Tuesday, 20 September 2016

What’s the optimum debt / GDP ratio, and what’s the optimum interest to pay on that debt?

This article deals with the differences between Modern Monetary Theory and what Simon Wren-Lewis (Oxford economics prof) calls the “consensus assignment” (which more or less equals the conventional wisdom).

I argue below that if the best of MMT and the best of SW-L’s ideas are combined, one ends with the ideal system, and that involves two important elements. First it results in a national debt that pays the optimum rate of interest: zero or near zero. Second, it results in the optimum debt / GDP ratio. But since the interest on that debt is zero or near zero, that so called debt isn't really debt at all: it’s more like money (base money to be exact).

Martin Wolf pointed to the similarities between “low interest national debt” and money. And Milton Friedman supported the “zero interest” idea. Moreover, at a near zero interest rate, government is by definition not influencing or interfering with the free market rate of interest. I.e. a genuine free market rate of interest is obtained under the above “ideal” system, and that presumably maximises GDP.

Note (added 26th Sept 2016). This article has been re-produced on the Seeking Alpha site.

Simon Wren-Lewis (SW-L) has taken an interest in Modern Monetary Theory (MMT) recently. He is agrees with some MMT claims, but says there is nothing new in MMT, and in particular that MMT offers nothing that the so called “consensus assignment” doesn’t offer.

The consensus assignment is the idea that in normal times, i.e. when interest rates are significantly above zero, interest rate adjustments should be used to adjust demand, while fiscal policy (i.e. having government borrow and spend more) should be used to control the debt. Plus fiscal policy as a demand increasing tool comes into its own at the zero bound. See endnote No2 below for some passages from SW-L’s writings which confirm the latter description of his “consensus assignment”.

Incidentally the so called “consensus” amongst mainstream economists is far from perfect (which is why they’re always arguing with each other!). Likewise, there is far from complete unanimity amongst MMTers. However, in both cases there is SOME SORT OF consensus.

What’s the optimum amount of debt?

In fact there’s an important omission from the consensus assignment: SW-L simply refers to stabilising the debt and to ensuring it does not rise excessively. But he doesn’t tell us at what the optimum debt / GDP ratio is. Or at least far as I can see he doesn’t – I haven’t read everything he has written.

A second omission is the question as to what the optimum rate of interest is. I.e. SW-L simply goes along with the conventional wisdom that because interest rates have been significantly positive for several decades, that must represent some sort of optimum.

So what are MMTers’ answers to those two questions?

The optimum amount of debt.

As Warren Mosler (a leading MMTer) has made clear, there is no big difference between base money and national debt – certainly not at low interest rates. As Warren has put it, national debt can perfectly well be regarded as a term account at a bank called “government”.

Plus Martin Wolf (chief economics commentator at the Financial Times) made the same point about the close similarity between base money and national debt (1). As he put it “Central-bank money can also be thought of as non-interest-bearing, irredeemable government debt. But 10-year Japanese government bonds yield less than 0.5 per cent. So the difference between the two forms of government “debt” is tiny…”.

In fact MMTers sometimes lump national debt and base money together and refer to them collectively as “Private Sector Net Financial Assets”. So what’s the optimum amount of PSNFA?

Well the more PSNFA the private sector has, the more it is likely to spend, all else equal, in just the same way as when a household wins a lottery or gets a tax rebate, its spending tends to rise. So the optimum amount of PSNFA is whatever induces the private sector to spend at a rate that keeps the economy as near capacity, i.e. full employment as is feasible while keeping inflation under control.

That was easy enough, wasn’t it?

Interest on the debt.

Now for the second question, i.e. what’s the optimum rate of interest to be paid on the debt? Well there’s a fundamental question here: why pay interest on it at all?

There is certainly an argument for having the state issue a finite volume of liabilities in the form of money (base money to be exact). The US government / central bank issues dollars and other countries do likewise. Dollars enable people and firms to do business with each other.

But why have the state issue a volume of liabilities which are so large that people and firms then have to be paid interest to stock those dollars and with a view to discouraging people and firms from spending those dollars? That doesn’t make sense. Indeed Milton Friedman  and Warren Mosler argued for a ban on government paying interest. (Re Friedman, see here (2), and re Mosler see 2nd last paragraph here (3), plus here (4).

Friedman and Mosler were right: my only slight reservation is that I wouldn’t rule out an artificial rise in interest rates if an emergency dose of deflation is required. Indeed, Friedman said something similar: he suggested government borrowing is only justified in war-time.

