Great Leap Forward

Martin Wolf’s Liquidity Traps and Free Lunches Through Fiscal Expansion

A couple of weeks ago I wrote a critique of Chairman Bernanke’s understanding of money (here: At the end of my blog, I summarized a good column written by Martin Wolf that did get money (mostly) right: Wolf promised a Part II on the topic of appropriate monetary and fiscal policy in a “liquidity trap”, which he has provided here: Wolf also indicated he would write a piece on Modern Money Theory, an approach he does not address in either of these two articles. I look forward to that.

Meanwhile, let me say that I do not disagree with the substantive points made in his Part II—which examines an article by Brad DeLong and Larry Summers. The main argument is this: when there is substantial excess capacity and unemployed labor, fiscal expansion is a “free lunch”. There really should be no surprise about that—it was a major conclusion of J.M. Keynes’s 1936 General Theory, and indeed already had some respectability even before his book. Expansionary fiscal policy can put otherwise unemployed resources to work, so we can enjoy more output.

So what DeLong and Summers do is to show that given assumptions about the size of the government spending multiplier as well as a link between income growth and tax revenues (so that economic growth increases revenues from income taxes and sales taxes, for example) then it is entirely possible for a fiscal expansion to “pay for itself” in the sense that tax revenue will rise. If the “real” interest rate is low, then one can show that the “debt burden” of servicing additional government debt due to an increase of budget deficits does not rise. Hence “the fiscal expansion is self-financing”. (I have problems with all the terms in quotation marks, but will deal with only the first of these here, the notion that expansion can “pay for itself”.)

Let me skip to Wolf’s summary conclusion, with which I whole-heartedly agree: “Policy-makers have allowed a huge financial crisis to impose a permanent blight on economies, with devastating social effects. It makes one wonder why the Obama administration, in which prof Summers was an influential adviser, did not do more, or at least argue for more, as many outsiders argued. The private sector needs to deleverage. The government can help by holding up the economy. It should do so. People who reject free lunches are fools.”


But….. well, you knew there had to be a catch.

Let me first deal with a complaint some of my fellow MMTers have made. They do not like the use of the phrase “free lunch” because in “real” terms the fiscal stimulus creates more jobs so that more of that “real stuff” can be produced. It isn’t a “free lunch” because someone had to do the cooking. OK, that is certainly true. However, to the extent that fiscal stimulus provides more jobs for the involuntarily unemployed, the extra work is desired and is socially beneficial in all sorts of ways that go beyond producing the extra lunches. Involuntarily unemployed are not voluntarily enjoying “leisure time” as orthodox economics argues—rather the time spent unemployed is stressful for the individual and for her family and friends, and unemployment generates lots of social costs. Most humans want activity, and especially enjoy roles as productive members of their social groups. Indeed, this is so obvious, I only need to explain it to economists who alone believe in this work/leisure dichotomy. I don’t.

That leads to the more important issue raised by MMTers, and it is one that I hope Wolf will address in his “Part III” devoted to MMT. Is it at all important for a fiscal stimulus to “pay for itself” by generating tax revenue to match spending (including interest payments)? And, more precisely, is there any sense in arguing that tax revenue “pays for” spending?

Let me say that I am not disputing the math of the simple models used by DeLong and Summers and reported by Wolf. I’ve long pointed out that increasing government spending in a fiscal expansion need not increase the current and prospective budget deficits for precisely the reasons they present. Deficits are not discretionary, they are outcomes that depend largely on economic performance. And Wolf certainly understands the sectoral balance approach of Wynne Godley—which demonstrates that there is a necessary, ex post, link among the balances of the government, domestic private, and foreign balances. All else equal, if fiscal expansion leads to sustained growth, the budget deficit will be smaller over coming years than it would have been without growth.

A fiscal expansion can very well affect both the domestic private balance and the foreign balance in such a manner that the government’s balance moves away from deficit and toward surplus (think Clinton years). But the relations are complex and will depend on country-specific circumstances. Still, we can understand that in the right conditions, a fiscal expansion “does not materially affect the overall long-run budget picture” (as DeLong and Summers put it) since current and future tax revenues rise to match current extra spending plus future interest payments on government debt.

(In the US, a successful fiscal expansion that generates growth will probably cause the private sector to want to spend more relative to its income, which causes its own balance to move to smaller surpluses while at the same time increasing imports that cause the current account balance to move toward larger deficits. If the leakage due to the current account deficit increases less than the fall of the leakage due to the private sector’s smaller savings, the government budget deficit can fall. Sorry, that is a bit complex—read it twice.)

