Part 3: The Battle of the Interest Rate – NKE vs. MMT
Trying to unpick the economics of the public finances can feel like traversing a rabbit-hole-ridden labyrinth, blindfolded, whilst dodging jargon-filled bullets being exchanged by economists from all parts of the economic spectrum, and nonsense-filled bullets from the political one.
The mechanisms on which public finance debates are centred are extremely complex. This makes them opaque, inaccessible and, as discussed in previous blogs in this series, commonly (and unsurprisingly) misunderstood.
On top of this opacity, there is fierce disagreement amongst economists about how these mechanisms actually work, making the task of unpicking them all the more treacherous. But while a lack of transparency is objectively bad, varied opinions on this subject are infinitely good. Unlike with many other topics in economics, all sides of the public finance discussions are getting significant airtime – which makes the subject a fantastic example of live pluralistic economic debate.
Nowhere is disagreement more explicit than in exchanges between mainstream New Keynesian Paul Krugman on the one hand, and heterodox Modern Monetary Theorist Stephanie Kelton on the other. They battled it out on the pages of Bloomberg and the New York Times early last year (paywalls are on opacity’s side in this case, but the disagreement is summarised well here).
While most of the anxiety surrounding government spending in the news is linked to inflationary outcomes, these two prestigious economists hold distinct beliefs about what government spending does to interest rates. While discussing interest rates isn’t as sexy as discussing inflation, it’s a really important element of the public finance debates and should not be ignored.
The New Keynesian/Krugman view is that too much government spending causes interest rates to increase, in turn discouraging investment. The logic behind this is two-fold: firstly, the supply of loanable funds available for investment are limited, and if the government enters the market for loanable funds (as they must borrow to spend over and above tax receipts), thereby increasing the demand for them, the price of those loanable funds (real interest rates) will increase. This is commonly known as ‘crowding out’.
Secondly, if government spending is seen as inflationary, central banks will increase the policy rate to reign it in as a means of curbing inflation. So there is both a ‘natural’ and a Central Bank-inflicted dynamic, which both increase the interest rates following government spending. In a situation where government debt levels are already high, if interest rates increase faster than GDP growth this could mean spiralling interest costs for the government and reduced investment elsewhere.
But surely if we are facing inflationary pressures, increased interest rates aren’t necessarily a bad thing? Although we are currently facing high inflation levels, this is likely to be short-lived (‘transitory’), and increased interest rates could cause a plunge back into recession. It follows, according to New-Keynesian theory, that while government spending will stimulate the economy in some ways – putting more money into people’s pockets and stimulating demand, it will also work to increase interest rates (if you buy the crowding out argument, that is, or if the Central Bank reacts by increasing them). According to NK logic, this will reduce investment which could be catastrophic when a strong recovery is needed following the pandemic.
The New Keynesian view is based on three disputed assumptions: firstly that government spending must be financed through the issuance of public debt (so it enters the loanable funds market), secondly that this necessarily pushes up interest rates (due to limited loanable funds) and thirdly that interest rates are the main determinant of investment decisions. So while government spending to a degree is desirable in stimulating growth, its side effect of increasing the interest rate, thereby crowding out private investment and increasing public debt, is not.
Conversely, the Modern Monetary Theory/Kelton view is that government spending has the opposite effect on interest rates. MMTists see government spending and government borrowing as separate mechanisms. While New Keynesians assume government spending over and above tax receipts necessitates borrowing, and therefore the government entering the loanable funds market (pushing up interest rates), MMTers clearly demarcate between the impacts of government spending on the one hand and the issuance and purchase of government debt on the other. As discussed in part 2 of this blog series, both public and private banks can create money by simply crediting reserve accounts held with them, so government spending does not have to equal government borrowing.
Let’s first explore the impact of government spending itself on interest rates, according to MMT. Private banks hold reserve accounts with central banks – at the end of each day the private banks must ensure they have enough reserves in that account to satisfy the central bank’s requirements (the rest can be profitably loaned out). The amount of reserves in that commercial bank’s account with the central bank at the end of any given day is determined by transactions between their customers and customers of other banks.
