Raghuram Rajan | How much debt is too much?
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 per cent 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 3.0 per cent of GDP to about 2.0 per cent, 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 sizeable 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 scepticism. 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 baulk at holding vast quantities of claims on the central bank (reserves), they should not baulk 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.
© Project Syndicate, 2020