Large Fiscal Deficits and No Defaults: Is it Possible?

Modern Monetary Theory (MMT) is an unconventional economic theory that has been gaining traction recently. Though the theory has been in development for many years now, the coronavirus pandemic sparked a debate about the usefulness of the theory in the real world. So, this might be the right time to know what the theory is about and what are the implications of it. For better understanding, let us try to contrast this with conventional economic theory.

Taxes and Inflation

MMT states that countries with a higher degree of monetary sovereignty can run large fiscal deficits without worrying about defaulting on the debt. A country is said to have monetary sovereignty if it prints its own currency, issues debt in its currency, and does not promise to convert it into, say, any other currency or gold. The theory asserts that governments are not dependent on taxes or borrowings to finance their expenditure. According to MMT, taxes are instruments through which governments create demand for their currency. This makes sense.

For example, if the Indian government were to declare that taxes are to be paid in the form of rice crops from tomorrow, all the transactions would shift to being carried in rice crops and it would become the medium of exchange. Therefore, by ordaining the acceptable medium to settle one’s debt obligation, a country is essentially creating demand for that medium (dollars, rupees, etc.). The power to levy taxes and to issue currency makes the government a ‘money monopolist’. This is in contrast to mainstream economics which says that the government needs to borrow or increase taxes to bridge the government deficit. According to MMT, the only constraint on government expenditure is inflation and the availability of real resources.

MMT also says that as long as there is no (excess) inflation, the government can spend money to achieve full employment in the economy. It further supports the idea of a tax to control inflation: increase taxes to rein in inflation and decreases in taxes to boost aggregate demand. However, for tax cuts to work well, they should benefit people whose marginal propensity to spend is high. MMT rejects the idea of Non-Accelerating Inflation Rate of Unemployment (NAIRU), which is the level of unemployment below which inflation begins to increase. It is a theoretical concept which cannot be observed or calculated, and one can only find it when a further rise in employment (or fall in unemployment) raises inflation.

What all the central banks across the world do today is that they set an inflation target and alter the interest rate to reach the target, withstanding any amount of unemployment in the process. Dr Stephanie Kelton, a proponent of MMT, observed in her book The Deficit Myth that, “to put it crudely, the [central banks] use unemployed human beings as [their] primary weapon against inflation.” Instead, MMT prescribes a universal job guarantee to combat unemployment. It believes that such a job guarantee will act as an automatic stabiliser that will promote both full employment and price stability.

Interest Rates

Conventional economic theory states that huge government debts will lead to an increase in the interest rates in the long run, which is harmful to the economy. This idea, however, is rejected by MMT. According to MMT, since the central banks have control over the short-term interest rate and also significant influence over the long-term interest rates, large debts will not increase interest rates. Apart from this, MMT also notes that markets can always be stripped off of any influence over the interest rates. Japan is a case in point. With a debt-to-GDP ratio of 238%, highest in the world, the interest rates are near-zero. This is because, along with influencing the short-term interest rates, the bank of Japan (BoJ) had committed to maintaining the interest rates on ten-year government bonds near zero (which is done by buying government bonds on large quantities, i.e. buying government debt). Note how both long-term and short-term interest rates are influenced by the central bank of Japan. By doing this, the central banks anywhere in the world can prevent interest rates from rising.

One could question whether this would not lead to inflation. (The answer is, no) Eric Lonergan, an economist and a hedge fund manager has an answer to this question. It goes like this. When BoJ buys the Japan government bonds and pays out cash, the investors, instead of government bonds, will now hold the same value (of that of bonds) in cash. While there is no effect on wealth, there is a loss of interest income. So essentially, paying off government debt will lead to a fall in interest income in the private sector. MMT further argues that there is no need for a government to buy bonds to finance its debt and it is only a choice the government makes. This is because the government can spend by crediting the appropriate bank account (through the central bank), without issuing any bonds.

Crowding Out Effect

The conventional thinking is that the government will compete with the private sector from a limited pool of savings to fund its deficits. When the fiscal deficit increases, the government will have to borrow more; which will leave lesser funds available for the private sector, leading to the crowding out effect. This idea is also contested by MMT. According to MMT, government spending is self-financing. Government running deficits, in the first place, will put the money the private sector uses to buy bonds. Let’s understand this using some equations given by an important MMT figure, Wynne Godley.

(Y= National Income; C= Consumption; I=Investment; G= Government expenditure; X-M= net exports; S= savings; T= taxes)

Y = C + I + G + X - M — (1)

Y = C + S + T — (2)

From (1) and (2)

S + T = I + G + X - M


(S - I) = (G-T) + (X-M)

If (X-M) <= 0, there is no current account surplus,

For (S-I) to be positive, (G-T) must be positive. Therefore, government deficit means private surplus.

Therefore, when the government issues bonds to bridge its fiscal deficit, the deficit itself is supplying the money necessary to purchase the bonds. For this very reason, MMT states that there will be no crowding out. It is also apparent from the above equations that government deficits will always lead to a fiscal surplus (surplus in financial assets) in the non-government sector.

Indian Context

Let us now look at MMT from an Indian vantage point. Though India doesn’t have the monetary sovereignty as high as the US, UK or Japan etc., Indian government borrows in Indian rupees only. That leaves scope for implementation of MMT prescriptions. In fact, one study shows that despite high fiscal deficits there has been ‘crowding in’ effect rather than crowding out effect in India in the period 1980-2015. This is clearly in agreement with the MMT theory. The high fiscal deficits that India ran could very well be the reason for the faster growth that India achieved since the 1991 reforms. Also, India already has in place the job guarantee scheme advocated by MMT economists, MNREGA, although not universally. But there are some problems in India as far as MMT recommendations are concerned. First, the number of taxpayers in India is marginal. Second, the underground economy is prevalent in India. These two factors might not be very effective when it comes to using taxes to create space for fiscal expansion. However, there is also one argument that India is already using MMT solutions unwittingly.


MMT essentially argues for a greater role of fiscal policy and subsidiary role of monetary policy. Prescriptions like a universal job guarantee, using taxes to cut inflation, etc. are cases in point. According to MMT economists, taxes (or borrowing) pay for nothing. However, taxes are important for other purposes like controlling inflation to create space for fiscal expansion, redistribution of wealth, ensuring not too much political power is concentrated in a few hands, and so on. For them, the universal job guarantee is an automatic stabiliser which will provide employment to all those who are unemployed by the private sector, and mitigate the pains for those who are fired from employment. The final result is that MMT wants everyone to focus on economic balance, full employment, and price stability. All that MMT asks from you is to concentrate on the economic outcomes rather than budget outcomes and economic balance rather than balanced budgets.

For more on MMT, you can read the following books:

1. The Deficit Myth – Stephanie Kelton

2. The Case for a Job Guarantee - Pavlina R. Tcherneva

3. Soft Currency Economics II: The Origin of Modern Monetary Theory – Warren Mosler

4. Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems - L. Randall Wray


Kartik Balaji Kundeti

A low-key individual with keen interest in Economics and Policy making. Currently pursuing Economics from SRCC, University of Delhi.

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