Raghuram Rajan explains why today's abnormal financial conditions do not justify unlimited borrowing and spending

Raghuram Rajan explains why today's abnormal financial conditions do not justify unlimited borrowing and spending

As the COVID-19 pandemic rages, governments in advanced economies have opened their coffers to support households and small businesses, spending on the order of 15-20% of GDP in many cases. Cumulative debt levels now exceed GDP in many developed countries; and, on average, debt as a share of GDP is approaching post-World War II highs.

Nonetheless, according to Olivier Blanchard and other economists, advanced economies can afford to take on much more debt, given the low level of interest rates. Calculations using International Monetary Fund data show that in the two decades before the pandemic, sovereign interest payments in these countries fell from over 3% of GDP to about 2%, even though debt-to-GDP ratios increased by more than 20 percentage points. Moreover, with much of the newly issued sovereign debt now paying negative interest rates, additional borrowing stands to reduce interest expenses even more.

In this strange world of ultra-low interest rates, what limits are there on government borrowing? According to advocates of Modern Monetary Theory (MMT), there are none, at least not for countries that issue debt in their own currency and have spare productive capacity. After all, the central bank can simply print money to pay off maturing debt, and this should not result in inflation as long as there is sizable unemployment. No wonder MMT has become the go-to idea for politicians advocating government spending to alleviate every problem.

Of course, any “theory” that promises a free lunch should be approached with skepticism. To see why, suppose we were in a normal environment with positive interest rates. The central bank could decide to print money to buy government bonds, and the government could then spend that money by transferring it to citizens. As a practical matter, however, there is only so much cash that someone will hold in her purse. If she already had enough on hand before the central bank started printing money, she will deposit the government transfer in her bank account, and her bank will deposit all the cash it has accumulated in its reserve account with the central bank.

Ultimately, the central bank will have bought government bonds by issuing reserves to commercial banks, which will then want to be paid interest on those excess reserves. The government could just as soon have issued Treasury bills directly to commercial banks. The interest cost would be more or less the same. The only difference is that there would be no appearance of a free lunch.

In today’s abnormal environment, the central bank can finance the purchase of government bonds by issuing zero-interest-paying reserves to commercial banks, which in turn are willing to hold large quantities of such highly liquid reserves. That sounds like MMT nirvana. Yet, again, the government could just as soon issue Treasury bills paying zero interest to commercial banks. If commercial banks do not balk at holding vast quantities of claims on the central bank (reserves), they should not balk at holding vast quantities of claims directly on the government, of which the central bank is a subsidiary.

In other words, the monetary financing advocated by MMT is just smoke and mirrors. Yes, the government can avoid short-term disruptions in money markets by financing via the central bank. Over the medium term, however, this approach does not allow it to borrow any more than it could have by financing directly. In fact, if long-term interest rates are also low or negative, it is far better for the government to lock in those rates by issuing long-term debt directly in the markets, bypassing the central bank altogether.

That brings us back to the initial question of how much debt a government can issue. It is not enough for a government to ensure that it can afford to make its interest payments; it also must show that it and its successors can repay the principal. Some readers will protest that a government does not need to repay debt, because it can issue new debt to repay maturing debt. But investors will buy that new debt only if they are confident that the government can repay all its debt from its prospective revenues. Many an emerging market has faced a debt “sudden stop” well before it reached full employment, triggered by evaporating market confidence in its ability to roll over debt.

Put differently, the investor in new debt needs to be confident that the government’s current and future tax revenues (net of critical spending) will be sufficient to repay its accumulated debt. There is a limit, but if the funds raised through new debt are invested in high-return infrastructure projects, it probably will never be tested – additional future revenues will pay for the additional debt. If, however, the money is spent on much-needed support for poor and vulnerable households, the limit eventually will come into view.

In this case, if the government is already raising as much revenue as is politically feasible from tax revenues, it will have to reduce the stock of existing debt to create room for new issuances. The simplest way to do this is to default on old obligations; but most advanced-economy governments would consider this unthinkable.

The other option is to allow for higher inflation, which would erode the stock of debt denominated in current dollars vis-à-vis future tax revenues. Inflation, in this case, would emerge not because the economy is at full employment (as MMTers would have it), but rather because the government had reached the limits of the debt it can repay. New debt holders would demand higher interest rates – including perhaps a premium for inflation risk – and the curtain would drop on the era of ultra-low interest rates and unlimited borrowing.

