The Breakdown - How Much Debt Can a Country Handle?

Episode Date: December 13, 2020

This week’s edition of Long Reads Sunday is a reading of “How Much Debt Is Too Much?” by Raghuram Rajan on Project Syndicate. In it, the author explores the shifting conventional wisdom on national debt and worries that countries may reach their limit far earlier than they think.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by Crypto.com, nexo.io, and level. And produced and distributed by CoinDesk. What's going on, guys? It is Sunday, December 13th, and that means it's time for Long Reads Sunday. So I have started recording my end-of-year episodes. We will, be out and not in regular production for the last couple weeks of the year. And so I have a huge number of great guests. And obviously, we're going to be talking about the year that was, the

themes to come, the trends, all of that sort of stuff. One thing that is abundantly clear is a sense that we are headed towards some pretty serious policy experiments when it comes to both monetary and fiscal policy and the combination thereof. Many people that I'm talking with feel, and I certainly feel as well, that a certain levy was breached this year when it comes to conventional wisdom around debt, around government involvement in the economy. There is, of course, a waiting set of theories and ideologies that are ready to take this breach and run with it and turn it into the new policy de jour. With that in mind, our selection for Longreach Sunday this week comes from Raghuram Rajan, the former governor of the Reserve Bank of India and a current professor

of Finance at the University of Chicago Booth School of Business. He's also the author of the Third Pillar, How Markets in the State Leave the Community Behind, and this appeared in Project Syndicate. The piece is called How Much Debt is Too Much, and it gets right at the heart of one of the most important macro issues of the moment. The new conventional wisdom in these unconventional times is that advanced economy governments can take advantage of today's ultra-low interest rates to borrow and spend without limit in order to support the economy. But the fact is that there is always a limit and it may come into view sooner than many realize. 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 to 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 or 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 has 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 is 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 have soon issue treasury bills directly to commercial banks. The interest costs would be more or less the same. The only difference is there would be no appearance of a free lunch. This episode is brought to you by Crypto.com, the Crypto super app that lets you buy, earn, and spend crypto all in one place and earn up to 8.5% per year on your Bitcoin.

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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 lower 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 principle. 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 in emerging market has faced a debt's 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 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 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 has 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 anytime 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.

So just a quick reflection on this piece, you can tell from his tone that this is clearly not someone who is an ideologue who wants to tear down the very idea at the core of MMT. This isn't someone who is a Bitcoiner, necessarily. Instead, what I think this piece reflects is something that we're about to see a lot more. MMT, I believe, is going to enter the mainstream economic discourse in a way that is even more profound than we see it today. I think it'll find its way into different legislation in various forms. I think it'll become something that's hugely in vogue. I think that you'll see people try to adapt it to politics in a pretty significant way. As that happens, I expect that we'll see

pushback, not just from those of us in the Bitcoin world, but also folks who just aren't convinced by MMT's answers about how long it can persist without falling in upon itself. I think in many ways, these mainstream economic critiques and questions of MMT are going to be just as important as the ones we have coming from the sound money perspective, because they're going to create a lot of space for countervailing takes on what could prove to be an extremely politically popular economic ideology. And that's the point, the thing about MMT that makes it such a huge, potential political force is how appealing it will sound and does sound from a political standpoint. As you can probably tell, I think it's hugely important to be paying attention to and to be

engaging with as much as possible. So I appreciate you listening. I hope you enjoyed today's selection on Longreed Sunday. Until tomorrow, guys, be safe and take care of each other. Peace.