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Functional Finance and MMT — Krugman still does not get it!


Prof Stephanie Kelton (Flickr cc)
Prof Paul Krugman (Flickr cc)

The following extracts made in a recent blog by Lars Syll [1] are from a longer article by Stephanie Kelton [2], in response to Paul Krugman’s criticism of Modern Monetary Theory (MMT) and Functional Finance (as described by UK economist Abba Lerner) [3]

Krugman complains that Lerner was too “cavalier” in his discussion of monetary policy since he called for the interest rate to be set at the level that produces “the most desirable level of investment” without saying exactly what that rate should be.

It’s an odd critique, since Krugman himself subscribes to the idea that monetary policy should target an invisible “neutral rate” that supposedly exists when the economy is neither depressed nor overheating. For what it’s worth, research suggests the neutral rate “may be flat-out wrong,” and Fed Chairman Jerome Powell has admitted that the Fed has been too cavalier in relying “on variables that cannot be measured directly and which can only be estimated with great uncertainty”.

But Lerner wasn’t trying to use interest rates to optimize the economy. That was a job for fiscal policy. He argued that the government should be prepared to spend whatever is necessary to sustain full employment without raising taxes or borrowing …

Krugman’s other objection is that Lerner “didn’t fully address the limitations, both technical and political, on tax hikes/or spending cuts” as a means of fighting inflation.

In fact, Lerner actually had quite a lot to say about this. Here’s the opening sentence to an entire chapter on the subject in his 1951 book The Economics of Employment: “We have now concluded our treatment of the economics of employment, but a word or two must be added on the politics and the administration of employment policies in general and of Functional Finance in particular” (emphasis in original) …

Where does that leave us? Now Paul Krugman and I agree on a great many things, but we come at certain questions from a fundamentally different place.

He believes there are inherent tradeoffs between fiscal and monetary policy.

Outside of the so-called liquidity trap, Krugman adopts the standard line that budget deficits crowd out private investment because deficits compete with private borrowing for a limited supply of savings.

The MMT framework rejects this, since government deficits are shown to be a source (not a use!) of private savings. Some careful studies show that crowding-out can occur, but that it tends to happen in countries where the government is not a currency issuer with its own central bank.

This seems like a disagreement we should be able to resolve either empirically or intuitively. But who knows? As Lerner wrote, “a man convinced against his will retains the same opinion still.”





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