Rajan Accuses MMT Of Making Errors Made By Mainstream

Raghuram G. Rajan rcently wrote "How Much Debt is Too Much?," which includes an attempted critique of Modern Monetary Theory (MMT). As quite often happens when mainstream commentators critique MMT, no attempt was made to cite or quote MMT sources. In this case, that would have been useful -- since he accuses MMTers of making basic analytical errors. Unfortunately for his case, those errors are actually made by mainstream economists, and MMTers take the other side of debates.

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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.
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