Marc Lavoie On The New Fiscalism

Writing for the Broadbent Institute’s blog, Marc Lavoie argues that now that Conservatives are out of power in Canada, the Federal Balanced Budget Act passed in June 2015 should be repealed. According to the Act, pay of the Prime Minister and Ministers and Deputy Ministers have to be reduced by 5% if the federal government is in deficit outside a recession and frozen if the economy is in recession.

Marc Lavoie says:

The Federal Balanced Budget Act that was included in the omnibus Bill C-59, and which passed third reading in June 2015, does not seem to have attracted much engagement either. The Act does not force the federal government to adopt a balanced budget – it has some of the flexibility advocated by the PBO. But it includes measures that discourage the federal government from taking expansionary fiscal measures pre-emptively before a recession is declared. Furthermore, it will induce the federal government to attempt to minimize budget deficits during recessions and to quickly achieve a balanced budget or budget surpluses.

The article also coins the phrase new fiscalism (term originally by Mario Seccareccia):

counter-cyclical fiscal policy should only be used when things are really bad, in particular when monetary policy seems to be running out of ammunition; otherwise, governments should achieve balanced budgets or surpluses.

Marc Lavoie instead argues that the Canadian federal government should use the large borrowing powers to aim to achieve full employment.

The full article Wage Suppression And The Federal Balanced Budget Act is here.

Rules about fiscal policy always have some dubiousness about them. This can easily be seen in stock-flow consistent (SFC) models. Let government expenditure be denoted by G, the tax rate by θ, and households’ propensities to consume out of income and wealth by α1 and α2, respectively. Imagine two almost similar economies

Economy 1: High propensities to consume – i.e., high values for α1 and α2.

Economy 2: Low propensities to consume – i.e., low values for α1 and α2.

Also assume the government expenditure G, and the tax rate θ are the same for both the economies. The budget deficit depends (among other things such as firms’ behavior) on G, θ, α1 and α2. Economy 1 will have a lower budget deficit and higher output and employment than Economy 2. So in order for Economy 2 to have the same level of output and employment as Economy 1, the government of Economy 2 should have a more expansionary fiscal policy than Economy 2. What the fiscal rules do is to endogenize fiscal policy (the government G and the average tax rate θ) with respect to the budget deficit.  This is further deflationary for Economy 2. This implies that fiscal rules have no legitimacy. Even within an economy, (such as either Economy 1 or Economy 2), propensities to consume are changing with time.

Fiscal policy rules sometimes are slightly less strict and accept balancing current expenditures with taxes. Even this is dubious – expenditure on paying school teachers isn’t less important in any sense than building a school. Even more importantly, the budget deficit depends on the current account balance of payments and a nation with a higher current account deficit than a similar economy with no external trade will have a lower output and higher budget deficit for the same fiscal policy.

Budget rules are hence deflationary to output and are anti-full-employment.

I hope the new Canadian government follows Marc Lavoie’s advice.

United States’ Net Wealth, Part 2

This is a continuation of my previous post, United States’ Net Wealth. There I pointed out a new table which has been included in the Federal Reserve Statistical Release Z.1, Financial Accounts of the United States – Flow of Funds, Balance Sheets and Integrated Macroeconomic Accounts. This table in flow of funds report is B.1: Derivation of U.S. Net Wealth.

In the meanwhile, the Federal Reserve has released a note U.S. Net Wealth in the Financial Accounts of the United States which is worth your time.

In the note, the authors detail about the meaning of the measure of the “U.S. Net Wealth.” The definition is similar to the System of National Accounts 2008 (2008 SNA). The net worth of a nation is the sum of non-financial assets plus the net international investment position. The note says:

In estimating U.S. net wealth, we use direct measures of the value of households’, nonprofits’, noncorproate businesses’, and governments’ nonfinancial wealth. For corporate businesses, we use the market value of their outstanding equity shares to better capture the value of intangible assets, such as intellectual property. We then net out financial obligations between U.S. resident households, businesses, and government agencies and the rest of the world, because the concept of U.S. net wealth should exclude nonfinancial assets that are financed abroad rather than domestically, and include the value of nonfinancial wealth held by U.S. entities abroad. Taking all this together, we define net U.S wealth as the value of tangible assets controlled by households and nonprofits, noncorporate business, and government sectors of the U.S. economy, plus the market value of domestic nonfinancial and financial corporations, net of U.S. financial obligations to the rest of the world.