Moreover, there is certainly no excuse for government failing to collect enough tax to cover CURRENT spending (as opposed to capital spending). If government DOES borrow because of failure to collect enough tax for current spending, that will result in an entirely ARTIFICIAL rise in interest rates. That is, a zero rate gives us the genuine free market rate. (Incidentally that’s not to say that zero is the free market rate of interest for everyone: obviously the rate paid in connection with mortgages, corporate bonds etc will be above zero. The point is that at zero, the state is not artificially boosting the rate of interest.)

In contrast to current spending there is capital spending (on infrastructure etc). I’ve dealt with that under “Querie No Z” below. But briefly, and contrary to popular perception, the excuses for borrowing to fund capital spending are about as feeble as the excuses for borrowing to fund current spending, so I'm assuming in this article (as per Milton Friedman) that there are scarcely any good reasons for government borrowing.

Another possible excuse for using interest rate adjustments to control demand is that lags might be shorter than in the case of fiscal adjustments. But that’s not the case, far as I can see.

Is the Mosler “zero rate” idea generally accepted by MMTers?

Having suggested just above that MMTers as a group tend to advocate the Mosler zero rate idea, it’s possible that is not correct. Certainly SW-L suggests MMTers are happy to see interest rates rise significantly ABOVE zero – see SW-L’s first paragraph here.

At any rate, if SW-L is right there, then I agree with that criticism of MMT: i.e. I think the rate should always be kept as near zero as possible.

Rising interest rates.

Of course whenever anyone mentions a rise in the debt, people raise concerns about the extra interest that will have to be paid on that debt. Well the simple answer to that is that if there is excess unemployment caused by the private sector not having the stock of PSNFA that it wants (aka caused by Keynes’s “paradox of thrift”), then the private sector will be willing to hold more PSNFA at a zero or near zero rate of interest!!

Another potential problem is that creditors may lose faith in a government and start demanding a higher rate of interest. Well the answer to that is simple: put the whole process into reverse – i.e. print money and pay off debt as it matures. And as to any excessive inflationary effect that has, deal with that by raising taxes.

Indeed we’ve been doing just that, i.e. printing money and buying back government debt on an astronomic scale over the last two years or so and under the guise of QE. And as you may have also noticed, QE does not have a huge effect, inflation wise. Indeed, that feeble effect confirms that above point that debt and base money are much the same thing. I.e. QE is a bit like the Fed offering everyone two $50 bills for each of their $100 bills.

How to raise PSNFA?

Having answered the question as to what the optimum amount of debt / PSNFA is, there is a subsidiary question, namely how to GET TO that optimum level. One option is helicopter drops. Another is a more conventional route, namely conventional fiscal stimulus combined with a bit of buying back government debt so as to keep interest rates down, and/or combined with QE.

Personally I prefer the latter conventional route, as do most MMTers I think. Reason is that REVERSING helicopter drops may be politically difficult, should the need arise, and the government spending that gradually raises PSNFA itself has an employment raising effect. I.e. relying to some extent on the latter “conventional” fiscal policy makes it possible to get the economy up to capacity even where PSNFA is not yet at its optimum level, and that’s helpful.

Interest rate adjustments are defective.

In that the above advocated idea about interest on the debt remaining at or near zero is achieved, that rules out interest rate adjustments. But that’s at conflicts with the conventional wisdom, namely that interest rate adjustments are a perfectly good way of adjusting demand. So are interest rate adjustments really that defective? Well yes: they are.

There is absolutely no reason to assume that because demand is deficient, that lack of borrowing, lending and investment is the problem any more than the problem is a lack of demand for cars, ice-cream, whiskey, education or anything else!

Put another way, if there’s a lack of demand, the solution (surprise, surprise) is simply to increase demand from the public and/or private sectors. As to interest rates, they can be left to market forces.


MMT answers two questions which the consensus assignment doesn’t. First, what is optimum amount of national debt / PSNFA? The answer is: whatever amount keeps the economy at capacity / full employment without exacerbating inflation too much.

Second, what is the optimum rate of interest on national debt / PSNFA? The answer is there is little reason to pay anyone anything just because they want to keep a hoard of dollars / PSNFA / “state liabilities”. So the optimum rate is zero (which is not to totally rule out raising interest rates if the economy needs a large and quick dose of deflation).

To clarify the difference between MMT and the conventional assignment, suppose we had full employment and interest was well above zero, the conventional assignment says we’re back to the normality that prevailed between WWII and ten years ago, so nothing needs to be done. MMT (or at least my suggested compromise between MMT and SW-L) says that any positive rate of interest is not optimum, and that in the latter scenario, interest rates should be cut with any consequent inflation being dealt with by cutting the private sector’s stock of PSNFA  - e.g. by raising taxes.

