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NRO is 90 Degrees Off

Practicing What I Preach: How ... Creative Non-Destruction...

When Tom Nugent of National Review Online tells us:

Will private borrowers be crowded out [by increased government deficits]? Impossible. The causation is “loans create deposits,” as taught on day one of every traditional money and banking class. The act of borrowing itself creates exactly that same amount of new liabilities (deposits). The process is “self funding” and circular, as a matter of accounting. The concept of a “pool of savings” that somehow gets “used up” by borrowers is a throwback to the time of fixed exchange rates and gold standards, and has no application in today’s floating-exchange-rate world.

Arnold correctly scoffs:

When I was in grad school, I somehow missed the lecture where they said that government deficits are self-funding in a flexible exchange-rate regime.

But my co-blogger is actually being too charitable. Most of the empirical evidence says that savings is highly INelastic, and the NRO story essentially assumes that savings is perfectly elastic. If you rotated NRO's horizontal supply curve 90 degrees to the left to get a vertical supply curve, you'd be close to the truth.

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nobody writes:

I'm confused. Isn't the author of the NRO piece essentially arguing that savings are highly inelastic, that they're largely unaffected by government spending? If he were arguing that saving is highly elastic, then he'd be in agreement with Prof. Caplan.

I'm near certain that the confusion is mine, but if someone could explain to me what it is that I'm not understanding, I'd really appreciate it.


ErikR writes:

Nugent is arguing that there is plenty of savings for the government and private investors to borrow -- in fact, there will be a lot of new savings available if more private investors want to borrow more (according to Nugent). This is close to the definition of an elastic supply curve.

Bill Woolsey writes:

The argument is that the government finances its deficits by money creation. The quote here suggests that this is automatic--government deficits are automatically financed by money creation by banks.

The reality is that the government can finance deficits by money creation, but that there is nothing automatic about it. If the Fed has any kind of nominal target (like the price level,) the amount of lending by the banking system is limited. More lending to the government by the banking system, less lending to someone else.

The story is not really that complicated. The government finances deficits by selling bonds. To the degree that the Federal Reserve chooses to buy them, it finances the deficit by creating money.

The Fed does target interest rates these days. So, unless the Fed chooses to change its target for the interest rate, it would tend to "automatically" respond to goverment budget deficits and bond sales by purchasing those bonds with newly created money.

But the Fed does change its interest rate target to maintain some kind of control over nominal values in the economy--like inflation.

If the Fed chooses to allow price inflation, it must allow for higher nominal interest rates--unless it wants to head for some kind of hyperinflationary crisis.

And there are limits to the real revenue that can be generated through money creation.

Either there was more to the story, or else the writer was one of those introductory macro students who only paid attention to the occasional lecture. Or, maybe, his instructor didn't cover everything relevant.

knzn writes:

Bill Woolsey, I think you’ve gotten to the main issues here. I have rationalized Nugent’s argument by saying that he is implicitly assuming that the Phillips curve is highly convex, and that we are on the flat side of the curve. In that case monetization of the debt is not inflationary in the time frame with which he is concerned (financing hurricane reconstruction). Furthermore one might support the view that the Fed’s behavior is automatic by noting that they have been raising rates at exactly the same pace for 15 months now without speeding up or slowing down in response to economic data. I would hope that their choice of a stopping point, at least, would not be automatic, but Nugent may not think so.

The thing that I just can’t get past, though, is this nonsense about the exchange rate. All of the arguments that Nugent applies to our flexible regime would apply equally under Bretton Woods, except that there might be a small gold outflow. A little bit of gold might get “used up”, but there is little evidence that the Fed cared very much about gold outflows under Bretton Woods, except maybe at the very end, and even then the solution ultimately chosen was devaluation rather than monetary restriction. The presence of crowding out (under Nugent’s purely financial definition) depends not on the exchange rate regime but on the structure of Fed policy. There certainly was crowding out in the early 80s, when the Fed was trying to control monetary aggregates, but exchange rates then were, if anything, more flexible than they are today.

wkwillis writes:

I thought that when governments created money the inflation that resulted destroyed money equal to that which had been created, that inflationary money creation just moved money around.

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