But how much debt is too much? Raghuram Rajan explains what limits are there on government borrowing in this strange world of ultra-low interest rates...
“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 Modern Monetary Theory (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,” writes Rajan.
“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,” he explains.
He further makes a point that it is not enough for a government to ensure that it can afford to make its interest payments but to also show that it and its successors can repay the principal. He explains that investors will buy that new debt only if they are confident that the government can repay all its debt from its prospective revenues.
The other option is to allow for higher inflation, Rajan writes. "This 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," he explains.