Thursday, October 21, 2010

Debt to GDP

Government debt as a percentage of GDP is a popular measurement to determine if a government is spending too much, with various "thresholds" given for when the debt gets too excessive. Unfortunately it is not a good measure in itself.

The first problem is with the items being measured. GDP is measured with the formula "Y = C + I + G + ( X - M )", or GDP is equal to consumption plus investment plus government spending plus exports minus imports. Although there are many criticisms of GDP the worst is that it includes government spending as a positive component.

Government spending is, at best, a transfer instead of an actual investment or consumption. A measure of the GDP that leaves that out would be "Y = C + I + X - M". But given that there’s inefficiency in the process, every government dollar spent is actually a drain on the economy. They Keynesian "multiplier effect" is a myth unsubstantiated by actual results. To measure the full effect of GDP would be to subtract government spending, giving "Y = C + I + X - M - G".

The other part of the ratio, the debt, is also a problem. The government debt is not a stationary target, but is moving, which means to get an effective measurement includes the deficits. That means government spending is on both sides of the ratio. Increasing government spending will increase both GDP and Debt, making all ratio measurements unreliable.

The second problem is that debt to GDP is used to measure a government's ability to repay the government debt. That implies that the government has a claim on the GDP of a country, which implies that the government has a claim on the whole of the wealth of a country. Any attempt to claim that wealth in an effort to pay off the debt would destroy the economy and deplete the wealth of the country.

Third, given that both parts are moving targets, an 'improving' ratio doesn't necessarily show any greater or lesser responsibility on the part of politicians. If the debt increases slower than the GDP climbs, or if the debt decreases but the GDP decreases by a smaller amount, the result is the appearance of improvement. Reverse the ratios and it gives the appearance of economic degradation. In the first half of each example, debt increased. In the second half of each example, the GDP declined. None of those are good, but two of them give the appearance of a better economy.

Fourth, the measures can be manipulated. Take a country with a debt to GDP ratio far in excess of 100%, such as 130% or higher. That country's government can use the central bank to monetize the debt and borrow money a thousand times more than owed before, such as a country that owes trillions can create quadrillions. The government can then spend the money. That would surely alter the GDP equation, with G increasing by an exponential amount while C, I, X, and M trend towards zero, leaving Y increasing while basically equaling G. Debt would also be basically equal to the newly created money, leading to a debt to GDP ratio of approximately 100%. By those who favor debt to GDP as a measure, that leads to the conclusion that the economy of that country has improved, while any objective measure would show hyperinflation and the collapse of the economy.

There really is little use in debt as a percentage of GDP. It doesn't measure what it is supposed to measure, it is very prone to manipulation, and its components aren't very as reliable as one would desire in an economic measure.

1 comment:

Otto said...

More than two weeks ago I read this, forgot to bookmark it and have spent that time searching for it. I thought maybe I'd dreamed the whole thing. Thank goodness I found it again and thank you, Ayn R. Key for writing this column. The idea that government spending is a positive component of ANY economic equation is LUDICROUS. For me, it has been forty years since Econ 101. I was young, what did I know about economics? Who was I to question Paul Samuelson or any other Keynesian economist? Today, I think it should have been obvious to me and any intelligent person that government spending has no business being a positive factor in computing GDP. What products does government produce? What services does government provide? Everything government does is, at best, a complicating factor rather than a service. Of course, we know that government spending is financed by taxes, borrowed dollars, and "new" dollars. Government is necessary, there are valid reasons for the existence of the Registry Of Motor Vehicles, for instance, but in no way does anything government does contribute positively to economic output.