But why does Debt/GDP need to come down? So, we are told, that the debt doesn't become unsustainable - that is, impossible for the government to at least pay the interest owing on the debt.
In reality, it turns out that the Debt/GDP ratio can be a very big number indeed, with the government still able to service it's debt. So targeting a lower Debt/GDP ratio is not necessary. And this is important because we are told that we must endure some pain (it's generally agreed that lowering the deficit will have detrimental effects on the economy in the short-term) in order to reduce Debt/GDP. We are needlessly facing austerity so that an arbitrary outcome may be achieved!
Ok, now for some pretty simple math. Obviously any projection that results in a Debt/GDP ratio heading toward infinity is not good - the interest bill on an infinitely large amount is unsustainable! So how could this occur?
For any given year, we have these statistics:
- GrowthRate = the change in GDP (the GDP growth rate, or how much the economy has grown)
- InterestRate = the interest rate on the government debt
- DeficitRatio = the deficit divided by the GDP (a negative number if there is a surplus for the year)
If we assume that these values remain constant, it turns out that over time, the Debt/GDP ratio approaches this equation: DeficitRatio / (GrowthRate - InterestRate)
For example, if GrowthRate = 4%, InterestRate = 2%, and DeficitRatio = 8%, then the Debt/GDP ratio will stabilise at 8 / (4 - 2) = 400%. Given these values, a government could run an 8% deficit indefinitely! It would never need to have a surplus. The key is that the GrowthRate is greater than the InterestRate, otherwise Debt/GDP will eventually grow to infinity (applying the equation above).
The thing about the interest rate on government debt is that the Reserve Bank effectively controls it. So it can always set the interest rate below the growth rate. But what if inflation rears its ugly head and the Reserve Bank has to raise interest rates to try and reign it in? This is possible, and the interest rate may exceed the growth rate for a period of time. However if inflation is apparent, then we are very likely seeing GDP growth too! Obviously during recessions we'll see GDP growth below the interest rate (as GDP growth is negative), but this is usually only for short periods of time.
As long as on average, between economic booms and busts, we are seeing a growth rate that is greater than the interest rate on the government debt, then the government can run deficits in perpetuity!
Some links to read with more math/proof etc:
http://www.economonitor.com/lrwray/2013/01/07/bond-vigilantes-and-math-sustainability-of-fiscal-deficits/
http://neweconomicperspectives.org/2012/12/functional-finance-and-the-debt-ratio-part-i.html