Now in the case of a nonsovereign government—say a New York State, or a Greece or Portugal, that is important. As a currency user (not issuer) New York really does use tax revenues plus borrowing to “pay for” its spending. If it could be shown that ramping up spending by the state government would generate growth and revenues to “pay for” the spending, then the state could stop down-sizing its labor force and other spending—and instead go on a much-needed spending spree. Otherwise, New York’s only hope is transfers from Washington to stop the downward spiral (see below)—but there’s no audacity of hope left in an Administration that is determined to cut its way back to prosperity. We are seeing similar behavior across Euroland, which has pinned its last hopes on the ECB. I won’t go into that can of worms here, but I’d put money on a born-again Washington before I’d bet on the ECB.

But a sovereign government like the US spends by “keystrokes”—it does not really need an increase in tax revenue in order to spend more. Indeed, in these models used by DeLong and Summers it is important to note that the increase to tax revenues is ex post, resulting if and only if the spending spurs growth. I’m not pointing out anything they do not understand, of course. I’m just repurposing their explication.

What if the revenue did not go up? Well, the spending would have occurred already, anyway—without being “paid for” by taxes. How was it paid for, then? By keystrokes—whether the tax revenue goes up or not, the spending is accomplished by keystrokes, crediting banks with reserves as the banks credit the deposit accounts of the recipients of the government’s largess.

What is the implication? Normally the Treasury sells bonds more-or-less equal to its deficit (I’ve explained the procedures over at the Modern Money Primer; begin with this one and read through Blog 24.). And in normal times, these bonds are sold to private banks that use the reserves created by the government’s spending to purchase them. In abnormal times (now!) when the Fed is running QE1, QE2 and QE3, the banks then sell those bonds to the Fed and get stuck with low-earning reserves. So in normal times the Treasury pays interest to the private banks; in abnormal times the Treasury pays interest to the Fed, which pays lower interest on reserves to the banks. (The Fed then turns most of its profits back to the Treasury—so it is as if the Treasury did not pay that interest in the first place.)

How do the Treasury and Fed make these payments? Keystrokes, as Chairman Bernanke has patiently explained. Can they run out? Not so long as we can find any electrons to push through fiber optic cables in order to make electronic entries in balance sheets. I don’t think we’re running out any time soon.

To sum up. What am I complaining about? Well, not much. A clarification.

All government spending “pays for itself” in the sense that the payment through keystrokes is made simultaneously with the spending. If we need more spending, just do it. If a deficit results, so be it. If bonds are sold that entail future interest payments, stroke the keys to credit accounts. If you don’t want to pay the interest on bonds held by banks and others in the private sector, don’t sell them—or have the Fed buy them and pay the interest to the Fed, which then turns profits over to the Treasury. (We Want Our QE! QE Now! QE Forever!)

The problem, of course, is politically-imposed constraints: debt limits, deficit ratios, and the budgeting process itself. To be sure, that is a difficult problem. I suspect that will be Wolf’s main beef with MMT.

Finally there is one other complaint. Wolf argues that in the scenario posed by DeLong and Summers investors don’t need to worry about the long-run budget posture (since the spending “pays for itself”). But investors don’t need to worry about the budget posture in any case. A sovereign country that issues its own floating currency (the US, Japan, and the UK, for example) cannot go insolvent in its own currency; it can always make all payments as they come due (aside from those politically imposed constraints—that could lead to a voluntary default, which I think is a low probability default even if Republicans take over the government in the next election).

This is why credit downgrades of such nations do not “materially” impact interest rates on government debt. So it is not just in the “liquidity trap” that investors should not worry about budgetary outcomes.

What should they worry about? Inflation. And, yes, too much government spending can cause inflation. But that is true regardless of the budgetary outcome—indeed, for the reasons discussed by Wolf, rapid growth will probably reduce the budget deficit while generating inflation pressures! So looking at the budgetary outcome is misguided both inside and outside the liquidity trap.

Let me finish with what should be seen as a scary picture. If we look at total government employment over the current and previous presidential administrations we see that President Obama’s has seen an unprecedented destruction of public sector jobs. If I were President Obama, I’d be worried about the campaign slogan that he’s sure to be stuck with: “Obama the job destroyer”. No wonder we’re still in the doldrums.






26 Responses to “Martin Wolf’s Liquidity Traps and Free Lunches Through Fiscal Expansion”

Dan KervickMay 2nd, 2012 at 12:10 am

Great post Randy. I can never understand this obsession with whether government spending pays for itself in terms of tax revenues. The national government is a vast public enterprise. Running it absorbs real resources, and in turn government operations generate real benefits. The operations "pay for themselves" if the benefits exceed the costs.

Insisting that the operations also pay for themselves in terms of revenue returned to the public treasury is wrongheaded.

