Tuesday, December 28, 2010

Followup to the sustainable 12% deficit

I was plugging away on some calculations and came to a shocking conclusin It appears if we have the nominal size of the economy expand at 6% a year, (2% productivity, 1% population growth and 3% inflation..

Once you get to a national debt of 200% of gdp.. then the 6% nominal growth in gdp exactly cancels out the 12% deficit. So the national debt remains at 200% of gdp for the next year.
In that scenario the national debt would never rise above 200% of gdp even with a constant deficit of 12% of gdp.  Now for the USA that is quite significant, 12% of gdp 1,759 billion dollars.  Or 5,674$ per man, woman and child in the country.  Over 20 grand for your average family of 4.  That can be sustainably borrowed.

Historical graph of UK national debt

This graph dates back to the 1690's when the Bank of England was first created.  Many economists and popular pundist are 'alarmed' at the current national debt of the United Kingdom.  Surpassing 50% as the nation is running a budget deficit of 12% of gdp.  Yet clearly the nation survived and prospered with much higher national debt levels in the past.  The UK was the main world econoic power in the 1800's, and had a national debt of 150% of gdp for a good period of that.

It seems strange but the national debt is really just something that balances the expansion or contraction of private credit.  In periods like the modern era, where there has been a huge and ever growing private credit expansion, the national debt is low by historical standards.  Now as the deleveraging in the private sector begins, the national debt must expand to keep the money supply going in the economy.

The US budget deficits are sustainable

At first impression if a nation currently had a debt of 80% of gdp, and ran a budget deficit of 12% of gdp for 10 years, one would assume at the end of the 10 years, the debt would be 200% of gdp.  But actually that is not what happens.

Each year productivity pushes forward about 2%, population by 1% and the national target rate of inflation in the US is 2%.  This means the nominal size of the economy grows by 5% per year.  And this causes debt taken out in prior years to become much smaller in relative terms.

So with a 5% nominal increase in the size of the economy, and running a deficit of 12% of gdp for 10 years, starting at a base of 80% of gdp.. At the end of the 10 years the debt is 149% of gdp, not the 200% of gdp expected.

149% of gdp is not out of hand, in the new era we are in.  Japan, which was the first nation into this era, already has a national debt of 200% of gdp.  And looks stable.  It would take the USA 20 years of running a budget deficit of 12% of gdp to get to 200% of gdp.