Critique of Rajan on Debt

{} For necessary background, please see previous posts on “ABC’s of Modern Monetary Theory” and “Differentiating Social, Market, and Government Debt”. In this post, I will provide a critique of Raguram Rajan’s article “How Much Debt is Too Much?”. (Alternative link to Rajan’s article)

The article opens with a description of the governments “opening their coffers, to support small households and firms” in the COVID era. Required spending has been on the order of 15-20% of the GDP, and the article examines the extent to which government can finance this extra expense by borrowing at low interest rates from the private sector.

The language reminded me Robin Hood and his team swooping down on government convoys laden with coffers of gold. In face of this generosity by the government, it seems churlish to examine their coffers, to see if they contain gold, or just paper promises. Rajan’s theories are based on archaic understandings of money as gold. Rajan’s article assumes, without discussion, the following premises:

  1. Government are like households. Spending must by financed by taxes or borrowing.
  2. Borrowing from private sector increases the amount of money available for government spending.
  3. Government ability to pay off the debt created by private borrowing depends on the interest rate, and on its capabilities to raise revenues (by taxation or borrowing) in the future.

All three of these propositions are false, as would be evident to readers of my earlier post on ABC’s of MMT. It is worth clarifying that my views are based on insights acquired from MMT, but need not coincide with the official doctrines of MMT.

To begin with, we must ask why the government should “borrow” money from the private sector financial organizations, instead of just creating it ex-nihilo? Since this possibility is not even mentioned by Rajan, we will provide answers from other sources of orthodoxy.

  1. Money -creation by the government is inflationary, while borrowing is not.
  2. Borrowing leads to fiscal discipline, while money creation could lead to harmful spending sprees by the government.

Both of these claims contain elements of truth, and cannot be dismissed summarily. Separating the facts from falsehoods requires a deeper understanding of modern money. Having raised these flags, we postpone discussion of answers, and go on with our reading of Rajan’s article. After sketching the background, and pointing out that real interest rates are negative, Rajan poses the central question discussed in his article: “In this strange world of ultra-low (negative) interest rates, what are the limits on government borrowing?”  Rajan sets up strawman opponents – MMT’ers – who claims that there are no limits to government borrowing. He goes on to explain why MMT’ers are wrong. Economic mechanisms create obstacles in the path of apparently limitless borrowing made possible by the negative real interest rates.

Borrowing vs Mopping-Up

Rajan’s brief description of MMT is false and misleading on several fronts. Firstly, MMT does not say anything about limits on government borrowing. MMT says that the government does not need to borrow, to finance its expenditures. Indeed, the word “borrowing” is misleading. When the government sells Treasury Bonds, this is not a way of “borrowing” money from the private sector. It is a way of reducing the money stock in hands of the private sector. This is called “mopping-up” of excess money. This operation my be useful for reducing aggregate demand, changing the distribution of wealth, managing the interest rate, or other economic purposes. It is definitely NOT a way for the government to raise revenues in order to finance expenditures. In the remaining portion of this critique, we will look at three different issues. One is the correct position of MMT, mis-represented by Rajan. The second is an examination of the economic mechanisms which Rajan claims impose limits to Government borrowing. The third is the motivations of Rajan for writing this article.

What Does MMT Say?

Contrary to what is claimed by Rajan, MMT does not say that “there are no limits to government borrowing for countries which issue debt in their own currency and have spare productive capacity.” Instead, MMT says that there are no limits to money creation by the government PERIOD There is an entry in Central Bank computers which indicates the amount of money in the government’s account. The Central Bank can revise this entry upward, creating money and putting it into the government’s account, without any restrictions. This power to create money does not have anything to do with spare productive capacity, or issuance of debt in own currency. It is an entirely separate matter as to whether or not the government should EXERCISE this power. Should the government create more money whenever there is spare productive capacity? Not according to MMT. When money is created by the government, it often flows to sectors operating at full capacity, causing inflation long before the money reaches the slack sectors.

Here is it useful to set out clearly the difference between the supply-siders (like Rajan) and the Keyesians. According to the supply-siders, the total output is determined by the supply factors and not influenced by demand. Given a fixed amount of output, if the government injects money in an attempt to raise demand, this will lead to a rise in prices. In contrast, Keynesians say that if there is spare productive capacity, and the extra money is targeted so that it leads to increased production, then more money together with more goods will not lead to inflation.  However, it is crucial that the additional money reaches the slack sectors and creates additional output. To the extent that the additional money creates additional production of output, it will not cause inflation. One example is government support for rent payments to those who have lost their jobs. If the government does not provide such support, the apartments will become vacant and the corresponding production of housing services will be lost to the economy. Rental support pumps money into the economy and also enables the production of the corresponding service. Similarly, any money creation which leads to corresponding production of goods and services will not be inflationary.