[emphasis, boldening: mine]

So what table B.1 does is that it uses non-financial assets for all sectors except when shares of companies are publicly traded.

There is however an issue here. Value of equities outstanding needn’t be a good measure. This is because firms issue both debt and equity. Imagine the case of a corporation which has a debt/equity mixture of 9:1.

Suppose the balance sheet is like this (in the SNA/IMA format):

Non-financial assets: $1 bn

Liabilities and Net Worth
Market value of bonds issued: $900 mn
Market value of equities issued: $90 mn
Net Worth: $10 mn

I am assuming that “non-financial assets” is the correct value of both tangibles and intangibles, which is $1bn here. But because of debt securities, the value of equities ($90 mn) is highly unlikely to touch $1bn. In other words, the total outstanding value of equities issued by the corporation is hardly a measure of non-financial assets in this case. Applying this idea further, it can be concluded that we need to keep track of the debt securities of the corporation as well. In summary, table B.1 needs to be updated conceptually.

United States’ Net Wealth

The latest release of the Federal Reserve Statistical Release Z.1, Financial Accounts of the United States – Flow of Funds, Balance Sheets and Integrated Macroeconomic Accounts or just “flow of funds” has a new table B.1: Derivation of U.S. Net Wealth.

According to the release:

A new table on the derivation of U.S. net wealth (table B.1) has been added to the summary section of the “Financial Accounts.” The calculation of U.S. net wealth includes the value of nonfinancial assets (real estate, equipment, intellectual property products, consumer durables, and inventories) held by households and nonprofit organizations and noncorporate businesses. For the federal government and state and local governments sectors, only structures, equipment, and intellectual property products are included; values for land and nonproduced nonfinancial assets are not available. The measure of U.S. net wealth also includes the market value of domestic nonfinancial and financial corporations, and is adjusted to reflect net U.S. financial claims on the rest of the world. This definition of U.S. net wealth differs from the sum of the net worth of sectors shown in the Integrated Macroeconomic Accounts (IMA). A forthcoming FEDS Note will provide additional information.

United States Net Worth

click to expand, and click again to zoom

According to it, the United States net wealth was $79.69 trillion.

It’s important to understand how this is reached. Normally we divide the world in various sectors: households, production firms, the financial sector, government and the rest of the world. In real life one adds more nuances to all this. So for example, in the table above, we have a sector “non-financial non-corporate businesses”.

Now, there are two types of assets: non-financial assets and financial assets. Non-financial assets are things such as houses, machines and so on. Financial assets are things such as currency notes, bonds, equity securities and so on.

In the system of national accounts (e.g., the 2008 SNA), all financial assets have a counterpart liability. So financial assets = liabilities for the world as a whole. It’s of course not true for a nation because assets and liabilities between residents and non-residents do not cancel out.

There is one complication, however: equity securities. The 2008 SNA treats equity securities as liabilities of corporations, just like debt securities. This is despite the fact that a company isn’t bound by law to pay dividends to holders of equity, unlike the case for debt securities or loans (for which interest is needed to be paid periodically and also the principal upon maturity).

All economic units have a net worth. This is the difference between assets and liabilities. So,

Assets = Liabilities + Net Worth.

Since equities are treated as liabilities in the 2008 SNA, the net worth of firms can in fact turn negative. This might happen if the price of equities is high.

So it is easy to derive the net worth of a nation. Resident economic units’ liabilities held by resident economic units cancel out and one is left with non-resident units’ liabilities to residents (i.e., resident units’ assets “held abroad”) and residents’ liabilities to non-residents.  This is the net international investment position.