Or, and taking a slightly different scenario, suppose interest rates were significantly positive and demand was excessive. The conventional assignment would say “raise interest rates”. In contrast, MMT (or the “compromise”) would advocate that fiscal measures be used to impose deflation: e.g. a rise in taxes and/or cut in public spending, while efforts to cut interest to near zero should continue.

Endnote No 1 -  infrastructure borrowing.

There are a number of queries that can be raised in relation to the above arguments which I’ll now deal with.

Re the above advocated zero or near zero rate of interest, it might seem there is a good reason for government to borrow and pay the full normal rate of interest, namely borrowing to fund infrastructure and other investments. That is sometimes referred to as the “Golden Rule” (5). In fact the arguments for borrowing for infrastructure are feeble, as I demonstrated here (6). Milton Friedman (3) also argued for zero borrowing. Thus I’ve made the implicit and not unreasonable assumption in this “Ralphonomics” article that there is no borrowing to fund infrastructure etc (i.e. that infrastructure is funded via tax).

 However, if any chance the case for borrowing to fund infrastructure can be made to stick, my answer to that is that the above “MMT versus conventional assignment” is concerned with government AS ISSUER OF THE NATION’S CURRENCY. It is not concerned with government as investor in infrastructure.

So if the argument for borrowing for infrastructure can be made to stick, the answer is to have special “infrastructure bonds” or similar, and have them issued on the same conditions as a private provider of such bonds would offer (and that includes a realistic chance of bond holders losing their money, as occurred with the original investors in the Anglo-French channel tunnel.)

In contrast, there would be a separate type of bond issued by “government as issuer of the nation’s currency”. The aim in respect of those bonds should always be to keep interest on them as near zero as possible.

Endnote No2 - SW-L and the conventional assignment.

SW-L says here (7), “Demand management should be exclusively assigned to monetary policy, operated by central banks pursuing inflation targets, and fiscal policy should focus on avoiding deficit bias.”  (By “deficit bias” he means the ever present temptation for politicians to incur too much debt)

And here (8) he says in the abstract, “the consensus assignment, where monetary policy controls demand and inflation and fiscal policy controls government debt.”

And again (9): “What I call the ‘consensus assignment’ in modern macroeconomics is that monetary policy keeps output stable at a level that leaves inflation at target over the medium term, and fiscal policy stabilises the ratio of government debt to GDP.”

Incidentally, if you look at the above SW-L articles you may see some comments by me. Don’t expect those comments to be entirely consistent with this “Ralphonomics” article. This article is as much about me trying to sort out my own ideas as it is an unsolicited attempt by me to sort out SW-L’s ideas!

Endnote No 3 – is the above article council of perfection?

It could be argued that the above article (and indeed SW-L’s “consensus assignment”) are counsel of perfection in that (at least in the US) fiscal policy is not determined in anything remotely resembling the above rational manner: it is the outcome of a bunch of squabbling school children who know next to nothing about economics. Those children are commonly known as “politicians”. Or as former US defence secretary Robert Gates put it, US politicians are more concerned with “scoring ideological points than with saving the country”.

My answer is that that’s a particular US problem at the moment. In contrast, if the above “SW-L / MMT” compromise system makes sense, it should be possible to explain it to politicians in Europe and get them to go along with it.


1. Martin Wolf. “Warnings from Japan for the Eurozone”. Financial Times.
2. Milton Friedman  “A Monetary and Fiscal Framework for Economic Stability”. American Economic Review.
3. Warren Mosler.  “Proposals for the banking system”. Huffington Post.
4. Warren Mosler & Matthew Forstater. “The natural rate of interest is zero”.
5. Kersten Kellerman. “Allocative Inefficiency of Debt Financing of Public Investment  - an Ignored Aspect of “The Golden Rule of Public Sector Borrowing”. University of Fribourg.
6. Ralph Musgrave. “Government borrowing is near pointless”.
7. Simon Wren-Lewis. “The strong case against independent banks”. Mainly Macro.
8. Simon Wren-Lewis. “Monetary and Fiscal Policy Interaction: The Current Consensus Assignment in the Light of Recent Developments”. Mainly Macro.
9. Simon Wren-Lewis. “Fiscal rules and MMT”. Mainly Macro.
10. “Gates slams Congress for managerial cowardice.” Published by Military.com.

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