Sunday, 15 January 2017

Krugman says excess deficits will raise interest rates. “Progressives” object.

Krugman recently wrote a short article making the entirely reasonable point that large deficits are OK in a recession, but that come the recovery, one needs to be more careful with deficits.

That produced a storm of protest from people, who can loosely be called “progressive”, e.g. here, here, here, and here.

One of the objections to Krugman’s article was that in saying a large deficit would crowd out private investment, Krugman invoked the loanable funds idea.

Well, not so fast. The fact of saying that an excessively large deficit will crowd out private investment does not prove one is invoking the loanable funds idea. One could equally well be invoking Scott Sumner’s “monetary offset” idea: the idea that when a central bank spots what it thinks is an excessively large deficit, it will raise interest rates so as to counter that excess. And that rise in interest rates will of course crowd out some private investment.

Incidentally, Sumner is far from the first person to tumble to the point that an independent central bank on spotting what it thinks is an excessive deficit will raise interest rates to compensate. But Sumner is a keen advocate of the idea, so I thought I’d give him a mention.

So my conclusion, at least as regards the charge that Krugman invoked the loanable funds idea is: case not proven.

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