If HSBC customers happened to spend a lot one day, and Barclays customers didn’t, then at the end of the day Barclays will have more in it’s reserve account with the central bank than HSBC. Barclays will earn a kind of ‘reward’ interest on the extra reserves they have (‘support rate’) like earning interest on savings. HSBC could borrow from the central bank to fulfil its reserve quota for that night and would be charged at the ‘policy rate’ or ‘repo rate’ – which will be a higher rate than the ‘support rate’.
But HSBC could equally borrow what it needs from Barclay’s at a lower rate. Barclay’s would forgo earning the support rate but by setting it’s interest rate in between the support and policy rates end up earning more interest. And this ‘interbank lending rate’ or ‘short term rate’ – along with what the central bank sets as its ‘policy’ and ‘support’ rates (the upper and lower limits) – is what determines the “true” interest rate.
How does government spending affect all this? When the government spends money, the central bank debits the government’s reserve account and credits the reserve accounts of commercial banks affiliated with recipients of that spending (e.g. contractors, public sector employees, etc). Note that this does not require the selling of gilts – the central bank can credit commercial bank accounts with the stroke of a keyboard. Government spending credits commercial banks with more reserves. There is less demand for fulfilling reserve quotas at the end of the day, so the interbank interest rate falls. In contrast to Krugman’s assertion, a government deficit actually reduces the interest rate.
Separately, MMT’ists recognise that when governments issue public debt – when they sell gilts to private investors (which is decoupled from government spending) – they are increasing the interest rate because they are taking liquidity (potential reserves) out of circulation, thereby reducing reserves supply and increasing the interbank lending rate. When Central banks then buy up those gilts (QE) they are attempting the opposite – by injecting liquidity into bond markets the interest rate will reduce (although whether that transpires in reality is another question).
Despite recognising this theoretical logic, MMTers assert that ultimately these are just small deviations in the interest rate from the Policy Rate, which is set by the Central Bank, and is what anchors interest rates and therefore is important. Setting the interest rate has much less to do with reserves liquidity and much more to do with policy decisions by the central bank – so we should not be worrying about the impact of government spending on interest rates, as any ‘natural’ impact can be overridden by central bank policy decisions. Thus, we can increase government spending to try to achieve full employment without worrying about the impact on interest rates.
This raises another fundamental disagreement between Krugman and Kelton – Krugman believes that interest rates have a significant impact on investment and are therefore a useful tool in cooling inflationary pressures, while Kelton, true to Keynes himself, believes investment decisions to be much more determined by ‘animal spirits’ – emotional and psychological factors based on confidence. So according to MMTists, interest rate manipulation is in fact not a useful tool for macro management at all.
The Critical Macro Finance post on which this blog is based sums up the debate nicely (text in brackets added):
“Krugman and Kelton have two differences in assumptions that matter here. First, Krugman assumes a mechanical relationship between interest rates and investment… while Kelton rejects this relationship. Second, they are assuming different central bank behaviour. Krugman assumes that the central bank will react to fiscal expansion with tighter monetary policy in the form of higher interest rates: the central bank won’t allow employment to exceed the “full employment” level. Kelton assumes, firstly, that fiscal policy can be set at the “full employment” level, without any direct implications for interest rates [as the Central Bank can choose not to increase them without causing damage] and, secondly, that deficits are monetised [government spending doesn’t equal government borrowing] so that money market rates fall as the deficit expands.”
I’ll leave it to you to decide who is right and who is wrong in this debate – whether government spending increases or decreases interest rates, to what extent interest rates impact expenditure, and how the central bank should be responding to the current crisis. In economics, your beliefs, ideologies and ways of interpreting the world are a critical determinant of the conclusions you draw.
This makes intellectual curiosity and critical thinking a vital component of studying the subject, while all too often economics is taught from one perspective and pluralism is ignored or even actively discouraged. Social media has made it easier for descriptions of the economy to be obscured, hyperbolised and misunderstood, but it can also bring forth transparency in economics and a platform from which to challenge economic orthodoxy. It provides us the opportunity to engage with the debate – we must seize it.
Jaya Sood is an Analyst in HM Treasury. Please feel free to email her with any questions