Austerity arithmetic: the dreaded r > g trap.

July 19th, 2015 at 9:50 pm

I’ve got a piece out in PostEverything on a lesson we should learn from some arithmetic embedded in the Greek debt crisis. Basically, I point out that when the interest rate a country must pay to service their sovereign debt is consistently and significantly above their growth rate, their debt/GDP ratio just keeps growing.

In this course of the piece, I say a bit about the US case, stressing that when we’ve reduced our debt/GDP ratio, it’s typically been through strong growth, i.e., by closing the output gap and getting to full employment.

The figure below plots the change in the debt/GDP ratio against the output gap, which is just the % by which real GDP is above or below potential GDP, so a -5% output gap means real GDP is below where it should be at full employment by 5%.

I circled the 1990s as an instructive example. As the economy strengthened, the debt/GDP ratio began to grow more slowly and then, as the output gap more than closed and the federal budget went into surplus, the debt ratio fell quite sharply.

Over the full period, the correlation between the two series is -0.79.

As I stress in the piece, there’s such a thing as fiscal rectitude (and lack thereof), but the history of advanced economies also reveals that growth is often the critical variable in debt and deficit outcomes. Conversely, to the extent that austerity measures strangle growth in high interest rate environments, as in Greece today, it is bound to backfire.

Sources: CBO, BEA, OMB

One comment in reply to "Austerity arithmetic: the dreaded r > g trap."

1. Yessir says:

Jared, this is an excellent point I haven’t seen anyone else make. I suspect the reason you are not more quoted is because you are so honest and smart.

Thank you for pointing to this next point:
What if capital is not actually capital? What if banks can loan money that isn’t actually capital? Then isn’t the return on bank ‘investment’ higher than economic growth rates also?

I hadn’t quite put this into words before your post. This is why I believe this is a group effort.