Krugman vs Kelton on the fiscal-monetary tradeoff

26 Feb, 2019 at 16:01 | Posted in Economics | 18 Comments

stefPaul Krugman is back again telling us that he doesn’t really want to spend time on arguing about MMT — and then goes on complaining that well-known MMTer Stephanie Kelton says things “obviously indefensible.” What has especially irritated the self-proclaimed ‘conventional’ Keynesian is that Kelton “seems to claim that expansionary fiscal policy … will lead to lower, not higher interest rates.”

Now, the logic behind Krugman’s “conventional Keynesian” loanable-funds-IS-LM-theory is that if the government is going to pursue an expansionary fiscal policy it will have to borrow money and thereby increase the demand for loanable funds which will — “other things equal” — lead to higher interest rates and less private investment.

The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credits set by banks and determined by supply and demand in the same way as the price of cars and raincoats.

It is a beautiful fairy tale, but the problem is that banks are not barter institutions that transfer pre-existing loanable funds from depositors to borrowers. Why? Because, in the real world, there simply are no pre-existing loanable funds. Banks create new funds — credit — only if someone has previously got into debt! Banks are monetary institutions, not barter vehicles.

In the traditional loanable funds theory — as presented in Krugman’s own textbooks — the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving is the supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate.

The loanable funds theory in the ‘New Keynesian’ approach means that the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras’ law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks’ interest rate adjustments. From a Keynes-Minsky-MMT point of view, this can’t be considered anything else than a belief resting on nothing but sheer hope.

The traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. This is seriously wrong:

gtThe classical theory of the rate of interest [the loanable funds theory] seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shifts​, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down … In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no ‘direct and immediate’ automatic interest mechanism at work in modern monetary economies. What happens at the microeconomic level is not always compatible with the macroeconomic outcome. The ‘atomistic fallacy’ has many faces — loanable funds is one of them.

We have to free ourselves from the loanable funds theory — and scholastic gibbering about ZLB — and start using good old Keynesian fiscal policies. Keynes — as did Lerner, Kaldor, Kalecki, and Robinson — showed that it was possible to promote economic growth with an “appropriate size of the budget deficit.” The stimulus a well-functioning fiscal policy aimed at full employment may have on investment and productivity does not necessarily have to be offset by higher interest rates.


  1. Totally agree. Krugman is living in a different world. He wrote an open letter to the Malaysian PM Mahthir Muhammad saying that he would be sorry for imposing capital controls to deal with the Asian financial crisis. Most experts believe that capital controls saved Malaysia from the disaster that Indonesia suffered with an open capital account. Krugman should have said sorry, but never did.

  2. I agree with Kingsley. I don’t think Krugman is going down the Loanable Funds track. His IS with inelastic LM curve approach is more or less Keynesian. However, he seems to be presuming the reduced deficit would be funded by lower bond sales, explaining the fall in the interest rate. Kelton on the other hand is talking about funding the deficit with CB created money.

    Kelton also finishes with the claim that the sectoral balance equation (SBE) shows that increased deficits add to private surpluses and there is thus no crowding out effect. MMTers are treading on precarious ground when they invoke the SBE in their arguments. The SBE is an ex post statement of account. Saying an increase in the deficit will result in increased private savings is not possible without bringing into play a behavioural/functional model. MMTers play very fast and loose with the SBE.

    • And NAIRU is what again relative to MMT, yet some will tell you that structual deflation baked in by market preferences is some how an IR ongoing concern relative to investor sediment … and the war was won.

  3. Jerry Brown,
    You may well be right that Krugman has been guilty of ‘Loanable Funds Theory’ thinking in the past.
    However, there is no trace of such thinking in his recent comments on MMT.
    We should consider his arguments without paranoia.

    I think we can agree that the IS curves drawn by Krugman describe macroeconomic possibilities for the markets for goods and services. They do NOT describe financial markets. The curves show possible equilibia where the aggregate output/supply would be equal to aggregate expenditure/demand, as described by Keynes in Chapter 3 of his “General Theory” and as formalised by Hicks in his “Mr. Keynes and the Classics”.
    The curves show that at full employment there is a policy trade-off between larger deficits (which increase demand) and higher interest rates (which reduce demand).
    Kelton herself accepts that interest rates might be “be reduced too low…and induce too much investment, thus bringing about inflation”. This is tantamount to admitting that at full employment higher deficits require higher interest rates.

    • Kingsley, to have a sensible discussion we need to get away from those curves, or be very precise about what economy we are talking about and if such an economy actually exists.

