post on Alphaville from three MMT authors stood out: the piece responded directly to various criticisms while discussing the policy challenges associated with controlling demand and inflation when fiscal policy is the primary macro stabilisation tool. These are the debates we should be having.

Unfortunately, it is one step forward, two steps backwards: elsewhere Stephanie Kelton and Paul Krugman have been debating across the pages of the Bloomberg and the New York Times websites. The debate is, to put it politely, a mess.

Krugman opened proceedings with a critique of Abba Lerner’s Functional Finance: the doctrine that fiscal policy should be judged by its macroeconomic outcomes, not on whether the financing is “sound”. Lerner argued that fiscal policy should be set at a position consistent with full employment, while interest rates should be set at a rate that ensures “the most desirable level of investment”. Krugman correctly notes the lack of  precision in Lerner’s statement on interest rates. He then argues that, “Lerner neglected the tradeoff between monetary and fiscal policy”, and that if the rate of interest on government debt exceeds the rate of growth, either the debt to GDP ratio spirals out of control or the government is forced to tighten fiscal policy.

Kelton hit back, arguing that Krugman’s concerns are misplaced because interest rates are a policy variable: the central bank can set them at whatever level it likes. Kelton points out that Krugman is assuming a “crowding out” effect: higher deficits lead to higher interest rates. Kelton argues that instead of “crowding out”, Lerner was concerned about “crowding in”: the “danger” that government deficits would push down the rate of interest, stimulating too much investment. Putting aside whether this is an accurate description of Lerner’s view, MMT does diverge from Lerner on this issue: since MMT rejects a clear link between interest rates and investment,  the MMT proposal is simply to set interest rates at a low level, or even zero, and leave them there.

So far, this looks like a straightforward disagreement about the relationship between government deficits and interest rates: Krugman says deficits cause higher interest rates, Kelton says they cause lower interest rates (although she also says interest rates are a policy variable — this apparent tension in Kelton’s position is resolved later on)

Krugman responded. This is where the debate starts to get messy. Krugman takes issue with the claim that the deficit should be set at the level consistent with full employment. He argues that at different rates of interest there will be different levels of private sector spending, implying that the fiscal position consistent with full employment varies with the rate of interest. As a result, the rate of interest isn’t a pure policy variable: there is a tradeoff between monetary and fiscal policy: with a larger deficit, interest rates must be higher, “crowding out” private investment spending.

Krugman’s argument involves two assumptions: 1) there exists a direct causal relationship between the rate of interest and the level of private investment expenditure, and, 2) the central bank will react to employment above “full employment” with higher interest rates. He illustrates this using an IS curve and a vertical “full employment” line (see below). He declares that “this all seems clear to me, and hard to argue with”.

250219krugman1-jumbo

At this point the debate still appears to remain focused on the core question: do government deficits raise or lower the rate of interest? By now, Krugman is baffled with Kelton’s responses:

It seems as if she’s saying that deficits necessarily lead to an increase in the monetary base, that expansionary fiscal policy is automatically expansionary monetary policy. But that is so obviously untrue – think of the loose fiscal/tight money combination in the 1980s – that I hope she means something different. Yet I can’t figure out what that different thing might be.

This highlights two issues: first, how little of MMT Krugman has bothered to absorb, and, second, how little MMTers appear to care about engaging others in a clear debate. Kelton, following the MMT line, is tacitly assuming that all deficits are monetised and that issuing bonds is an additional, and possibly unnecessary, “sterilisation” operation. Under these assumptions, deficits will automatically lead to an increase in central bank reserves and therefore to a fall in the money market rate of interest. But Kelton at no point makes these assumptions explicit. To most people, a government deficit implicitly means bond issuance, in correspondence with the historical facts.

So Krugman and Kelton have two differences in assumptions that matter here. First, Krugman assumes a mechanical relationship between interest rates and investment and thus a downward sloping IS curve, while Kelton rejects this relationship. Second, they are assuming different central bank behaviour. Krugman assumes that the central bank will react to fiscal expansion with tighter monetary policy in the form of higher interest rates: the central bank won’t allow employment to exceed the “full employment” level. Kelton assumes, firstly, that fiscal policy can be set at the “full employment” level, without any direct implications for interest rates and, secondly, that deficits are monetised so that money market rates fall as the deficit expands.

The “debate” heads downhill from here. Krugman asks several direct questions, including “[does] expansionary fiscal policy actually reduce interest rates?”. Kelton responds, “Answer: Yes. Pumping money into the economy increases bank reserves and reduces banks’ bids for federal funds. Any banker will tell you this.” Even now,  neither party seems to have identified the difference in assumptions about central bank behaviour.

The debate then shifts to IS-LM. Krugman asks if Kelton accepts the overall framework of discussion — the one he previously noted “all seems clear to me, and hard to argue with”. Kelton responds that, no, MMT rejects IS-LM because it is “not stock-flow consistent”, while also correctly noting that Krugman simply assumes that investment is a mechanical function of the rate of interest.

