Lesson 2 of 5 · 14 min
Deficits, national debt and whether debt matters
A deficit is a one-year flow and the national debt is the stock of past deficits; whether a high debt-to-GDP ratio matters depends on growth versus interest rates, inflation, who owns the debt, what it financed and how long it lasts.
In short
- Deficit = revenue minus spending over a period (a flow). National debt = the accumulation of past deficits (a stock), financed by borrowing mostly from the private sector.
- If real growth is below the real interest rate on the debt, the debt-to-GDP ratio rises even with a growing economy. Inflation shrinks the real value of debt; deflation keeps the ratio high.
- Beyond some unknown level, debt raises solvency doubts; interest payments to GDP is a second warning indicator.
- Reasons not to worry: debt owed to own citizens, borrowing that funds productive investment, a chance to fix distorting taxes, Ricardian equivalence, and unemployment (no resources diverted).
- Reasons to worry: higher future tax rates that weaken incentives, money printing and inflation if markets lose confidence, and crowding out of private investment.
- Crowding out and tax distortions are mild over a few years but damage capital accumulation if they persist.
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