So, as per the 2008 SNA (and the Balance of Payments Manual, 6th Edition),

Net Worth of a nation = Non-financial assets held by residents + Net International Investment Position

The Federal Reserve however does not do the same for flow of funds. It does not treat equities as liabilities.

But one has to be careful about double counting. It’s easy to sum up non-financial assets of all economic units, such as as done by the SNA. But in the flow of funds, with the special treatment on equities, we shouldn’t use corporate businesses’ non-financial assets. If you read the explanation and see the table B.1 carefully, corporate businesses’ assets have not been added, only “non-corporate businesses'” non-financial assets have been added. Since equities are not treated as liabilities in the sense of debt securities, the market value of corporations is needed to be added. This is line 13 in Table B.1.

There is one complication however. Even though equities is not treated as liabilities, that held by foreigners is treated as liabilities. Otherwise, one can have a source of inconsistency. Suppose equities held by a non-resident economic units is not treated as liabilities. Suppose foreigners sell $1bn of equities and purchase T-bills with that. This will mean that the net wealth reduces. Which doesn’t make sense. Hence, one is forced to treat foreigners’ equity holdings as liabilities. So the foreign aspect of the whole calculation is the same as as done in the SNA and one needs to include the net international investment position of the United States which is line 24. (minus $5.47 trillion).

So that basically summarizes the calculation of the United States net wealth as per the Federal Reserve flow of funds report.

How does this compare with the SNA measurement? Some tables in the report are only updated to 2014. So let’s use those numbers.

Flow of funds’ net wealth for 2014 = $77.89 tn (Table B.1, line 1).

Now, go to Table S.2.a. These tables use SNA definitions. Add lines 76-81.

This gives us a value of $87.34 trillion.

However the Z.1 report has an error in the way SNA/IMA way of calculating net worth. Line 77 in Table S.2.a is incorrect. There’s double counting. It uses the SNA/IMA concept of net worth but instead calculates it using the FoF concept. One should subtract line 29 in table B.101 which is $10.04 trillion. Hence the US net worth in the SNA definition is $87.34 trillion minus $10.04 trillion which is $77.30 trillion.

So in short, the net worth of the United States as per the flow of funds definition at the end of 2014 was $77.89 trillion and according to the SNA/IMA it was $77.30 trillion.

What does all this mean? Hmm. Not to easy to answer, except saying that familiarity with the system of measurement helps in understanding how the economy works. Which measurement is better – the new table B.1 or S.2.a? Doesn’t matter.

I am thankful to commenters in this blog post by Steve Randy Waldman, especially JKH and Marko.

Last edited 8 Oct 2015, 2:22pm UTC. [Error in Fed’s Z.1 report pointed out and my own fixed]

Update: Part 2 of this post/afterthought here United States’ Net Wealth, Part 2

UNCTAD On Economic Dynamics

From United Nations’ Conference on Trade and Development (UNCTAD)’s 2015 report, page 44:

… exposure to unregulated and large financial flows alters macroeconomic developments in ways that can lead to a slowdown of GDP growth as well as unstable internal dynamics marked by sudden shifts of income and wealth between the main sectors (private, public and external). A convenient way to map these shifts and their relationship with economic growth is by using the “demand stances” framework (see Godley and Cripps, 1983; Godley and McCarthy, 1998; and Taylor, 2001 and 2006). This framework reasserts the Keynesian principle that sustained growth requires continuously increasing injections (which, in simple macroeconomic terms, include private investment, government expenditure and exports) into the flow of income. These injections, in turn, require a steady growth of leakages (measured by the propensity to save, the tax rate and the import propensity), which over time ensure financial stability, as credit rises along the circular flow of income. Thus GDP growth can be explained as the growth, along stable norms, of injections relative to leakages; these eventually determine financial transfers between the main sectors. Such ratios of injections to leakages are termed stances and provide a measure both of demand drivers and financial balances.


