Debt Arithmetic (Wonkish)

The whole tone of current discussion about deficits is one of urgency: deficits must be brought down now now now or crisis looms. Where is this coming from? Not from the arithmetic.

The way the story is often told, deficits mean higher debt, which means higher interest payments, which can mean a spiral into bankruptcy. And qualitatively that?s not wrong. If you put numbers to it, however, for countries that are not facing huge risk premia, the spiral is very, very slow.

Here?s a sample calculation.

The latest IMF Fiscal Monitor predicts that general government in the US ? that?s federal, state and local combined ? will run a deficit of 7.5 percent of GDP next year, and that net debt will be 75 percent of GDP.

So how fast would the debt spiral be going?

You need to bear in mind that growth and inflation limit the rate of rise in the debt ratio. Suppose that we have 4 percent nominal GDP growth, which is actually low by historical standards. This shaves 3 percentage points off the rise in the debt/GDP ratio. So a year later, given those numbers, debt rises by 4.5 percentage points of GDP.

What?s the interest burden of that rise? At minimum we should correct for inflation, so use the TIPS yield. That?s currently below 1, but let?s be pessimistic and call it 2. Even so, the added interest burden is less than one-tenth of one percent of GDP.

So even with substantial deficits, the pace of long-term budget worsening is very slow. If it?s a debt death spiral, it?s a slooooowww motion death spiral.

But, say the critics, psychology can change suddenly, sharply raising those interest costs. The question then is why psychology should change. Investors can do the same arithmetic I?ve just done; why should they panic over a small rise in the interest burden?

Now, investors might well panic over signs of political deadlock ? but that could happen regardless of the current year?s deficit.

Still, Serious People tell us that investors will turn on us unless we slash the deficit immediately ? and they know this because, well, um ?

As I?ve often written, we?re in a strange state now where people who actually take textbook economics and simple arithmetic seriously are seen as dangerously radical and irresponsible, while people who believe in invisible bond vigilantes and confidence fairies, who claim to know what the market will want even though there?s no sign of that desire in current asset prices, are viewed as Very Serious.

Anyway, the arithmetic of debt is much less scary than you might think.

Source: http://krugman.blogs.nytimes.com/2011/05/24/debt-arithmetic-wonkish/

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