To be sure, advanced economies will not become Zimbabwe any time soon – if ever. But some of them are permeated by divisive politics that typically encourages higher spending but not higher revenues – as many an emerging market can attest. If so, it would not be surprising to see somewhat higher inflation in a few years.

This is not an argument for immediate austerity. To the extent that governments can target spending to protect the economic capacity of households and firms during the pandemic, they will recover those investments through future revenues. Public spending, however, must be sensible, not based on magical monetary thinking.


Raghuram G. Rajan, former governor of the Reserve Bank of India, is Professor of Finance at the University of Chicago Booth School of Business and the author, most recently, of The Third Pillar: How Markets and the State Leave the Community Behind. This content is © Project Syndicate, 2020, and is here with permission.

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

51 Comments

Even in an MMT universe, the money is supposed to go to unutilised assets if it's to be effective, if they are being utlilsed it's purely inflationary. In the current world, its going to assets that are being lived in, which is inflationary, but we don't count that.

It's bank created money that drives house price inflation. The Bank of England explains here how banks create money. https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creatio...
This is credit money though as distinct from money that the government creates which is currency.

too long,

Modern Monetary theory always has a ring of creative accounting around it. It always works well until it doesnt. Effectively governments can borrow (or effectively sell government bonds ) as much debt as they like as long as the interest on the debt is less than tax revenues, but something has to give to pay the interest on the debt either lower government spending or higher taxes (neither are usually liked by the taxpayer.) More so problems can occur if an unexpected event ie an economic downturn or a war , or a major crisis (ie natural disaster) all of which can result in either lower tax revenue or higher government spending - the house of cards starts to collapse.
Its no different to the average business - if a business borrows to expand - as long as their profit covers their interest repayments all is good, but a sudden downturn in sales or an increase in costs - if the interest cant be repaid then the business goes broke and assets need to be sold.
Governments need to look further into the future than the next 12-36 months, if something goes wrong - how will they cover their debt repayments (without upsetting the electorate) and what assets will they sell to make those repayments.

You are confusing currency users with currency issuers. It's the money that the banks create that eventually leads to economic crisis as with the GFC. Bank created money carries a debt liability along with an obligation to pay interest on it. Only money that the government creates is free of debt for us to use and to save until the government requires us to return it in taxation where upon it is cancelled.

"This is not an argument for immediate (government) austerity".
However, this cheap money has had a flow on effect at a personal level and I would be prudent and paying down debt (i.e. additional payments on the mortgage to that required).
While I do not see mortgage interest rates returning to pre-GFC levels at least for considerable time - and although banks apply a 6% stress test - an increase of even 1% to 2% would hurt the lifestyle of many.
From my observations it is common for FHB to really appreciate the intrinsic value of new homeownership and have a tendency to want to put in a new deck, swimming/spa pool etc. Temptation should be resisted and albeit rather boring I would be paying the mortgage down for increased security. This is especially so as many additions or "improvements" tend to not give a full return on expenditure with a high risk of over-capitalising.

One thing is certain....default is inevitable, only the timing and process are in question

A private sector debt default perhaps as with the GFC, a currency issuing government cannot default unless it chooses to do so. What does QE do but repay the governments debt?

That will depend on whether the private debt continues to be supported by government issued debt...either way the debt will be defaulted as the wherewithal to continue to expand or service it does not exist. We are using greater and greater debt to service the already too great debt load, where that debt resides is of no import...public or private.

I disagree, private debt and government debt are entirely different things. Government debt issued in its own currency can always be repaid.

except that not all government debt is issued in its own currency (unless you happen to be the worlds reserve currency) as Argentina et al discovered....what can you buy with NZD?...pharmaceuticals? machinery? tech? aircraft?shipping?...good luck with that.

As stated the debt (credit) will be defaulted and it dosnt matter who issued it....and is why the calls for jubilee to maintain some semblance of control

The powers that be are shitting themselves

Our government only issues debt denominated in NZ Dollars. Our imports are paid for with NZ Dollars even if we have to swap them for US Dollars for trade. The government doesn't borrow to buy imports anyway all of its spending is done in NZ currency. Have you ever heard of the police or nurses being payed in US Dollars.

