The EZ wants structural deficits to be no more than 0.5%, with a maximum total deficit for any country of 3%. (A “structural deficit” is the deficit that exists when an economy is at capacity.)

There is a simple flaw in the 0.5% deficit limit. You need the maths skills of a five year old to understand it. I’ve set it out several times before on this blog. But I’ll do it again.

The EZ, like most monetarily sovereign countries / areas, targets a rate of inflation of about 2%. (I’ll treat the EZ as a nation by the way.)

That means that the national debt and monetary base of the nation will shrink at 2% a year unless the debt and base are regularly topped up in nominal terms. And that means enough deficit to effect the topping up. So let’s do some back of the envelope calculations so as to see how big the deficit needs to be to effect this topping up.

Say the debt and base are 50% of GDP. Given the 2% rate of inflation, the deficit needs to be 1% of GDP, (50% of 2%). Which is DOUBLE the above 0.5%!!! But it gets worse.

Assuming economic growth of let’s say 2%, yet another 1% worth of deficit is need (50% times 2% again).

So the total structural deficit needs to be 2% of GDP, not 0.5%.

Or have I missed something?

.

The EZ wants structural deficits to be no more than 0.5%, with a maximum total deficit for any country of 3%. (A “structural deficit” is the deficit that exists when an economy is at capacity.)

There is a simple flaw in the 0.5% deficit limit. You need the maths skills of a five year old to understand it. I’ve set it out several times before on this blog. But I’ll do it again.

The EZ, like most monetarily sovereign countries / areas, targets a rate of inflation of about 2%. (I’ll treat the EZ as a nation by the way.)

That means that the national debt and monetary base of the nation will shrink at 2% a year unless the debt and base are regularly topped up in nominal terms. And that means enough deficit to effect the topping up. So let’s do some back of the envelope calculations so as to see how big the deficit needs to be to effect this topping up.

Say the debt and base are 50% of GDP. Given the 2% rate of inflation, the deficit needs to be 1% of GDP, (50% of 2%). Which is DOUBLE the above 0.5%!!! But it gets worse.

Assuming economic growth of let’s say 2%, yet another 1% worth of deficit is need (50% times 2% again).

So the total structural deficit needs to be 2% of GDP, not 0.5%.

Or have I missed something?

.

Or alternatively on top of 0.5% budget deficit a 1.5% current account surplus

ReplyDeleteBarmy, not balmy, Musgrave.

ReplyDeleteStill, carry on.

paul

Is there really a stock constraint here? At constant money (debt) stock can't inflation simply be absorbed by an increase in velocity?

ReplyDeleteCig, Yes, inflation could be “absorbed by an increase in velocity”. But I was making the “all else equal” assumption, which is a reasonable assumption to make. Put another way, and making the over-simple assumption that the only financial assets that households have is government debt and monetary base, then when households find their financial assets shrinking in real terms because of inflation, they’ll respond by saving, and one would get paradox of thrift unemployment.

ReplyDeleteOk, but if the eurozone is to work people shouldn't use member state bonds as a risk free asset, low deficit do thus go in the right direction. In a non zero interest rate environment the rate can be moved accordingly, and I guess that's part of the deficit limits rationale.

ReplyDeleteIf the zero bound is hit or rates don't work for some reason or other, as arguably pretty likely, then you need ecb or federal treasury money (and that will most likely happen sooner or later). Under no scenario I can think of you want individual principalities to emit excess debt.

If your model assumes that eurozone gov debt equals the sum of principalities' debt it is outdated I think. Excluding the federal treasury on the pretext it's not quite fully embodied is not reasonable it seems to me.