In contrast, if the government does quantitative easing, making more money available to banks at low interest rates, there is no reason to believe that the banks will use this money to finance the sectors with spare productive capacity. They are much more likely to speculate in stocks and real estate, leading to inflated prices and profits in financial sectors, without any increase in production in the economy. This is why massive quantitative easing programs by the governments failed to stem the Great Recession which hit following the Global Financial Crisis. Although vast amounts of money were available to the financial sector, this money did not reach the sectors with high unemployment.

The Mechanisms of Rajan  

The premises of Rajan’s argument can be articulated as follows. The COVID crisis has created pressure on government to support the masses who are subjected to huge financial losses. Can the government support this additional expenditure by borrowing from the private sector? This question does not make any sense as stated. The government can create money and provide it to all who are suffering financial losses, without any need for borrowing (see ABC’s of MMT for a more detailed discussion). The question is: what will the effects of this money creation be? This depends heavily on how the created money is used. A broad-spectrum mailing of checks to every taxpayer does not target the critical sectors where support is needed. A well-designed support program could have beneficial effects without harmful consequences.

Rajan’s article can be seen as an effort to answer the following question: What if the government neutralizes the money injections into the economy by “borrowing” the same amount of money? That is, when government spends money, it also mops-up an equivalent amount of money by selling treasury bills in the same amount. For those who think that the government is just like a household, the equivalence of spending and mopping-up would be considered as the raising of revenue to finance expenditures. The spending and the mopping-up are two different operations, which will affect different sectors of the economy, and have complex economic consequences. We will not pursue this further, as it does not relate to the Rajan article.

My attempts to untangle the convoluted logic of Rajan failed. What he seems to be saying is that if the government creates money to household, they will just put it in the bank, since they already have enough money. “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.” Rajan’s key assumption is the consumers already have all the cash they want to hold. This perspective can arise from the idea that households are in equilibrium; that is, they are already holding exactly the amount of money they desire to hold. In this fantasy world of Rajan, Robin Hood would not find any households who want what he has stolen from the government coffers. In reality, distressed households will use the money to buy essential goods and services, and pay off debt. Rajan completely ignores the role of debt in the economy; see “Causes of the Global Financial Crisis” and “Debt, Levered Losses, & Unemployment” for more details about how economists ignore the role of debt, despite its overwhelming importance in explaining financial crises.

The WHY of Rajan

Some of the statements made by Rajan are truly bizarre fantasies, popular in economic theory textbooks but with no counterpart in reality. One of these is the idea that the government debt must eventually be repaid in full – principal and interest. To see that this has never been the case, see the Origins of Central Banking. Does anybody really expect Japan to repay the money it has printed over the years, now amounting to 200% of the annual GDP? What would it mean for the Japan to repay its debt? Would it issue new Yen notes to all holders of old Yen notes? There are many other issues one could raise about the logic of Rajan, but we want to look beyond the statements and ask about the reasons why Rajan has written this article.

Rajan is against the idea of bailouts to those suffering economic losses due to the COVID crisis. But why would anyone be against helping human beings in distress? A crystal-clear explanation is provided in Polanyi’s Great Transformation, and has been picked up by many economists like Kalecki and others, who are able to do out-of-the-box thinking. Capitalism requires a human labor to be available as a commodity for sale and purchase. A compliant labor class sells their lives for money to capitalists only when failure to do so exposes them to dire threats of starvation and worse. Polanyi writes that “The creation of a labor market was an act of vivisection performed on the body of society by such as were steeled to their task by an assurance which only science can provide”. It would appear that Rajan is a “scientist” who sees the necessity of performing vivisection on the poorer segments of society, so that the capitalist economic system can survive.

Links to Related Materials: Previous posts in this sequence are: “ABC’s of Modern Monetary Theory” and “Differentiating Social, Market, and Government Debt”. Whereas Rajan is concerned about how the government should finance its expenditures, the real source of concern is attempt to reduce deficits, and/or to create budget surplus. As shown in the ABC’s, government deficits are monetary injections into the economy which create profits and savings. Reducing them leads to depressions, as documented in following link:

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