LCRMay 2nd, 2012 at 2:16 am

The entire planet (of political technocrats) has been on a spending binge for the past 4 decades, promising more to it's people than the value of the goods and services that exist. This is evident by the debt levels we see. Governments have never been good stewards of the peoples money, especially when you count their unfunded future liabilities. If creating electronic "money" solves this dilemma, then why does anyone work at all (as stated by Ron Paul)? The misappropriations of capital we see today are enormous. Not all debt is bad but government debt "paid for" through currency debasement and pillaging of savers and the unborn should not be justified.

markgMay 2nd, 2012 at 2:21 am

I have been waiting over ten years to correct you on something. Electrons don't push through fiber optics cables; photons do!

buzzMay 2nd, 2012 at 2:24 am

Perhaps "Modern Monetary Theory" would find more followers if it was renamed "Futuristic Monetary Theory".

The idea that currency-issuing governments spend with mere "keystrokes" might be attractive, but it doesn't describe the current situation.

In the present arrangement, governments do actually still have to fund themselves by organizing auctions and selling bonds. Central banks are generally prohibited from directly funding governments, and do in fact enjoy considerable independence when deciding whether or not to indirectly fund them by buying previous bond issues in the secondary market.

buzzMay 2nd, 2012 at 2:51 am

Also, the notion that currency-issuing governments can only default "voluntarily" is misleading. Even where – in fact, especially where – central banks have little or no independence, defaults on domestic-currency debts do occur. See Reinhart & Rogoff for a long list of them. Or take the recent well-known example of Russia 1998.

Was it voluntary? Technically, yes – Russia could have instead devalued its currency even further. Practically, it was at least not any more voluntary than most defaults on foreign-currency debts, which happen when a political decision is taken to place the funding of public programs above foreign demands for repayment, and long before the government literally runs out of funds.

studenteeMay 2nd, 2012 at 3:52 am

There are numerous ways to get around this. The Fed will not bounce the govt's cheque.

studenteeMay 2nd, 2012 at 3:57 am

So Russia did in fact voluntarily default. Nothing misleading here.

Not one of Reinhart & Rogoff's examined countries match the situation faced by the US, UK, and other countries completely sovereign in their currencies.

buzzMay 2nd, 2012 at 5:08 am

What's misleading is the suggestion that domestic sovereign defaults are unique in being voluntary. Virtually all sovereign defaults are voluntary. Defaults are desperate decisions made in desperate times, when the alternatives are judged to be worse. That isn't different with domestic defaults.

There are many countries that have defaulted on their domestic debt issued in domestic currencies over which they had just as complete sovereignty as the US and UK have over the dollar and pound. R&R compiled a long list. What are you saying, that Russia didn't have complete sovereignty over the ruble?

Most domestic-currency-debt defaulters, including Russia, actually faced even less obstacle than the US or UK would face to "printing" as much money as needed to repay domestic-currency debts, because their central banks lacked independence (often helping to explain how they got into the crisis).

buzzMay 2nd, 2012 at 5:20 am

No, there is currently no way around the government's need to fund itself with taxes or debt sales. In practice the government can temporarily overdraft without penalty, but that doesn't mean no one would get in its way if it tried to run up a big negative balance, and in practice, it doesn't do that. It sells debt, and when bids for the debt are weak, it reduces spending.

The point is, our system does not work the way MMT describes. If you want to propose that it should, fine, make your case. But we in the developed world live in countries where explicit monetization of public debts is legally forbidden and even indirect monetization of public debts is at the discretion of independent central banks.

NeilWMay 2nd, 2012 at 6:29 am

It does.

If you want to argue for a constraint, rather than an elaborate fairy dance, then you need to find the guy who will say 'no' and still be in that job by nightfall.

There is no law without enforcement.

It is like the illusionist that appears to levitate. It just looks like that because of clever disorientation and misdirection. The laws of physics still apply.

LRWrayMay 2nd, 2012 at 11:14 am

Sorry Buzz, you don't know what you are talking about. Go over to the MMP at NEP using the link I supplied where the coordination of operations between the Treasury and Fed is explained in detail. As to Rogoff and Reinhart, they group together sovereign governments, nonsovereign govts, gold standards, and who knows what over a period of 800 years, add it all up, and refused to supply any of the underlying data so that we can see what they did. Yeva Nersisyan and I have provided lengthy critiques of what must be among the worst empirical work ever published.

SchofieldMay 2nd, 2012 at 2:17 pm

I think there is a missing argument here. It is all very well for MMT, or Martin Wolf through conventional Keynesian stimulus approach, to argue for a re-balancing of demand through government spending but what is going to stop the Banksters subverting this expansionary demand process yet again by blowing asset and commodity bubbles that increase the real economy's costs and debt repayment drain?

For me Dirk Bezemer made this point very strongly by implication in his paper to the recent INET Conference in Berlin:-….

I feel that this is a weakness of MMT that it does not stress sufficiently the corresponding need to rein in the asset and commodity bubble creating propensity of the financial sector as part of the demand stimulus activities of government. Perhaps my reading of MMT has been too superficial to justify this remark but my gut instinct tells me this is so.