"The Reserve Bank has re-established a temporary USD swap line with the US Federal Reserve. This will support the provision of USD liquidity to the New Zealand market, in an amount up to USD 30 billion. This is a facility that is being offered to many other central banks globally."

https://www.interest.co.nz/banking/104166/rbnz-issues-details-its-plan-e...

When the government requires offshore sourced goods and services it does not pay for them in NZD....just as the private importers do not. That requires a source of FX.

NZ Inc has a decades long consistent negative trade balance

This seems to be about maintaining stability in the banking system and has nothing to do with the governments spending. How do foreign sources end up holding NZ Dollars if we are not using them to pay for imports? The NZ Dollar is one of the most traded currencies. When the government sells bonds to foreign interests it is these NZ Dollars that it is borrowing back not foreign currency.
We all know that NZ runs current account deficits, that is no secret.

That 'seems' to be about securing access to FX for trade purposes.

If a Japanese pension fund decides to buy NZ Gov Bonds what initial currency funds the purchase?...anyones desire to hold NZ gov debt is not guaranteed.

Knowing and understanding are two different animals

Japan

Really good debate, folks. Debt owed in foreign currency can erode a country’s monetary sovereignty. As noted, Argentina is a case and point along with Weimar Germany. I largely agree with treadlightly, though: we do not buy overseas goods in their currency. We buy them in ours multiplied by the exchange rate, and an entry is made in their local account.

The overwhelming majority of international trade is conducted in USD and unsurprisingly the RBNZ dosnt have USD issuing rights....as you note the exchange rate is the method of account used by the proxy banks....do you think the RBNZ (or Treasury) have the FX reserves to support the NZD value should they need to do so?

https://www.rbnz.govt.nz/statistics/e1

Many of our exports are also priced in US Dollars, dairy for example. The NZ Dollar is readily exchangeable for US Dollars when needed and our currency is one of the most traded. You should describe how you think that it is that we pay for our imports?
Some countries run surpluses and others deficits and that is reflected in the value of their currencies. NZ has a floating exchange rate and many people say that it is actually over valued.

12
up

https://www.forbes.com/sites/investor/2020/06/26/inflation-baked-in-as-u...

https://www.ceicdata.com/en/indicator/new-zealand/household-debt--of-nom...

We are all buggered. If you can't see the issue with these numbers you are not looking.

2x massive global events in the last 15 years that should challange us to ask "what is sustainable" and our only answer is to print and borrow exponential amounts.

2019 share market wobble was a taste of what's coming. Asset prices are sustainable only via ever increasing (and cheaper) money supply.

Central banks are making shit up as they go.

And most people in nz are climbing over each other to take on more debt.

Keep an eye on Brexit.

Central banks are making shit up as they go.

That's because they're blindsided. As are most economics-trained folk. I texted RNZ's Mulligan a couple of years ago, about the prognostications of a well-known ' financial advisor' he hosts. I asked if the person was taking the Limits to Growth into account? The reply?

"Not in my skill-set". I kid you not. And I'll bet that person is still advising, and still short a skill-set. Same with the banking crowd; this has never happened to them and they're no more skilled in understanding it, than anyone else.

The comment appears to apply to the writer, too.

MMT is a description of how a sovereign currency issuing governments finances operate all of the time, it is not something that has to be introduced or adopted. They must create their currency first through spending before it can even exist to be taxed and borrowed, spending happens first taxing and borrowing occur afterwards.
When a currency issuing government deficit spends it creates a surplus in the private sector that adds to private savings which is all that its debt represents. (Sectoral Balances). Debt does not even need to be issued, the central bank could just pay a support rate on bank reserves at a rate of its own choosing, it could even give individuals a savings account at the central bank to hold our savings.
The Levy Economics Institute tells us here that taxation and borrowing do not finance government spending.
http://www.levyinstitute.org/publications/can-taxes-and-bonds-finance-go...

MMT is a fantasy free lunch.
If a government creates money it will use it to buy goods and services. (lets call them widgets). So diverts widgets from use by individuals.
Being a government without a leash it spends more, and makes poor spending decisions.
It could even grab controll of all the widgets that can be produced, leaving nothing for individuals.

MMT is a fantasy free lunch.
If a government creates money it will use it to buy goods and services. (lets call them widgets). So diverts widgets from use by individuals.
Being a government without a leash it spends more, and makes poor spending decisions.
It could even grab controll of all the widgets that can be produced, leaving nothing for individuals.