In mathematical terms, the main accounting identity defines GDP as the sum of consumption (C), private investment (I), government expenditure (G) and exports(X) minus imports(M). Simple assumptions allow specifying the tax rate (t) and the savings and import propensities, s and m respectively, as: T = t · GDP; S = s · GDP; M = m · GDP, where T stands for total tax revenue and S for private savings. Arrangements of these equations around the accounting identity yield the expression: GDP = (G + I + X)/(t + s + m), or alternatively: GDP = wt · (G/t) + ws · (I/s) + wm · (X/m) where wt , ws and wm are the weights of each of  the leakages (tax, savings and import propensities, respectively). This equation establishes that growth of GDP depends on the growth of the three variables, G/t, I/s and X/m; defined as fiscal stance, private stance and external sector stance, respectively, amplified by the strength of the respective multipliers, given the mentioned weights, in the macroeconomic context. To avoid complicating the presentation with derivation of the steady state conditions, it is sufficient to note that these stances reflect financial conditions as well, where a larger numerator than the denominator points towards a net borrowing position. Thus, a steady path of sustained growth and financial stability requires that none of these stances grow at a proportionally faster pace than the others for a prolonged period of time.


Sergio Cesaratto On TARGET2 Balances

Sergio Cesaratto has posted a reply on Matias Vernengo’s blog, replying to a paper by Marc Lavoie on economic problems of the Euro Area

For previous discussions, see the citations in that post or see my previous post on this.

Marc’s point is that because TARGET2 allows unlimited and uncollateralized credit/debit facilities between Euro Area NCBs and the ECB, the troubles facing the Euro Area are not balance-of-payments in origin.

As mentioned earlier, this however is not the thing to look at. One should look at counterparts to the intra-ESCB (TARGET2) debts. Intraday overdrafts, marginal lending facility, MRO, LTRO, ELA … none of these can rise without limit. At some point, a crisis occurs and foreigners’ help is needed.

Greece, Portugal, Ireland, Spain, Cyprus all have high negative net international investment positions. No wonder these nations have seen the most troubles.

I echo Sergio’s example (on Calabria) with a similar example of my own. If nations in a monetary union cannot face a balance-of-payments crisis, why not have the whole world join the Euro Area and adopt the Euro as their currency and have the ECB as the central bank of the world and guarantee all government debts without any condition? Surely, that should be the solution to the problems of the world! Not!

Surely austerity has been high and the ECB can help to keep government bond yields in check and allow for expansionary fiscal policies. It had its “OMT”, which has never been used as the annoucement effect itself has kept government bond yields low. But Greece has faced difficulties despite this.

The ECB alone cannot resolve the crisis.  Attempts to boost domestic demand with fiscal policy will bring higher imbalances within the Euro Area. The Euro Area needs a central government with high powers to tax and spend. Regional imbalances will be kept in check via fiscal transfers and regional policies of the government. And the powers of the government won’t be limited with this. There are many other things such as wages which need to be coordinated at the federal level, for example. Euro Area balance-of-payments cannot be neglected.

Thomas Palley – Website 10th Anniversary: 10 Things I Got Right

by Thomas Palley

Ten years ago (September 2005) I launched my website []. To mark this anniversary, here are ten postings that I think got it right. Many of them are included in my book, The Economic Crisis: Notes From The Underground (2012).

  1. Keynesianism: what it is and why it still matters (September 18, 2005). My first post. What was intellectually unfashionable back then is now in.
  2. The Questionable Legacy of Alan Greenspan (October 16, 2005). Raining on the Maestro’s parade was not popular.
  3. Winner’s curse: The Torment of Chairman-designate Bernanke (November 4, 2005). I suspect Mrs. Bernanke wishes Mr. Bernanke read this before accepting the job.


Free Trade And Tight Fiscal Policy

Harvard economist Dani Rodrik recently responded to a question/critique on why he doesn’t believe in the faith about free trade between nations while not showing that much dissent for trade within boundaries. Among the various points in his defence are fiscal transfers and regional policies. Rodrik says:

Another thing that happens is that there is an overarching state that will engage in transfer payments and other policies that aid the lagging region. The region will have political representatives in the national government who will push for the interests of those adversely affected.

