10 December 2012

Deficits For Ever

If Dean Baker were writing this blog, the headline would probably be "Janan Ganesh doesn't know that the national debt has fallen in the last 50 years."

At the weekend Janan Ganesh, an FT columnist, argued that Britain can no longer afford the welfare state. Underlying the deficit hysteria there lurks a right-wing ambition to roll back the welfare state. Unfortunately the case for blaming social spending for debt and deficits doesn't hold up, not in the UK nor anywhere else.

Government deficits exploded after and in response to the financial crisis.

Now right-wing pundits are making the argument for cutting the welfare state more directly. Sadly, the same flawed understanding of the economic facts wounds their case. Mr Ganesh, for example claims:
"The Treasury has run budget deficits for much of the postwar period.
"...Not even Labour entertains the notion that, once the current crisis is over, deficits can again become as common as they were in the last half century."
Deficits have indeed been the norm in the postwar period; but that is not a problem. Mr Ganesh seems to be unaware that government net debt 50 years ago stood at 99.9% of GDP. Forty five years later, in 2007, it was 36% of GDP. It has gone up since the crisis and is now around 66%. If we go all the way back to the start of the postwar period we find debt at 237% of GDP in 1946.

So governments have run deficits more often than not and the national debt has come down. How is this possible?

The answer lies in this equation: d=gD.

In a stable state (ie the debt ratio remaining constant), deficit (d) should equal the nominal growth rate (g) times the debt ratio (D). So if nominal growth is 5% and the government wants to keep the debt to 40% of GDP then it can run a deficit of 2% of GDP (5% x 40%).

Governments do not need to balance their budgets; a little bit of inflation and a little bit of growth allow government to maintain a sustainable debt level while regularly running a deficit. Unlike Mr Ganesh, I think deficits will be just as common in future as they have been in the last half century.

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