You are trying to deny reality. MMT is how it works now. Where do you suppose that our NZ Dollar Currency comes from? Only the government has the authority to create it, it has its own central bank.

MMT is indeed a description of how the system works...however, and it is a massive 'but', the system functions (or has done to date) because it wasnt widely recognised....consider what will occur when the populous realise their ability to vote themselves resources, especially in an economy where most of the needed resources are not available in the issued currency...Even Keen and Hudson acknowledge the limitation.

If you desire a workable MMT you need autarky AND a fiscally competent electorate....and not an overpopulated, resource and energy depleted multi currency trading world.

Oh yes, the peasants might rise up against their masters if they understood the truth in that we don't need to endure poverty. NZ is not short of food to feed hungry kids.

Not short of (some) food....but chronically short of just about everything else we expect.

And yes the distribution could and should be better but that is exactly what MMT advocates call for....the finacialisation of government debt is a means to an end and dosnt ignore the restraint required....MMT dosnt advocate unlimited debt but simply a more community focused use of it.

Treadlightly - You seem to think NZ operate in some parallel universe separate from the world
It TRADES WITH THE WORLD
In exchange for ........ OIL & products MADE FROM OIL
So our ability to make this food (and underwrite those apparently limitless NZ$ you keep on about) depends on our relative trade with .... the PETRODOLLAR

The world is an ENERGY system
NOT a monetary one
You dont appear to understand this
As most proponents of MMT (Magic Money Tree) dont

Yes NZ produces commodities that other countries desire and we buy commodities from them that we desire. So what? Isn't that what international trade is all about. NZ also exports oil and the world is switching away from oil due to climate change.
Try paying your bills with a four litre oil pack rather than money and see how you get on.

So you are saying NZ can never default on its currency... no matter how much we print... and we can also use it to buy other countries commodities?
So why the hell are we working?

Most imports are purchased by the private sector and have nothing to do with the government and the private sector mostly uses bank credit. Some study of sectoral balances would be helpful. https://gimms.org.uk/fact-sheets/sectoral-balances/

"Most imports are purchased by the private sector "

Really?
Doesnt the Govt have to run a deficit to allow this to continue? Using NZ currency?
Surely we dont have all the stuff to undertake all that roading / health / education / defence / govt employees / infrastructure etc lying around the house?

From your link
"Indeed, a currency issuing sovereign government, like that of the UK, which does not borrow in foreign currencies, can never be forced to default. Its spending and taxing decisions – in terms of output and employment, social inclusion, ecological repair and prevention of excessive household debt – are crucial to the health of the economy and well-being of citizens. It is the role of government to manage its financial flows by observing and matching the demand for money with the productive capacity of the nation."

Two points
- ... which does not borrow in foreign currencies .... match the demand for money with the productive capacity of the nation"

So looks like the MMTree has some kickers

Yes MMT only describes governments with sovereign currencies, it does not apply universally to all countries. A sovereign currency government is one that does not borrow in foreign currencies and has a floating exchange rate and as economist Steven hail tells us here that NZ is such a country. https://independentaustralia.net/politics/politics-display/modern-moneta...
MMT does not say that a government can spend without limit but that the productive capacity of the economy is the limit.
Yes the government should finance our current account deficits otherwise the private sector will incur ever increasing levels of debt but the government does not finance all of our trade, the banks create most of the money that we use issued to us as debt and NZ households carry some of the highest levels of debt in the world.

TL - try underwriting that money, without oil. I notice you slip into 'some other kind of energy' because of CC.

Try reading up about that:
https://www.withouthotair.com/ he was a Regius Professor, so takable seriously.....

And you underwrite zero money with zero energy; all else is on a sliding scale. Were you economics-educated?

Yes. In a way they could. Eg Millennials take over running the country (20 years time) and vote to bring in a death tax of 50% on anyone born before 1980. Any wealth transferred as gifts or inheritance prior attract another 50% etc. You spent it, you pay it back...

Change and and re-alignment does not need to be violent or involve a complete social breakdown.

But all violent breakdowns (ie French, English, American revelations, ww1/2 etc.. where avoidable at a point in time.

We are at a pivotal point in human history.

It's here now. But not beneficial. And future risk is huge.

As Michael Hudson says...its MMT for the wealthy (his perspective is the USA) ..its true to a lesser extent here but still true.