That’s a nice point. See my blog post on how fiscal transfers help in reducing regional balance-of-payments problems.

Cafe Hayek responded to Rodrik here. An important point in that argument is: why does it matter if the consumer buys from a domestic producer as opposed to a foreign producer. The Cafe Hayek author Don Boudreaux says:

Now to point (1) – the more narrowly economic point.  Sellers in foreign countries sell things to buyers in the home country only because they – the foreign sellers – wish to increase their wealth.  The motives are identical to those of sellers in the domestic economy.  What do foreign sellers do with the revenues they earn from the sale of their exports?  They spend them.  They save them.  They invest them.  Perhaps on occasion they hoard them.  These options are no different from the options confronting domestic sellers.  If the funds spent on imports return to the domestic economy as demand for exports, jobs and economic activity shift from import-competing domestic industries into exporting industries.  No problem.  If these funds instead return as investments in the domestic economy, again there’s no problem: when, for example, Ikea opens a store in New Jersey it employs workers in that store no less than would an American who opened a similar store.

Now to argue straight with the above. FDI flow is just one flow in the capital and financial account of the balance of payments. And in the stock sense, FDI is just one type of liability among many others such as government debt held by foreigners. These just pay interest to foreigners.

Apart from that, foreigners are not likely to import as much as they export. A nation can have a high amount of imports and less exports. So there’s an asymmetry here – differing level of competitiveness.

But even if competitiveness were equal, nationality of buyers and sellers still matters. This is because creditor nations’ governments may not expand fiscal policy to the extent that is needed for the benefit of the world as a whole. If the government of a nation keeps fiscal policy relatively tight, it affects domestic demand, output and incomes of economic units and hence their imports.

So to summarize, difference in competitiveness and a relatively tighter fiscal stance of creditor nations affects trade and balance-of-payments of other nations. This in turn affects output because a nation which could potentially grow fast may find itself with balance-of-payments problems. Free trade doesn’t help poor nations.

This discussion can also be used in the case of the Euro Area where trade was made more free when the Euro Area was formed. Since there is no central government for the Euro Area, free trade works against nations which have been affected by the crisis.

Sergio Cesaratto’s Debate With Marc Lavoie On Whether The Euro Area Crisis Is A Balance-Of-Payments Crisis – II

This is a continuation of the post from the end of 2014, although reading that isn’t necessary. 

In a new paper, Marc Lavoie continues his debate with Sergio Cesaratto on whether the Euro Area crisis is a balance-of-payments crisis or not. For the sake of completeness, here’s the list of papers, with references copy-pasted from Marc’s latest paper. Not all links are final versions and some may not be available to read in full).

  1. Cesaratto, S. 2013. “The Implications of TARGET2 in the European Balance of payments Crisis and Beyond.” European Journal of Economics and Economic Policy: Intervention 10, no. 3: 359–382. link
  2. Lavoie, M. 2015. “The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 1 (Spring): 3–17. link
  3. Cesaratto, S. 2015. “Balance of Payments or Monetary Sovereignty?. In Search of the EMU’s Original Sin–Comments on Marc Lavoie’s The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 2: 142–156. link
  4. Lavoie, M. 2015. “The Eurozone Crisis: A Balance-of-Payments Problem or a Crisis Due to a Flawed Monetary Design?” International Journal of Political Economy 44, no. 2: 157-160. (abstract)

As mentioned in my part 1, referred to on top of this post, I agree with Sergio Cesaratto.

sergio-and-marcSergio Cesaratto with Marc Lavoie (picture credit: Matias Vernengo)

Marc Lavoie’s main point in the final paper seems to be that, “Eurozone countries can never run out of TARGET2 balances, which can take unlimited negative values, so that the evolution of the balance of payments cannot be the source of the crisis”.