In fact, Krugman isn’t even using an IS-LM model — he has no LM curve — so the “not stock flow consistent” response is off target. The stock-flow issue in IS-LM derives from the fact that the model solves for an equilibrium between equations for the stock of money (LM), and investment and saving (IS) which are flow variables. But without the LM curve it is a pure flow model: Krugman is assuming, as does Kelton, that the central bank sets the rate of interest directly. So Kelton’s claim that “his model assumes a fixed money supply, which paves the way for the crowding-out effect!” is incorrect.

Similarly, Kelton’s earlier statement that Krugman “subscribes to the idea that monetary policy should target an invisible ‘neutral rate'” makes little sense in the context of Krugman’s IS model: there is no “invisible” r* in a simple IS model of the type Krugman is using: the full employment rate of interest can be read straight off the diagram for any given fiscal position.

Krugman then took to Twitter, calling Kelton’s response “a mess”, while still apparently failing to spot that they are talking at cross purposes. Kelton hit back again arguing that,

The crude, IS-LM interpretation of Keynes demonstrates that, under normal conditions, an increase in deficit spending will push up interest rates and lead to some crowding-out of investment spending. There is no room for a technical analysis of monetary operations in that framework.

Can this discussion be rescued? Can MMT and IS-LM be reconciled? The answer, I think, turns out to be, “yes, sort of”.

I wasn’t the only person pondering this question: several people on Twitter went back to this post by Nick Rowe where he tries to “reverse engineer” MMT using the IS-LM model, and comes up with the following diagram:

Rowe-IS-LM
Does this help? I think it does. In fact, this is exactly the diagram used by Victoria Chick in 1973, in The Theory of Monetary Policy, to describe what she calls the “extreme Keynesian model” (bottom right):

Chick-Theory-Monetary-Policy-scaled

So how do we use this diagram to resolve the Krugman-Kelton debate? Before answering, it should be noted that MMTers are correct to point out problems with the IS-LM framework. Some are listed in this article by Mario Seccareccia and Marc Lavoie who conclude that IS-LM should be rejected, but “if one were to hold one’s nose,” the “least worst” configuration is what Chick calls the “extreme Keynesian” version.

To see how we resolve the debate, and at the risk of repeating myself, recall that Krugman and Kelton are talking about two different central bank reactions. In Krugman’s IS model, the central bank reacts to looser fiscal policy with higher interest rates. Kelton, on the other hand, is talking about how deficit monetisation lowers the overnight money market rate. Kelton’s claim that a government deficit reduces “interest rates” is largely meaningless: it is just a truism. Flooding the overnight markets with liquidity will quickly push the rate of interest to zero, or whatever rate of interest the central bank pays on reserve balances. It is a central bank policy choice: the opposite of the one assumed by Krugman.

But what effect will this have on the interest rates which really matter for investment and debt sustainability: the rates on corporate and government debt? The answer is “it depends” — there are far too many factors involved to posit a direct mechanical relationship.

This brings a problem that is lurking in the background into sight. Both Kelton and Krugman are talking about “interest rates” or “the interest rate” as if there were a single rate of interest, or that all rates move together — the yield curve shifts bodily with movements of the policy rate. As the chart below shows, even for government debt alone this is a problematic assumption.

yc

Now, in the original IS-LM model, the LM curve is supposed to show how changes in the government controlled “money supply” affects the long term bond rate of interest. This is because, for Keynes, the rate of interest is the price of liquidity: by giving up liquidity (money) in favour of bonds, investors are rewarded with interest payments. But the problem with this is that we know that central banks don’t set the “money supply”: they set a rate of interest. So, it has become customary to draw a horizontal MP curve, allegedly representing an elastic supply of money at the rate of interest set by the central bank. But note that in switching from a sloping to a horizontal LM curve, the “interest rate” has switched from the long bond rate to the rate set by the central bank.

So how is the long bond rate determined in the horizontal MP model? The answer is it isn’t. As in the more contemporary three-equation IS-AS-MP formulation, it is just assumed that the central bank fixes the rate of interest that determines total spending. In switching from the upward sloping LM curve to a horizontal MP curve, the crude approximation to the yield curve in the older model is eliminated.

What of the IS curve? Kelton is right that a mechanical relationship between interest rates and investment (and saving) behaviour is highly dubious. If we assume that demand is completely interest-inelastic, then we arrive at the “extreme Keynesian” vertical IS curve. But does Kelton really think that sharp Fed rate hikes will have no effect on total spending? I doubt it. As Seccareccia and Lavoie note, once the effects of interest rates on the housing market are included, a sloping-but-steep IS curve seems plausible.