LRWrayMay 2nd, 2012 at 3:28 pm

Yes, apparently you have missed the hundred or so pieces I have written on financial crises, instability, bubbles in housing and commodities, and fraud. I've been writing about all this since the Saving and Loan Crisis. Minsky was my dissertation advisor. For more academic pieces go to and click on scholars then on my name then on all publications.

SchofieldMay 2nd, 2012 at 3:44 pm

I'm aware of your great many articles and greatly appreciate them but my point is that for the general public MMT would have more reasoned resonance with the use of a twin argument that making using of a sovereign currency issuer's powers needs to be accompanied by a reformed money creation ( currently dual ) that allows Banksters to load costs onto the operation of the real economy through bubble blowing.

SchofieldMay 2nd, 2012 at 4:03 pm

Ooops typo.

I'm aware of your great many articles and greatly appreciate them but my point is that for the general public MMT would have more reasoned resonance with the use of a twin argument that making using of a sovereign currency issuer's powers needs to be accompanied by a reformed money creation ( currently dual ) that restricts Bankster's ability to load costs onto the operation of the real economy through bubble blowing.

Michael E PicrayMay 2nd, 2012 at 5:26 pm

Depends on whether you are an adherent of the visual equivalent of hole theory or electron theory. (ie do the photons move through the fiber optic pathway, or do the holes move to be filled by the photons?) ;-D

Michael E PicrayMay 2nd, 2012 at 6:13 pm

Buzz said:
"In the present arrangement, governments do actually still have to fund themselves by organizing auctions and selling bonds."

The current US Fed does both – they currently are buying 61% of US Treasury bonds, as well as directly funding elements of the government.

("The Consumer Financial Protection Bureau was created by last year's overhaul of financial regulations, concentrating consumer protection responsibilities from seven other agencies.

Once it is operational in July, the bureau will be funded directly from the Federal Reserve outside the congressional appropriations process."… )

SergioMay 3rd, 2012 at 8:18 am

Each year, poor road conditions cost U.S. motorists $67 billion in repairs. Let’s fix the roads rather than keep fixing the vehicles.
Government austerity becomes an expense for the private sector. We are not fixing our roads. There is a report that shows that if we don't fix our roads, by 2040 most interstate highways will have extremely high levels of traffic.

Also, look at The American Society of Civil Engineers. Look at America's score card on everything. Our productive capacity is suffering and will suffer much more later. That's fine, you can choose austerity while China uses fiscal policy to grow and innovate.

Now, I know that in in the future America will experience problems with obtaining clean water to drink,

We will make sure our children don't have working sewers and drinking water, but God forbid we leave a big debt to them, no, not that….

PaulMay 3rd, 2012 at 3:49 pm

Where can I find those critiques? I've been looking for specific critiques of R&R for a while now.

RobertLRiceMay 5th, 2012 at 7:06 pm

Randy, you wrote:

"(The Fed then turns most of its profits back to the Treasury—so it is as if the Treasury did not pay that interest in the first place.)"

As a loosely related aside, I actually called the San Francisco Fed a couple weeks back who transferred me over to the New York Fed to find out what the Fed does with the principal received on treasuries it holds at the time of maturity. As you noted, nearly all of the Fed's interest income paid from the Treasury is eventually returned to the Treasury. I thought it would be interesting to find out what the Fed does with the principal at maturity as well. The gentleman that I spoke with in their educational department (I don't recall exactly what they call it, but I still have the number) indicated that it depends–that is, the Fed may do any number of things with the money. He sounded like he might be in over his head with my question, but he did seem confident that the Fed does also return principal to the Treasury, at least in some instances. Whether this is accurate or not, the line of inquiry seems of value.

RobertLRiceMay 5th, 2012 at 7:12 pm

I'm not sure how much in treasury bonds held by the Fed are maturing yearly–perhaps it is a negligible quantity–but if it is any substantial quantity, and if a significant portion of this maturing quantity is returned to the Treasury similarly to the Fed's interest income, the Treasury can also utilize these funds to fund it's commitments/deficit.

Do you happen to know how much in treasuries held by the Fed are maturing over some period of time, what portion of that is returned to the Treasury if any, or where to find such data?

For the sake of like mindedness, I don't mean to suggest the Treasury is a currency user. We share the same views on the Treasury as an issuer. But because it behaves much like a currency user with its current unwillingness to finance deficits with money creation, whatever additional money it receives back beyond interest income (such as the principal paid at maturity to the Fed), it can utilize to fund it's commitments. This realization led to my curiosity as to whether the Fed was returning principal in addition to interest to the Treasury.

pebirdMay 11th, 2012 at 2:08 am

Well then, support transfer payment directly to the public, if you are concerned about money going to banksters and political flunkies.

How about expanding Social Security for a start?