Magical Thinking

Paul Krugman has a couple of posts criticizing MMT. He tries to be polite, pointing out that at the zero bound their policy recommendations are less bad than those of advocates of austerity. But deep down he must know that this model is sheer madness.

Stephanie Kelton responds and continues the long MMTer tradition of being unable to provide a clear explanation of the ideas. Here she responds to Krugman’s concern that massive deficits might eventually push the public debt so high that interest rates rise to a level that puts a big burden on taxpayers.

First, “there is a devil in the interest rate assumption,” as economist James K. Galbraith has explained.  Preventing a doomsday scenario is not difficult. As Galbraith explains, “the prudent policy conclusion is: keep the projected interest rate down.” Or, putting it more crudely, “It’s the Interest Rate, Stupid!”

And just how is the government supposed to “keep the projected interest rate down”? By magic?

Yes, by magic:

Since interest rates are a policy variable, all the Fed has to do is keep the interest rate below the growth rate (i<g) to prevent the ratio from rising indefinitely. As Galbraith says, “there is no need for radical reductions in future spending plans, or for cuts in Social Security or Medicare benefits to achieve this.”

Rather than presenting this as a problem for functional finance, Krugman should be wondering why the Fed would ever maintain an interest rate that would put the debt on an unsustainable trajectory. I don’t believe it would. If i>g, then debt service grows faster than GDP, which Krugman argues would be inflationary.

So his hypothetical scenario begs the question: Why would an inflation-targeting Fed permit i>g with a debt-to-GDP ratio at 300 percent? 

Notice that she doesn’t tell us how the Fed is supposed to keep the market interest rate down. It doesn’t just happen by magic. Market interest rates are not a “policy variable”; they are impacted by various policies. While the Fed directly controls the discount rate and the interest rate on reserves, the rates that really matter are market interest rates on public debt. How does the Fed keep them down?

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