In my previous post I showed that Krugman’s recent piece on Argentina completely glossed over the data in its assertions that the inflation in that country was due to fiscal deficits**. I also, somewhat offhandedly, referred to his argument as being ‘monetarist’. This caused some degree of confusion so I thought I should probably clear it up.
Okay, so let’s first try to get a grip on the monetarist position on deficits. This was most clearly brought out in the debates during the late-70s and early-80s under Thatcher in Britain. Note that in this period the fiscal deficit was referred to as the PSBR (Public Sector Borrowing Requirement).
In his seminal account of the monetarist era in Britain, The Scourge of Monetarism, Nicholas Kaldor lays out clearly the monetarist position on the relationship between fiscal deficits, inflation and the money supply.
In the Green Paper on Monetary Control of March 1980 it is asserted that “it is sometimes helpful to examine how a particular control will affect items on the asset side of the banking system”. The Paper then proceeds to state an accounting identity which shows the change in the money stock (£M3) in a given period as the sum of five separately identified items, of which the PSBR is one… The main monetarist thesis is that the net dissaving of the public sector in ‘inflationary’ in so far as it is ‘financed’ by the banking system and not by the sale of debt (bonds or gilts) to the public. (pp48-49)
Kaldor’s account is a rather nice and clear view of the monetarist theory of the fiscal deficit. If the deficit is financed by selling debt to the public it ‘crowds out’ private investment by driving up interest rates. But if it is funded by the banking system — i.e. the central bank — it is inflationary. Sadowski, for example, completely missed this distinction when he wrote in response to my piece,
Pilkington is evidently drawing from a peculiar rewriting of the history of the Thatcher years, when the UK’s public sector borrowing requirement (PSBR) was targeted for reduction as a means holding down interest rates. No form of monetarism, not even an imaginary special Thatcherian variation, believes that inflation is a fiscal phenomenon.
Both parts of Sadowski’s arguments are completely incorrect. First of all, in the Thatcher years the monetarists closely watched to what extent the fiscal deficits were being funded by the central bank and chalked these up as a major cause of inflation. Second of all, Really Existing Monetarism under Thatcher did indeed believe that the (monetised) fiscal deficits added — by identity — to the M3 money supply and thus to inflation. It is Sadowski that is rewriting history by asserting otherwise.
Now, how does this monetarist argument regarding the relationship between (monetised) fiscal deficits, the money supply and inflation square with Krugman’s? Well, let’s turn to his piece on Argentina to see.
Running deficits and printing lots of money are inflationary and bad in economies that are constrained by limited supply; they are good things when the problem is persistently inadequate demand. (My Emphasis)
Do you see that? That is identical to the monetarist argument made in the late-70s and early-80s. And that is why I called Krugman’s argument ‘monetarist’… because it is monetarist!
So, what was the Keynesian position in those years? I don’t want to run through this in too much detail as it is enormously complex but Kaldor gives us a taste.
[The monetarist view] ignores the fact that the net saving, or net acquisition of financial assets of the private sector will be the same irrespective of whether it is held in the form of bank deposits or bonds. The part of the current borrowing of the public sector which is directly financed by net purchases of public debt by the banking system — and which has its counterpart in a corresponding increase in bank deposits held by the non-banking sector — is just as much part of the net saving of the private sector as the part which is financed by the sale of gilts to the private sector. (p49)
Now, I don’t want to get into a debate regarding the truth of the above statement, that is not my point here. My point is simply that Krugman’s argument is far closer to the monetarist position than to the Keynesian position. Anyone who states otherwise is either ignorant of these debates or does not understand the implications of endogenous money theory sufficiently well. And that is the end of the story.
Update: Thanks to Nick Edmonds who pointed to the following document in the comments section. The document reads:
It is not the intention to achieve this reduction in monetary growth by excessive reliance on interest rates. The Government is therefore planning for a substantial reduction over the medium-term in the Public Sector Borrowing Requirement (PSBR) as a percentage of Gross Domestic Product (GDP). The relationship between the PSBR and the growth of money supply is important but is not a simple one; it is affected by the economic cycle, the rate of inflation and the structure of the tax and public expenditure flows generating the borrowing requirement. But although the relationship between the PSBR and £M3 is erratic from year to year, there is no doubt that public sector borrowing has made a major contribution to the excessive growth of the money supply in recent years. (p16 — My Emphasis)
** Note that Mark Sadowski questioned the data I provided and supplied IMF data that was somewhat different. Although I am suspect of the IMF data, as Argentina basically told the institution to shove it in 2001-2002 they have every incentive to exaggerate the fiscal deficit, even if we take it at face value it makes the same point that I originally made: namely, that inflation and fiscal deficits are not correlated. You can read the exchange between Sadowski and I here.