When Deficits Become a Problem, by Tim Duy: L. Randall Wray (ht
FTAlphaville) thinks that Paul Krugman has made the leap to MMT by
acknowledging the ability of the central bank to control interest rates. Wray
sees that Krugman was faced with
an intellectual roadblock to MMT:
The sticking point has been “crowding out”—the idea that once we get
beyond the liquidity trap and return to a more “normal” ISLM world,
government deficits will push up interest rates. And that will then reduce
private investment, which tends to lower economic growth. Higher interest
rates plus lower growth means the government’s deficit and debt ratios grow
beyond “sustainable” levels.
Wray argues that ultimately the central bank does not need to fear the bond
vigilantes because the Treasury need not issue long-term debt and can instead
issue only short term debt. The Fed is assumed to have complete control over
rates on short term debt:
But as I explained last week, the short term rate is completely within
the control of the Fed....Long term rates depend on the state of liquidity
preference plus expectations of future Fed policy. But in any case, the
Vigilantes cannot force Treasury to issue long term debt. It can stick to
the short end of the maturity structure and then pay whatever rate the Fed
Actually, I would go one step further than Wray and argue that the Fed's
expectations tools coupled with large-scale asset purchases allows them to
influence the entire yield curve. Wray then explains that this means the danger
is not the vigilantes, but the Federal Reserve:
The real danger is not that the Vigilantes go all vigilant on Uncle Sam,
but rather that the Fed decides to do a Volcker (raise the overnight rate to
20%). Congress can stop that by legislating that the Fed cannot act like a
Vigilante. Or, alternatively, Treasury can stay on the short end. Both of
these are policy choices, completely outside the influence of Vigilantes.
Wray takes Krugman's post today as evidence that Krugman believes that
crowding out is not a issue either in a liquidity trap or at potential output.
the short-term interest rate is set by the Bank of England. And the
long-term rate, to a first approximation, is a weighted average of expected
future short-term rates. Unless markets believe that Britain is going to
default — which it isn’t, and they won’t — this is more or less an arbitrage
condition that ties down the long run rate no matter what happens to
All he has to do is to carry that analysis beyond the current downturn.
This can go on forever, of course. Keep short term interest rates low, or
keep Treasury out of long maturities.
Wray seems to believe that this means Krugman has departed from
his earlier story:
I could go on, but you get the point: once we’re no longer in a liquidity
trap, running large deficits without access to bond markets is a recipe for
very high inflation, perhaps even hyperinflation. And no amount of talk
about actual financial flows, about who buys what from whom, can make that
point disappear: if you’re going to finance deficits by creating monetary
base, someone has to be persuaded to hold the additional base.
But I don't see anything inconsistent between the Krugman of the past and
that of today. The crowding out argument is a simply a bit more nuanced than in
Wray's description. Wray seems to want to overlook the inflation part of
Krugman's position. Specifically that in a more "normal" ISLM world, which I
would interpret as near potential output, then additional government spending
would tend to increase interest rates and crowd out private spending or - and
this is an important or - that the Federal Reserve could accommodate the
increased government spending and hold interest rates low, but that the end
result would be higher inflation.
In other words, I doubt that Krugman fears the bond vigilantes even at
potential output, but that he would expect the Federal Reserve to allow interest
rates to increase to prevent inflation. Presumably this crowds out private
investment, and shifts the mix of demand toward the government sector.
Does this mean that additional debt lowers growth in a Rogoff/Reinhart sense?
No, but it does mean that the Fed will not allow output to exceed potential due
to inflation concerns. The claim that crowding out leads to lower potential
growth in the long-run is generally a supply-side type story in which an
excessive level of government spending reduces the rate of resource
In short, I doubt that Krugman's acknowledgement of the Federal Reserve's
control over interest rates implies that he now believes that government
deficits do not matter or that he will make such an intellectual leap. Krugman
appears to have always believed that the Fed can control interest rates, thus
leaving the bond vigilantes impotent. And there is nothing in his blog today to
suggest that he no longer believes that at some point (hopefully) inflation -
and by extension, interest rates - will once again be a concern. Believe it or
not, it is not logically inconsistent to believe that concerns about rising
interest rates are not valid today, but might be valid at some point in the
Update: I see Ed Harrison is writing on Krugman and the bond vigilantes as well, and sees the difference in not the so much the outcome
Of course running enormous deficits when the economy is
operating at full capacity causes inflation to go haywire. Of course it
But in the rhetorical approach:
The difference is he straw-manned the deficit as an exogenous policy variable in 2011 when it simply isn’t one.
Harrison (correctly) views the deficit as largely endogenous. When
the economy improves, then the deficit will dissapear (or at least be
greatly reduced). So arguing about the deficit's impact on interest
rates is pointless:
This could only happen if our politicians went mad and added yet more
fiscal stimulus to the economy even after it was overheating.
The key point is inflation:
Wait until inflation starts to creep up. Then the bond vigilantes can get going. But this is a long way off.