This is not accurate in my view. Although the rules of the Eurosystem allow unlimited and uncollateralized credit facility between the Euro Area NCBs and the ECB, one has to look at the counterpart to the T2 imbalances. If an economic unit transfers funds across border from country A to country B, this first results in a reduction of balances of banks in country A at their NCB and may result in an intraday overdraft (“daylight overdraft” in U.S. language), usage of the marginal lending facility with the NCB, an MRO, or an LTRO and finally ELA in late stages of a crisis (if capital outflow is large).

Marc himself mentions this point in his latest paper:

If a Eurozone country is running a current account deficit that banks from other Eurozone members decline to finance, or if it is subjected to capital outflows, then all that happens is that the national central bank of that country will be accumulating TARGET2 debit balances at the ECB. There is no legal limit to these debit balances. The national central bank with the debit balances, which pay interest at the target interest rate, has as a counterpart in its assets the advances that it must make to its national commercial banks at that same target interest rate. And the commercial banks can obtain central bank advances as long as they show proper collateral. Why would the size of current account deficits or TARGET2 debit balances worry speculators? There might be a problem with the quality of the loans that have been granted by the banks, or with the size of the government debt, but that as such has nothing directly to do with a balance-of-payments problem.

[italics: mine]

But that is the case! It’s because of balance-of-payments. Nations who had high indebtedness to the rest of the Euro Area saw more capital flight. This is because in times of crisis, there is a home bias and international investors are likely to sell securities abroad and repatriate funds home. Large current account imbalances lead to a large negative net international investment position. (It’s of course also true that revaluations are important, and this is what happened in the case of Ireland). So when non-residents sell securities to domestic investors, banks are likely to get into a bad situation because they have to accommodate these transfer of funds and are losing central bank balances on a large scale.

It is precisely nations which had worse net international investment positions which were affected as charted in my previous post on this.

Now moving on to definitions: what is a balance-of-payments problem? The simplest definition is the problem for residents in obtaining finance from non-residents. Greece precisely has been struggling to obtain funds from non-residents.

So I do not agree with Marc’s view that:

Cesaratto, as others, is adamant that the Eurozone crisis is a balance-of-payments crisis, whereas I believe, as others do, that this is a side issue.

Marc Lavoie also says that the people arguing for this view are implicitly assuming some kind of “excess saving” view on all this:

In discussions with colleagues who support a “current account deficit” view of the Eurozone crisis, I sometimes get the impression that they are also endorsing a kind of “excess saving” view of the economy. They tell me that current accounts deficits are unsustainable within the Eurozone because the core Eurozone countries will refuse to lend to the periphery and will thus prevent these countries from financing economic activity. This seems wrong to me.

I disagree with this. It’s precisely because residents’ liabilities are large compared to their financial assets that they have to rely on non-residents/foreigners. And during the crisis a lot of capital outflow has happened and this precisely shows that non-resident private investors are unwilling to lend again on the same scale as before. This obviously means that to obtain finance, governments of nations affected have to take the help of the official sector abroad, such as from governments, the ECB and the IMF. If TARGET2 alone could do the trick, is the Greek government foolish to go abroad?

It is of course true that the design of the Euro Area was faulty. But that still leaves open the question about why Germany is not facing a crisis as severe as Greece. The design view cannot explain this. Any country (or all countries) in the Euro Area could have faced a crisis. There is a pattern here and that is where balance-of-payments comes in.

This debate is an interesting one. Both Sergio Cesaratto and Marc Lavoie agree on almost everything, except this BIG thing.

Of course this also spills over to policy proposals. Marc Lavoie believes that the European Central Bank can guarantee that all nations can have independent fiscal policies (by promising to buy all government debt which the financial markets isn’t interested in purchasing). Sergio Cesaratto is clear on this (and I agree very much) – in another paper Alternative Interpretation of a Stateless Currency Crisis:

A more resolute role of the ECB as lender of last resort accompanied by fine-tuned expansionary fiscal policies can only be imagined in a different political and institutional framework, quite close to that of a political union.

