Paul Krugman Does Monetary Realism’s Contingent Institutional Approach

Few things are more important than understanding precisely how the US government is able to eliminate solvency crisis through its institutional arrangements.  One of the key Monetary Realism contributions is understanding these relationships and how they create the autonomous currency issuer.  Banks are essentially harnessed as agents of the government in the funding process as they are required to bid at Treasury auctions.  So the notion of not being able to procure funding is nonsensical.  But even in a worst case scenario (let’s say a hyperinflation where the banks resort to self preservation mode and boycott auctions) the Fed can always step in as the lender of last resort.  For more on this please see the Monetary Realism primer.

Although few people have gone into the intricate detail that JKH has on this topic, this understanding is not unique to Monetary Realists as noted in a recent Paul Krugman piece here (via Manifesto for Economic Sense):

“The confidence argument. Their first argument is that government deficits will raise interest rates and thus prevent recovery. By contrast, they argue, austerity will increase confidence and thus encourage recovery.

But there is no evidence at all in favour of this argument. First, despite exceptionally high deficits, interest rates today are unprecedentedly low in all major countries where there is a normally functioning central bank. This is true even in Japan where the government debt now exceeds 200% of annual GDP; and past downgrades by the rating agencies here have had no effect on Japanese interest rates. Interest rates are only high in some Euro countries, because the ECB is not allowed to act as lender of last resort to the government. Elsewhere the central bank can always, if needed, fund the deficit, leaving the bond market unaffected.”

That’s the contingent institutional approach whether he knows it or not.  The next step is realizing that, because there is no solvency constraint for an autonomous currency issuer, that the true constraint is inflation rather than solvency.  The policy responses are obviously very different (particularly in the current balance sheet recession) when you recognize this fact.

If you have yet to read JKH’s Contingent Institutional Approach please see here.  It’s a must read.

About

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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56 Comments on "Paul Krugman Does Monetary Realism’s Contingent Institutional Approach"

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Guest
4 years 11 months ago

1. I think the “always” funding idea is incorrect (and so does JKH). It’s an extreme position to take.

2. The term “funding” is quite accurate since the Tsy does have to procure the funds as a currency user.

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wh10
4 years 11 months ago

1. “Always” in the sense that the Fed is “always” managing interest rates (which indirectly creates conditions that allows the Tsy to fund its deficit)

2. I don’t take issue with the point you make, but I do take issue with what is implied by the Fed funding the Tsy “if needed.” What does this mean? Under JKH’s approach, the Fed cannot directly fund the Tsy. The only way this could be interpreted as correct is if it is referring to the Fed’s actions in the secondary market, but in that case, the Fed is always doing that in some way or another.

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JP Koning
4 years 11 months ago

The modern Fed “always” funds the Treasury because it has precommitted itself to conducting open market operations in treasury bills and bonds, as well as agency debt. This creates an in-built liquidity premium in the prices of these instruments which perpetually reduces the funding costs of the Treasury and its various agencies. If it was permissible for the Fed to conduct open market operations in a broad array of private and public securities then this liquidity premium would be diluted across a broader spectrum of assets, reducing what has become for the Treasury a permanent liquidity and therefore funding advantage. For example, the Fed used to conduct open market operations in both government securities and bankers acceptances, and therefore the liquidity advantage it provided to markets would have been equally shared amongst the private and public sector. It is now entirely paid to the public sector.

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wh10
4 years 11 months ago
I don’t know, there is still a lack of clarity in what he says, but he is definitely in the right spirit. I am getting nit picky here (that after all is the essence of the contingent institutional approach), but under the contingent institutional approach, the CB CANNOT “always, if needed, fund the deficit,” if what he is referring to is some unusual scenario in which the Fed *directly* funds the deficit, by either providing overdrafts to the Treasury or buying in the primary market. And it sounds like he is referring to that type of scenario because he uses the words “if needed” and “fund.” But that is an alternate world with a different institutional structure; it’s the MMT general case. Rather, the key to properly understanding this from an operational perspective is that the Fed is effectively *always* indirectly “funding” the deficit by maintaining control of interest rates in the secondary market (as Marinner Eccles puts it). (And “funding” is really not such a great term, because it is really a matter of interest rates, rather than securing the right quantity of funds.) Under the contingent institutional approach, it’s just a matter of the *degree* to which the Fed needs to intervene in secondary markets; this is the same as Fullwiler’s semi-strong and weak cases. But the Fed is always doing this; it’s not a matter of “if needed.” I suppose one scenario of “if needed” would be if the Fed needs to announce a specific price for tsys in the secondary market, but Krugman doesn’t give me the feel this is what he is talking about (maybe I should give him the benefit of the doubt). I am being nit picky, but I actually think it is important. Because until you have crystal clear clarity, there will… Read more »
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Detroit Dan
4 years 11 months ago

I agree wh10. Your clarification helps me understand the situation much better than Krugman…

Guest
wh10
4 years 11 months ago

Well, I now realize my comment is embarrassingly garbled, because I had in mind JKH’s entire paper, rather than the specific contingent institutional changes, which could make it such that the Fed could directly fund The treasury. But my point still stands that Krugman was unclear about this in the way he wrote it, since he is mixing the reality we have today with a contingent institutional set-up; but also that I am being annoyingly nit picky and Krugman has the gist.

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