Thursday, May 6, 2010

Growth and Debt

A while back, I wrote a post - The Importance of Economic Growth.

In the current climate of rising debt to GDP ratios. Economic growth becomes even more vital.

With falling GDP (a recession) The debt / GDP ratio would rise even with zero borrowing.
But, in a recession of course borrowing rises. It rises because:
  • Tax revenue falls (less income tax, VAT, corporation tax)
  • Spending on benefits rises.
  • Reflationary fiscal policy to stimulate growth
The prospects of reducing debt depend heavily on the rate of economic growth.
To see the implications, imagine for a moment that both Greece and Britain were paying 5 percent on their debt, but that Britain was expecting 3 percent nominal GDP growth, Greece zero. Then Britain would need to run a primary surplus of 1.5 percent of GDP to stabilize the debt/GDP ratio; Greece would have to run a surplus of 5.75. (Why isn't Britain in more trouble)
This lack of growth prospects is one of the main reasons why markets have taken such an aversion to Greek Debt.

It looks very hard to foresee positive economic growth in Greece. A combination of strong Euro, spending cuts, very low inflation. 0% growth may be on optimistic side. By the way a primary surplus of 5% in Greece would require a remarkable turnaround.

The problem is that debt can snowball.
  • As your Debt to GDP ratio rises, you spend a higher % of GDP on debt interest payments.
  • As your debt to GDP ratio rises, markets may lose confidence and demand higher interest rates.
  • The effect is to create a negative spiral difficult to get out of.
  • To reduce debt, you cut spending. But cutting spending reduces Aggregate Demand and so reduces growth, meaning you have to cut even more spending.
Note on Debt Statistics.
  • There are sometimes different statistics used to show level of government borrowing.
  • For example, according to Eurostat, Greece's primary deficit is 8.5%. This primary deficit excludes spending on debt interest payments.
  • Before, I may have used a different statistic suggesting Greece's debt is higher (12-13% off the top of my head). Presumably this measure of government borrowing includes all the interest payments (total deficit).
  • If you really want to get confused try this seemingly never ending criteria for government debt. - Understanding debt statistics.

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