Let’s consider what happens if there is no federal government and if the ECB is the main supranational authority (ignoring other supranational institutions which have limited powers). Suppose the ECB were to guarantee the debt of governments of all Euro Area nations. There’s nothing to prevent, say, the government of Finland to increase the compensation of its employees every year by a huge percentage and thereby affecting Finnish corporations’ compensation of its employees. This will result in a reduction of competitiveness of Finnish producers and Finnish resident economic units will rely more on goods and services produced abroad. This will raise Finland’s net indebtedness to the rest of the Euro Area and the world. If someone believes that this debt is not a problem, how about the inflationary impact of this rise in demand on the rest of the Euro Area?

So the solution lies in bringing down the balance-of-payments imbalances (both negative and positive ones such as that of Germany). This requires a supranational institution, which is a central government. National governments would have rules on their budgets but the central government — since its goals and objectives are different — wouldn’t be bound by any rules. Wage rises would need to be coordinated. And as I argue in this post, fiscal transfers also plays a role of keeping imbalances in check.

Of course there are many other economists who also argue that the Euro Area problem is a balance-of-payments problem, but with a different motive. Their argument is to blame the nations in crisis instead of taking a humanist approach.

To summarize, the Euro Area problem wouldn’t have been a balance-of-payments problem had the official sector promised to act as a lender of the last resort to national Euro Area governments without any condition. As long as there are conditions, it is a balance-of-payments problem. One cannot pretend that the European Central Bank has or can be given such powers to lend without any condition. And hence the Euro Area crisis is a balance-of-payments problem.

Casual Monetarism

In an Op-Ed for The New York Times, Japan’s Economy, Crippled by Caution, Paul Krugman is seen using a highly Monetarist language:

As I said, you might think that ending deflation is easy. Can’t you just print money? But the question is what do you do with the newly printed money (or, more usually, the bank reserves you’ve just conjured into existence, but let’s call that money-printing for convenience). And that’s where respectability becomes such a problem.

When central banks like the Federal Reserve or the Bank of Japan print money, they generally use it to buy government debt. In normal times this starts a chain reaction in the financial system: The sellers of that government debt don’t want to sit on idle cash, so they lend it out, stimulating spending and boosting the real economy. And as the economy heats up, wages and prices should eventually start to rise, solving the problem of deflation.

… When you print money, don’t use it to buy assets; use it to buy stuff. That is, run budget deficits paid for with the printing press.

Now, there are several things wrong about this. The most important one is the implicit assumption in the “model” that fiscal expansion via increased government expenditure is about neutral and that domestic demand is boosted only because of the way in which the government debt is financed – i.e., central bank purchases of government debt. In other words, Krugman is saying that if there is deflation and if there is an expansion of fiscal policy via a rise in say government expenditures, it will have little effect when the central bank doesn’t purchase government debt. Put it in another way, it is saying that the government expenditure multiplier effect acts mainly because of central bank purchase of government debt and not because of the increase in government expenditure per se.

This is silly intuition and the cause of this is the notion that fiscal policy is more or less neutral except in special circumstances.

In reality, it is the other way round. If the government expenditure rises, and if the central bank purchases government debt, the rise in output is mainly attributable to the former. This can of course be seen in a stock-flow consistent model but can also be seen by simple accounting and flow of funds. A rise in government expenditure on goods and services raises output directly and also via the multiplier effect. The central bank has a huge control over interest rates and the additional debt is simply absorbed by the bond markets easily. There’s no competition with other borrowers as the wealth of the private sector rises. In addition, if the central bank purchases government debt, it is hardly clear if households know if inflation is going to rise and increase their consumption because of “inflation expectations”. Even if they think that if inflation is set to rise, they might reduce consumption as inflation might reduce their real wealth.

Which is not to say that asset purchase programs of the central bank or “quantitative easing” has no effect on demand and output. It works via capital gains in wealth leading to higher consumption and the feedback effects of this. It also works if economic units shift their portfolios to buying non-financial assets. The effect of all this is unclear. In addition, as mentioned earlier, casual Monetarism like the language used by Paul Krugman mixes up correct attributions of government expenditure and central bank government debt purchases on output, misleading everyone.

Simply say “raise government expenditures”. Why all this casual Monetarism with “printing presses”?