Rajan introduces his arguments with:
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.
This passage could be viewed as a plausible summary, except for the last phrase, which I will return to.
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 ... [deletion of lengthy passage describing operations] ... 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.
The above passage makes the unremarkable argument that in a positive interest rate environment, central banks need to pay a support rate on settlement balances, and so if we make simplifying assumptions, interest costs end up as a wash. There are a number of problems with this passage.
- No reliable MMT source would describe such operations as a "free lunch." Having a floating currency opens policy space, which sort-of is a free lunch, but that's not a fair characterisation. It just means that you are not following stupid policies, and most people would not characterise an absence of stupidity as a "free lunch" in the sense of being unrealistic.
- He is of course ignoring the policy proposal of locking rates at zero, which is part of the expanded policy space. Modern Monetary Theory offers theory on how to analyse fiscal policy. If a country refuses to use the policy space that MMT says it can use (and the mainstream argues does not exist), then it should surprise nobody that policy options are unchanged.
- He also ignores one of the key insights of MMT description of operations: involuntary default (a default forced on the central government by bond or currency vigilantes) is taken off the table. This is not a minor issue, it is a core property of central government finance, explaining why a floating currency sovereign is not in the same boat as a household or firm.
- The main issue is that he is describing a policy that has been implemented: Quantitative Easing. MMT proponents have pointed out that central bank purchases of central government debt is just a re-shuffling of liabilities of the consolidated entity, and presumably effects very little, Conversely, (some) mainstream economists pushed the theory that QE had some stimulative effect on the economy -- a free lunch, one might say.
He then makes the following condescending remark.
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.
As noted, MMTers say that central bank purchases of central government bonds does not do much if interest rate policy is not changed. The question is: why do mainstream central bankers follow the policy? Meanwhile, arguing that it is better that the Treasury term out debt ignores the elephant in the room: even if the Treasury lengthens maturity of bond issuance, the New Keynesians at the central bank just buy them back based on unproven theories about stimulus. Since Rajan admits the central bank is a "subsidiary" of the Treasury, the decision to engage in QE based on hand-waving theories undermines whatever issuance strategy bureaucrats at the Treasury come up with.
We then get back to the topic suggested by the title: how much can government's borrow?
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.
My rule of thumb is to expect dismal analysis of developed rates analysis from anyone who invokes emerging markets, and I am not seeing an exception to the rule here. To turn the tables on MMT critics: where is the model? All of the above is hand-waving that has absolutely no predictive value for dealing with developed floating currency sovereigns -- where the number of "sudden stops" is nil.
Instead of attempting to condescend to MMTers, he probably should look at the literature on operations, and try to explain how a hypothetical default process would work.
The other option is higher growth rates, which Rajan assumes is the result of inflation (real growth rates are apparently fixed as a result of a law of nature).
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.
I now return to the inflation comment and high employment. Although one could easily complain about the vagueness of many MMT treatments of inflation, it is very clear what view of inflation MMTers reject: NAIRU approaches. (Chapter 4 of Full Employment Abandoned by Mitchell and Muysken has the title "The troublesome NAIRU: the hoax that undermined full employment.") The premise of the Job Guarantee is that it provides full employment and stabilises inflation. The only group of people who believe (or at least, believed) that low unemployment rates are linked by an iron law to inflation are mainstream economists, not MMTers.
Once again, we see an attempt to critique MMT that is undermined by the reality that the author is apparently too busy and important to read anything written by a MMTer, and critique that text. It is an impressive own goal to critique MMTers for allegedly believing things that are actually part of mainstream economics.
(c) Brian Romanchuk 2020