      What Krugman assumes is NAIRU, that there is a tradeoff between aggregate employment and inflation. But is that always true? No it is not. Inflation is often caused by capacity constraints in certain sectors. This has nothing to do aggregate employment levels. You can have high overall unemployment rates and high inflation, and the reverse. Kelton is right in that quote – there can be an lag before new investment translates into reduced capacity constraints, and this can be inflationary. But in that quote you have, Kelton does not refer to aggregate demand or employment being the driver of inflation.

      The big difference I see between MMT and Neo-classical economics is that I think that MMT is far more interested in what actually goes on. For Neo-Classicalists its about modelling and trying to paint a picture of the world that reconciles with Samuelsonian theory. It is not without flaws, but it at least MMT making an effort to really understand how financial markets and real economies work and trying to root out long standing fallacies.

      • The type of economy described by ISLM/neo-classical synthesis is basically one where Say’s Law (the Law of Markets) operates. Even mainstream economists who have properly thought about this such as Farmer openly admit it:

        Kenton is very careful when talking about any link between aggregate demand/unemployment and inflation and interest rates.

        • Hicks may have intended it as some form of recasting a GEM but in modern economic texts (of the 1960s/1970s) the IS/LM system was directly derived from the Y = C + I equation, the MEC schedule and the liquidity preference schedule – all Keynesian artifacts. It had nothing to do with Say’s Law.

          • True. Thanks for the correction.

    • Kingsley, you are right that we should consider Krugman’s arguments without paranoia being involved. I’m guessing that you consider my previous comment sort of paranoid- but then that guess is probably just a manifestation of my paranoia also. Damnit- maybe I should put my helmet on and get into my bathtub where I will be safe.

      Look, Paul Krugman is a really intelligent person. I’ve read his columns and his blog posts and heard him speak and he is better at all of those than I could hope to be. And he has a Nobel prize of sorts and a PhD in economics and was a professor at a very prestigious university and writes for a very important newspaper and probably a whole bunch of other things. So I wonder how such a smart and capable man would not be able to understand MMT while a relative dumbass like myself usually understands what MMT is saying.

      It bothers me that he says he can’t understand MMT. It would not bother me if he said he disagreed with it and would explain why. In a way that made sense. That kind of disagreement you can argue with- saying you can’t understand something and therefore something is wrong with it… well I don’t know about that. It doesn’t seem right to me. Maybe it’s that paranoia thing.

      Paul Krugman is a gifted writer- he doesn’t need to use curves on a chart he devised in order to explain his points when he could just use his words to more effect.

      You say “The curves show that at full employment there is a policy trade-off between larger deficits (which increase demand) and higher interest rates (which reduce demand).” I think MMT would say that despite Krugman’s curves there is not necessarily a trade-off between larger deficits and higher interest rates. Maybe MMT would point to WWII government deficits and the interest rates on US federal bonds to make that point. Maybe MMT would just say the economy is rarely at or near full employment and so what is the point of making models that assume it usually is at full employment or making models that assume there is always a tendency towards full employment.

      You also say “This is tantamount to admitting that at full employment higher deficits require higher interest rates.” MMT doesn’t say that at all. MMT says that at full employment, and given the way government debt is issued now, higher deficits would result in increasing inflation- pretty much regardless of whatever interest rate was charged on any new debt issued along with the increased government spending (or reduced taxation whichever was causing the increased deficit).

      • “Maybe MMT would just say the economy is rarely at or near full employment and so what is the point of making models that assume it usually is at full employment or making models that assume there is always a tendency towards full employment.”

        Fair point.

  4. Prof. Syll,
    I agree that Krugman’s textbook is pathetic in its accounts of loanable funds and money multipliers.
    However these matters are irrelevant to Krugman’s disagreement with Kelton.
    His argument DOES NOT IN ANY WAY rely on the loanable funds theory of interest rates.
    Please read what Krugman says:
    “Suppose that the Fed or its equivalent in another country can set interest rates, and that a lower interest rate leads, other things equal, to higher aggregate demand. Then at any given point in time there is a downward-sloping relationship between the interest rate and GDP, as shown by the lines IS1, IS2, IS3.”
    This is a very simple and uncontroversial statement, though there may be differing empirical judgements regarding the slope and volatility of IS curves.
    Krugman makes the elementary point that the government may be able to achieve full employment by fiscal policy (which shifts the IS curve), or by monetary policy (which changes interest rates inducing aa movement along a given IS curve.)

    In contrast, Kelton’s arguments are unclear and muddled.
    She seems to agree with Krugman that, in her words:
    “borrowing was not about financing deficits but hitting some desired interest rate”.
    She also seems to agree with Krugman IS curves have a negative slope. In her words:
    “interest rates are a policy variable”
    ” low interest rates … might “crowd in” more investment spending and overheat the economy”
    Interest rates might be “be reduced too low…and induce too much investment, thus bringing about inflation”
    “short-term interest rate is [a tool] available to the Fed to slow the economy”.

