Krugman discovers the obvious

A philosophical truth, as I see it, is a truth that is obvious once you think about it but has been obscured by overwrought theory.

Paul Krugman has discovered a philosophical truth.

Here it is. There is no operational difference between:

(a) the state spending, selling bonds to ‘fund’ its spending, and then buying back the bonds, and

(b) the state spending and not issuing the bonds in the first place.

This is a point economists outside the mainstream have been making for years (see this post).

It’s obvious when you think about it. Suppose I give you $100. Then I ‘borrow’ back the $100. Then I buy back the debt from you, for $100.

Or suppose I just give you the $100.

It’s the same result. That’s not deep philosophy, but it is philosophy as I define it.

Why is Krugman even bothering to point this out? Because mainstream economists haven’t generally accepted it. It’s obscured under their layers of theory about ‘the money supply’, etc.

What Krugman has done is to look up from his theory long enough to notice how things actually work. If only he went all the way. In his last paragraph, he reverts to an old New Keynesian ‘exogenous money’ understanding, implying that the central bank can expand/contract the money supply by expanding/contracting ‘the monetary base’.

In other words, he sinks back into the old theoretical fustian. In the real world, the money supply determines the monetary base (the volume of reserve balances), not the other way around. When a bank makes a loan, it creates deposits, meaning it needs more reserves to settle payments. In the first instance, it overdraws its reserve account. I.e., the central bank loans it the required reserves. The monetary base expands. Basically (see Warren Mosler’s comments), when banks create deposits they also create reserves. They control the money supply and they control the monetary base. The central bank supplies the reserves automatically at the rate of its choosing.

You might defend Krugman by saying that what he actually means is that the central bank can expand/contract the money supply indirectly by lowering/raising the base interest rate. But this ignores another obvious fact, which is that the government is a net payer of interest, and so a rate cut/rise brings about a fiscal contraction/expansion that works in precisely the opposite direction to the intended monetary policy.

On these grounds, Mosler makes a good case that interest-rate effects, in the modern institutional context, go in the opposite direction to that taught in the texbooks. So does Eric Tymoigne, and so have several prominent central bankers (see Q10 here). There are two very important and quite obvious institutional facts: (1) the US government is a net payer of interest and (2) tax incentives favour savers, so that if rates fall the income effects of lost growth in savings are likely to outweigh the substitution effects of easier borrowing (and vice-versa if rates rise). Thus raising rates can result in increased spending (and an increased ‘monetary base’), while lowering them can result in the opposite.

This, too, should be obvious. But the simplistic textbook notions of ‘monetary base’ and ‘money supply’, along with the familiar pneumatic image of central bank policy pumping a handle to get the money supply it wants, keep interposing themselves between honest minds and plain facts. Just as Krugman digs one apparent fact out of the rubble of unnecessary theory, he buries another.

Economics is an endless Easter egg hunt.


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