Monday, March 24, 2014

Zoho: Debt, Growth, and Inflation

Dunno what I searched for, but it led me to an old (2012) Joe Weisenthal post with a really good name -- There's Only One Way To Fix The Deficit — And Actually It's Totally Painless. After some painful preliminaries, Weisenthal says

the primary driver of deficits is a lack of growth.

I agree.

Weisenthal's post is too long and shows too many graphs, as if he thinks his staying-power is enough to convince the reader. Ha. But he does get around to saying this:

Sadly, achieving growth is not trivial. So although it's the only meaningful solution to the deficit, there isn't agreement on the magic answer to get there.

The magic answer, of course, is to reduce private sector debt. But Weisenthal insists on writing about the Federal debt.

The same search led me to an old (again, 2012) Fictional Reserve Barking post, Evsey Domar's "On Deficits and Debt": A survival guide for making sense of today's economic challenges. Circuit writes:

Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP. So, for instance, the US federal government borrowed approximately 7 percent of GDP in 2012. If the borrowing continued at the same rate and the GDP (in money terms) grows at 2 percent per year, the ratio of debt to GDP will approach 3.5; with a 3 percent growth, it will be 2.3.

Thus, Domar showed that "less attention should be devoted to the problem of the debt and more to finding ways of achieving a growing national income" (1945:415)

I totally agree with the focus on growing national income. And it ties in nicely with Weisenthal's focus on growth. But it's Circuit's first paragraph that gets my attention: the long run, the ratio of debt to GDP, borrowing 7% of GDP annually, and 2% GDP growth. These are things I can do in a spreadsheet.

I can test to see whether the ratio of debt to GDP approaches 3.5 with 7% deficits and 2% growth, and approaches 2.3 with growth at 3% like Circuit says. Running a test like that is not a mathematical "proof" but it helps make the results real for me, and that's worth a lot.

In the Zoho spreadsheet below, you can enter numbers in the yellow cells and watch the graph change after the thing recalculates. If you mess up the sheet, you can fix it by refreshing the page.

The default settings match Circuit's example. The 7 in yellow cell A2 represents Federal deficits each year equal to 7 percent of GDP. And the 2 in yellow cell A3 represents GDP growth of 2 percent per year.

Circuit says "in money terms". Not sure what he means by that. I think he means "nominal" but based on Circuit's presentation, I think Domar must have been talking about "real" (not inflating) growth. Inflation would change the value of the long-run ratio. As Weisenthal says:

nominal growth is all you need to reduce our debt burdens.

If real growth is 2% and inflation is another 2%, nominal GDP growth is 4%. Existing debt shrinks faster relative to GDP if GDP is inflating.

So I added a third yellow cell, cell A4, to hold the rate of inflation. The default value is zero, no inflation; therefore the red line that represents eroded debt is hidden by the blue line which does not consider inflation. Click cell A4, type the number 2 (for 2% inflation) and press the ENTER key to see the erosion of debt that Weisenthal is talking about.

Try higher GDP growth rates also, to see how better growth reduces the debt/GDP ratio. If it looks like the blue line didn't move much, it may be because the numbers changed on the vertical axis.

Give the graph a moment to refresh after you make a change.

Check me on the "Eroded Debt" calculation.


Juan said...

This is not particularly related to your post, but I was wondering: have you heard of Thomas Piketty? He's a French economist who has a new book out here:

Anyway, he talks about inequality, and how that's driven by the growth of income going to capital relative to actual economic growth. He seems to have some pretty similar ideas to you, but instead of saying "private debt" he talks about "capital"; nevertheless the point is the same, as he says the economy (and democracy) suffers when capital income outpaces economic growth.

Some of the argumentation is a bit beyond me but I thought you might find him useful, apparently he's been causing something of a stir lately.

The Arthurian said...

Hi Juan. Yes... I read one review: The return of "patrimonial capitalism" (PDF, 21 pages) by Branko Milanovic of the World Bank. Interesting stuff.

The way you put it -- "the economy (and democracy) suffers when capital income outpaces economic growth" -- reminds me of Adam Smith's categories of income: land, labor and capital. If one category (capital) grows faster than another (labor) you have an imbalance, a self-perpetuating imbalance.

Hey, thanks for the link.