    Yet Kelton still tries to insist that “There are no inherent tradeoffs between fiscal and monetary policy” – the heading of her article.
    She seems to rely somehow, by some obscure reasoning, on the (correct) MMT proposition that budget deficits increase reserves at the central bank which “could drive interest rates down”, in which case “the government might want to sell bonds in order to mop up excess money (reserves)”.
    It seems that Kelton merely understands the possibility of the government selling bonds to avoid excess liquidity and to avoid very low interest rates.
    Krugman would doubtless agree with this. However Krugman extends the argument to include the possibility of raising interest rates to offset the inflationary effects of large budget deficits.

    • Kingsley, I see problems with both Kelton and Krugman, but in the case of the latter, the interest questions are the ones that Krugman avoids; for when and where do you get a clear relationship between government debt ratios and interest rates? This is the critical question really. Krugman also seems to imply that there may be ‘crowding out’ effects from raising Government spending over a certain level, because of its effect on the interest rate. But this can surely only apply if there is a managed currency system with a fixed supply of money. Otherwise this is a questionable assumptions and the causal links are by no means obvious or can generally applied across economies. A very big weakness of both Neoclassical and MMT theory is that they ignore issues relating to power. Sure the US, a powerful country with the world’s reserve currency will have a lot more leverage to inflate than a small open economy with a tight balance of payments constraint dependent on crucial inputs but of which it must nevertheless purchase with dollars.

      • There are people out there clearly stating – defending Krugman is not talking about loanable funds theory.

        When clearly the question then becomes one of tradeoffs: would the things the government could buy with a higher deficit be worth the lost private investment due to a higher interest rate? Often the answer will be yes. But there is a tradeoff.

        Why does Krugman assume a tradeoff between gov’t deficit and private investment?

        Not that it can only be determined ex post. Fiscal and monetary policies are not substitutes for one another, as one can directly effect demand while the other is a “let’s hope this works how we want it to” approach. And finally, there is no necessary connection between fiscal and monetary policy. CBs can set their rates at whatever they feel like, without regard for fiscal variables.

        Whilst the sound money proponents in the AMI camp wish administrate sovereign fiat by an unresponsive non democratic board and then let the fur fly.

    • Kingsley Lewis, in this sentence PK seems to me to be relying on ‘Loanable Funds Theory’ thinking – “The question then becomes one of tradeoffs: would the things the government could buy with a higher deficit be worth the lost private investment due to a higher interest rate? ” He assumes an increase in the government deficit causes an increase in interest rates. Why?

      Well, maybe he assumes the Fed will always raise its interest rate target to try to counteract expansionary fiscal policy. But that is not always true even if not at the ‘zero lower bound’. And even if it was always true, it doesn’t necessarily follow that a somewhat higher interest rate target will always reduce private investment, especially in the case of expected increases of demand.

      Or maybe (I think probably), he assumes fiscal deficits must always be accompanied by debt issuance by the Treasury and that those bond sales will always reduce the amount of ‘loanable funds’ left in the economy and that will cause interest rates to rise through a market mechanism. Which is what he has often written in the past (and which totally relies on loanable funds theory of interest rates). And which is very wrong, at least according to MMT.

      I didn’t think Stephanie Kelton was unclear or muddled at all. I think Paul Krugman is right when he says “The problem is that I don’t understand her arguments at all.” And the reason he can’t understand is that he is locked into some prior assumptions about how the modern monetary economy works. Some of which are based on a gold standard way of thinking and do not apply at this time, and some of which were always wrong. So he tries to fit MMT arguments into these prior assumptions and finds they don’t fit. But then instead of checking to see if what MMT says fits the actual economy we have, or questioning his prior assumptions, he either rejects it or says it is not understandable. Well, he will probably never understand it if he won’t consider that some of his prior assumptions could be wrong.

    • I agree that the loanable funds argument has nothing to do with the K v K argument. The reason, strikes me, is that monetarily sovereign governments do not borrow commercial bank created money when they borrow: they only borrow base money.

  5. Krugman failed to learn anything from his debate with Steve Keen

  6. Seeing those venerable professors – who are always so proud of their unfailing scientific methods, and so prompt in castigating those who hang onto their own outdated theories – try so pitifully to refute perfectly sound arguments is a sobering experience.

  7. I stand with Arthur C. Clarke:
    “The goal of the future is full unemployment, so we can play. That’s why we have to destroy the present politico-economic system.”
    Economists who laud full employment have the wrong goal. Economists should be ignored when making public policy.

Sorry, the comment form is closed at this time.

Blog at
Entries and Comments feeds.