Now, does the “extreme Keynesian” IS-LM model, all the heroic assumptions notwithstanding, represent the MMT assumptions? I think, very crudely, it does. The government can set fiscal policy wherever it likes, both irrespective of interest rates and without affecting interest rates: the IS curve can be placed anywhere along the horizontal axis. Likewise, the central bank can set interest rates to anything it likes, again without having any effect on total expenditure. This seems a reasonable, if highly simplified approximation to the standard MMT assumptions that fiscal policy and monetary policy can be set entirely independently of each other.

But is it useful? Not really, other than perhaps in showing the limitations of IS-LM. The only real takeaway is that we deserve a better quality of economic debate. People with the visibility and status of Kelton and Krugman should be able to identify the assumptions driving their opponent’s conclusions and hold a meaningful debate about whether these assumptions hold — without requiring some blogger to pick up the pieces.

10 comments

  1. I’m baffled by Krugman’s claim that “if the rate of interest on government debt exceeds the rate of growth, either the debt to GDP ratio spirals out of control or the government is forced to tighten fiscal policy.”

    Suppose interest on the debt is 1% and growth is zero. What of it? What’s the problem? All that means is that government grabs enough from taxpayers to pay interest to government bond holders. Yawn. I don’t see any “spiral out of control” there.

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    1. If the interest rate exceeds the growth rate then, at some point, the government has to run a surplus in order to pay off the debt. This means either decreasing expenditures or increasing tax revenues. Either one is consider a “tightening” of fiscal policy.

      The “spiral out of control” idea is the inverse of the classic result that governments (unlike households) can run perpetual deficits so long as the growth exceeds the rate of interest. As long as the growth of the economy exceeds the growth rate of sovereign debt, there is no need to ever levy new taxes or try to run a budget surplus. If the inverse is true then the debt accelerates away from GDP and “spirals out of control” (albeit potentially very slowly).

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    2. I think what Krugman meant there is when debt is already some major share of GDP. I read it as an inversion of Piketty’s r>g notion at least rhetorically, though I’m not sure why he chose to do so.

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    3. Krugman is referring to the case where government spending is having only a small effect on economic growth. In this circumstance, ever increasing government spending is required to achieve a small gain in economic growth. If the government’s spending is funded by borrowing then the debt-to-GDP ratio will indeed grow unless the government stops borrowing.

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  2. If private banks take up government bond issues then after the government has spent the proceeds into the economy the money supply (customer deposits at private banks) will increase. Kelton is correct to say this should exert downward pressure on interest rates.

    However, if the number of bonds available for sale exceeds the number of bonds demanded then bond yields will rise. So under this circumstance Krugman is correct to say this would exert upward pressure on interest rates (and depress demand and indirectly depress investment).

    If it is the non-bank private sector that takes up government bond issues (from their savings) then the money supply should not increase and Krugman is correct to say that fiscal expansion does not cause monetary expansion.

    It seems to me that whether interest rates rise or fall is entirely contingent on the state of the economy and on policy responses. For this reason, I believe Kelton and Krugman are speculating in areas that are unknowable and are hence arguing pointlessly.

    Liked by 1 person

  3. Here is my summary of the Jo M. essay.

    SK & PK debate starts politely. Debate gets messy. PK uses IS curve & a line. PK is baffled with SK. SK says an obviously untrue thing. PK has not absorbed MMT. SK cares little about PK. SK not explicit. SK rejects IS/LM relationship. Debate heads downhill. Neither party fixes each other’s heads. PK shifts to IS/LM but LM missing. PK & SK both incorrect. SK make little sense to PK’s world. PK calls SK’s statements a mess. SK hits back at crude IS/LM. Can PK and SK be rescued?

    Jo Mitchell now explains: Maybe – reverse engineer MMT using IS/LM. But hold your nose. Mechanical relationships not allowed. It’s complicated. Lurking background given daylight. Enter problematic assumption. Bonds, money, interest, supply – oh my! No upslope so no crudeness – LM good. SK right about IS. In summary: heroic assumption allow IS/LM = MMT. Gov can do what it wants. IS can be anywhere. Central Bank can set where it wants. Was this useful? Not really.

    So, SK & PK debate. We deserve better debate. SK & PK need to identify both sides now. Duel assumption debating suggested. SK & PK should address consciousness and sub consciousness. Be meaningful. Don’t ask me. I’m not really useful.

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  4. The record since the crisis is clear. While government debt soared globally interest rates headed lower. US Treasury coupon rates to the lowest in their history and in Europe reaching negative numbers thus exceeding the lows of the Black Death period.

    Ah, but were the result causal and in which direction? Did low rates bring more or at least grease the skids for more deficits or did large deficits cause the low rates? Or were the results independent of each other?

    The answer depends upon what angle you look at the question, from within the bubble. The bubble that is of industrial society dependent upon extracting energy from carbon. While mankind has managed to finesse the need to repay monetary debt nature will not be finessed.

    https://www.powells.com/book/-9780887848001

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