This articles title and contents comes from John Maudlins recent writing from his Thoughts From The Frontline weekly e-letters, a weekly emailed letter that you can get for free. You can read more here.
Let's assume a country that has a gross domestic product (GDP) of $1,000. In the beginning it taxes its citizens about 25% of GDP and spends the money for the public's benefit. But alas, it spends about 30% of GDP, so it must borrow the overage (about $50) from its citizens or from the citizens of other countries. Because the country starts out with relatively little debt, interest rates on this loan are low, because those who buy the debt can easily see that the the country can pay them back. If the debt of the country is only 5% of GDP ($50) and the interest rate is 4%, then the amount that must be paid as interest is only about $2 per year. Not a whole lot, about 0.2% of GDP.
But this goes on year after year. Sometimes the deficits get smaller and sometimes they get larger, depending on the economy; but government expenditures grow at the same rate as the country grows, and the debt keeps growing at an average of 5% of GDP per year. Now, if the country is growing at 3% a year, after 24 years the economy will have doubled to $2,000 GDP. That means the debt has grown (roughly) to a total of $1,800, which is now a debt-to-GDP ratio of 90%. Debt has grown faster than the country's economy. Note that if the country had held its budget down to where it grew slower than GDP, thus reducing its need for debt, that ratio would be lower, even if the debt had grown. You can indeed grow your way out of a debt problem if the growth of government spending is less than the growth of the economy.
But what if the size of government grows to about 50% of GDP, rather than 25% or 30%, over the 24 years, as politicians decide to spend more money and voters decide they want more benefits? (Think France.) Then the private sector must pay about 50% of its production to the state – plus, the debt is now growing unwieldly. The private sector has less to invest in new businesses and tools, and the growth of the economy slows.
And then along comes a very nasty recession. The revenues of the government fall as the economy shrinks. If the economy shrinks by 3% and total taxes are 50%, then tax revenue falls to $970. But the government does not cut back; and indeed, because it must pay unemployment benefits and welfare (because unemployment rises in a recession), its expenses actually rise by 5%! So it now needs $1,050 to pay all its budgeted expenses. And it must now borrow $80 to pay everyone it has promised to pay, in addition to the $100 it was already borrowing every year to cover its deficit, or a total of $180 a year, which is 9% of GDP.
(Yes, I know that debt must change as a percentage over time and nothing is stagnant, but work with me here.)
Now debt-to-GDP is rising by about 5% a year. Not a large number in the grand scheme of things, and everyone knows that the recession will soon be over and the deficits will come down. Sovereign governments never default on their debts – our government leaders assure us of that. They can always raise taxes or cut spending, can't they?
And things rock along just fine, and the bond market continues to buy the debt, until one day you look up and the debt is 120% of GDP. Then the bond market gets nervous and says that instead of 4% it wants 7%. Now the interest payments are over 8% of GDP and 16% of government spending, which means the government must either cut back on services or salaries or benefits, or raise taxes, or borrow more money. But cutting spending and raising taxes have consequences. They reduce GDP growth over the following 4-5 quarters as the economy adjusts.
What if that interest rate cost rose to 10%? Then the interest cost to the government would become 20% of its expenses and be rising faster than the country could grow, even in the best of times. And if they continued to borrow at 7% and the country did not grow, those interest expenses would rise at least 7% a year – as long as interest rates didn't go up.
And what if the other countries who had been buying the government's debt looked at the basic math and realized that, another step or two down the current path of government spending, there was no way they would be able to get their money back?
Trade with a plan