Graphic detail | Debt dynamics

The maths behind the madness

By The Economist online

Our interactive guide to reducing government debt

GOVERNMENT debt dynamics, once an esoteric subject of interest only to macroeconomists, are suddenly in vogue. With Greece flirting with default, Italy's bond yields rising fast, and America's government bonds losing their AAA status, public-debt burdens have become dinner-party talk. Our interactive chart above shows current IMF forecasts but also allows you to input some basic economic assumptions to see where general government debt as a percentage of GDP might head.

There are two things that matter in government-debt dynamics. The difference between real interest rates and GDP growth (r-g), and the primary budget balance as a % of GDP (ie, before interest payments). In any given period the debt stock grows by the existing debt stock (d) multiplied by r-g, less the primary budget balance (p).

The simple r-g assumption is one of the most important in debt dynamics: an r-g of greater than zero (when interest rates are greater than GDP growth) means that the debt stock increases over time. An r-g of less than zero causes it to fall.

Our interactive model uses the nominal interest rate (i)—approximately equivalent to the ten-year bond yield—and allows you to input your own inflation rate, ∏. Inflation helps reduce the total debt stock over time, by reducing the real value of debt. In our model and using approximations, r-g becomes i - ∏ - g. The greater the inflation rate, the lower r-g becomes.

The second consideration is the primary budget balance. A primary budget surplus causes the debt stock to fall, by allowing the government to pay off some of the existing debt. A primary deficit needs to be financed by further borrowing. As Greece has found out to its cost, interest rates increase when governments run large budget deficits, and as they do it becomes increasingly difficult to reduce r-g to a sustainable level.

In reality, these variables are all related. When inflation rises, for instance, bondholders will expect a higher nominal interest rate on new debt. If a country runs a larger primary surplus, the interest rate it is forced to pay may fall. Adjustments in countries' deficits will also affect their growth rates. To keep matters simple, we have ignored these interactions. Our calculator shows the evolution of a government's debt stock based directly on the values for inflation, growth, interest rates and the primary deficit that you determine.

Changing these assumptions can have striking results. Using the average IMF forecasts for 2011-16, general government debt in America is expected to rise from 94% of GDP in 2010 to 129% in 2020. Assuming anaemic GDP growth of just 1.5% a year as opposed to 2.6%, and a nominal interest rate of 4% rather than 2.8%, US debt rises to 157% of GDP in 2020.

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