No it is not KH. I and Treadlightly have explained this before - money creation comes at a cost, potentially a huge one. But the cost is not defined as debt, but it is an obligation. A part of that is that it still requires taxation and the true gem in MMT is that it changes the reasons for taxation from raising money to spend, to managing the economy, managing peoples (and corporate) behaviours, driving efficient use of resources and so on.

money creation comes at a cost, potentially a huge one

Yes it does. And one of those costs is the price of labor. Japan is an interesting case in point. Income growth has been in the toilet for 30 years. That being said, deflation has been kind to low and mid-income earners in Japan. But let's remember that Japan has a huge capacity to produce basic needs (shelter, food, transport) at a relatively low cost.

Genuine question: why then do the government's accounts (https://www.treasury.govt.nz/publications/financial-statements-government) show taxes as income and various government expenses as expenditure? That is, why do they publish a revenue and expenditure report?

Or this from Treasury: "The Government's main sources of revenue come from tax, levies, fees, investment income and from the sales of goods and services.
"Total core Crown revenue for the 2015/16 year was $76.1 billion. Tax revenue is the major source of core Crown revenue; this totalled $70.4 billion in the 2015/16 financial year." (https://www.treasury.govt.nz/information-and-services/financial-manageme...).

If taxes do not fund government expenditure, then why does the government not publish 'Creation and expenditure accounts' rather than 'Revenue & expenditure accounts'?

It's all a smokescreen to disguise the truth from us as is the governments borrowing, to give the impression that the government is financially constrained and dependent upon the private sector for its funding. Neo-liberalism in a word, they want the banks to be our only source of money.
Economist Prof Bill Mitchell gives an explanation here.
Part one. http://bilbo.economicoutlook.net/blog/?p=45106
Part two. http://bilbo.economicoutlook.net/blog/?p=45108

TL - you consistently miss the point.

What is the purpose of that issued proxy, and can it be underwritten?
https://surplusenergyeconomics.wordpress.com/

Rather a long read, it seems to be critical of and mostly talking about bank created credit and not government currency which is only created for the purpose of provisioning itself for the supply of public services to us.

Ah, no. You are reading with coloured glasses on. Try dispassionate learning - and bother to take the time (your 'long' comment is one I often hear, and usually means 'I don't want my assumptions challenged'.

You are a mile off in appraising that piece.

I have had another read through but it is far too long. There is much good sense there, it tells us that the world is in a mess and the future is bleak and that fiat currencies have no inherent value, all things that we know. I think that it makes some errors in its understanding of how government finances work and the difference between a sovereign currency country and a non sovereign country as when it talks about the EU for instance. It says that government debt is a liability to the private sector when in fact it is an asset as a government deficit equals a private sector surplus. it doesn't understand that government spending occurs before taxing and borrowing and that neither finance the government, all things that MMT explains.
MMT says that a government should balance its budget according to what is happening in the private sector to maintain demand and jobs. What our government is doing though is leaving it up to the Reserve Bank and monetary policy and using the banks to try to create spending and thus its also increasing house prices and private debt.

I have the theory that MMT only "works" when the world is in an inherently deflationary environment, like has existed since the end of the Cold War. A 30+ year span of expansion of free trade agreements, the WTO and most importantly capitalism-with-Chinese-characteristics - means that the cost of everything decreased as production soared.

However nowadays there are signs that China is starting to have manpower shortages, Trump/Xi trade disputes crippled the WTO and there is still all the stuff the PDK moans about (but that is probably still at least 70-100 years away). So we could be having some inflationary external shocks on our little MMT economy.

"But that is probably still at least 70-100 years away" References please.

https://www.theguardian.com/commentisfree/2014/sep/02/limits-to-growth-w...

Theres something to be said for optimism.

I don’t really get what you’re saying. The core principle of MMT concerns the fiscal capacity of a government with monetary sovereignty. That is, a government that issues its own currency, has a floating exchange rate, and does not have significant debt denominated in a foreign currency. A monetary sovereign can logically buy anything for sale in the currency it controls. So, your point about MMT not ‘working’ in a non-deflationary international economic context is really about the reduced availability of real resources and the increased trade pressures that apply to all countries. MMT is completely alive to such concerns because the binding constraint on expenditure from a monetary sovereign is the availability of real resources for purchase in the relevant currency.