Sustainable deficits

Hat tip to Nick Rowe for this analysis on how inflation and long-run GDP trends impact the potential for persistent deficits. The punchline (using Canadian figures):

The same debt that would ruin a poor country would be nothing to a rich country. Looking at the debt/GDP ratio seems a more sensible measure of whether a country is increasing or decreasing the difficulty of servicing the debt. Long run growth in real GDP is harder to forecast. I’m going to assume 2.5% real growth. It will be more than that some years and less than that in other years. It all depends on population growth, demographics (percentage of population that is working age), productivity growth, and the business cycle too in the short run. But something like 2.5% seems a reasonable average for the next decades.

$600 billion debt times 2.5% real growth equals $15 billion. If there were no inflation, and 2.5% real GDP growth, the Federal government could run a deficit of $15 billion this year and the debt/GDP ratio would stay the same.

Add 2% inflation plus 2.5% real GDP growth and you get 4.5% nominal GDP growth. The debt can grow at 4.5% per year and the debt/Nominal GDP ratio would stay the same. That means a deficit of $27 billion this year.

Once you adjust for expected inflation and expected real growth, the Federal deficit looks more like a small surplus.

In other words, when you look at the figure which matters (debt-real GDP ratio), there are forces (inflation and long-run growth trend) which will support a more forgiving impact of continued deficits on the size of debt.

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