Debt bomb debt bomb, you’re my debt bomb (on the debt-to-GDP ratio)Posted: March 1, 2015
Michael Cooney on Twitter pointed to one of the funnier mixed metaphors I’ve seen in a while: the headline on Samantha Maiden’s sneak peek at the intergenerational report: Does the bomb swallow us before it explodes, or after? You can’t blame a journalist for the headlines that get slapped on their articles (they don’t have any say on it at all) but there are some other aspects of the article itself that I think are a bit sloppy. Take the opening line:
AUSTRALIA faces a debt bomb so huge it will represent half the nation’s entire economy within two decades unless tough action is taken, according to Joe Hockey’s intergenerational report.
Or this sentence:
The report, to be released on Thursday, reveals if the Government did not change Labor’s current budget settings, net debt would represent a 50 per cent share of the nation’s entire economy within 20 years.
(Note, weirdly, the phrase: “Labor’s current budget settings”—the current government, a Liberal-National coalition, has been in power for two MYEFOs and one budget). Or again this assertion:
Without change over the next 50 years, net debt will swallow the economy and be equal to 100pc of the entire Australian economy by 2065.
Federal debt will apparently “represent” half the nation’s entire economy, or, apparently equivalently, be a “50 per cent share of the entire economy”. This is a strange way of talking about debt. Maiden is referring to the debt-to-GDP ratio, which is a fairly common way of providing some sense of scale to the size of a stock of debt. Maiden clarifies:
Australia’s gross domestic product (GDP) is a measures of national income and output and is equal to the total expenditures for all goods and services produced.
This is more or less right (it’s expenditure on all final goods and services produced within Australia’s physical borders—it doesn’t for example count intermediate goods, or goods produced by Australian-owned firms overseas) but it omits something very crucial. It’s the total output of an economy within a single year. Think of Australia’s debt as being the amount of water in a dam. It’s a single number: if it’s 100,000 megalitres, say, then that’s what it is: it’s not 100,000 megaliters per year, or per acre, or anything else: just one number that indicates how much water is in a hole in the ground. GDP, on the other hand, is like the amount of water that comes through the stream that flows into and out of your dam every year (200,000 megalitres a year, or whatever). Economists say therefore that debt is a stock, while GDP is a flow.
Now, it’s perfectly OK to compare a stock to a flow, as long as you know what the comparison then means. A debt-to-GDP ratio means, “How many years would it take to pay off the debt if we spent all of the proceeds from every final sale in the economy to paying the debt?” So when the Intergenerational Report forecasts a debt-to-GDP ratio of 100% in 2065 (a fifty-year forecast, by the way—good to do for fun, but imagine forecasting Australia’s GDP in 2015 back in 1965 and you’ll get a good idea of how accurate it’s likely to be), then what it means is it would take one year to pay off all debt if the proceeds of every final sale in the economy were devoted to that task.
What it does not mean is that net debt will be the same size as the economy, that it will “swallow” the economy, that it is in any way a numerical “share” of the economy, because none of these phrases make any economic sense at all.
To see what I mean, consider what would happen if the Earth moved a little tardier around its benevolent life-giving sun. Say that instead of taking 365.242 days to orbit the Sun, our planet took 730.484, or twice as long, to complete one orbit. Assuming nothing else changes, GDP will be twice as large (since the time frame for counting GDP is now the equivalent of two normal years). However, debt will be the same size in 2065 as it would have been under the old orbital arrangements, since, as we saw above, debt is a stock, and it doesn’t depend on how we measure time units*. In that case, the debt-to-GDP ratio will be 50%, not 100%! Crisis averted! The logical solution therefore to the threat of our economy being “swallowed” by debt in 2065 is to increase the statutory length of the year, no?
Debt-to-GDP ratios are interesting because they allow us to compare relative levels of debt across economies and across time periods. But they don’t tell us anything intrinsically interesting about an economy. There’s nothing special about a debt-to-GDP ratio of 100%, other than a sort of psychological effect that’s merely an astronomical and choice-of-base-10-numbering-system artifice, and reporters should be more careful about how they describe these things if they don’t want to mislead their readers.
There are other problems, generally speaking, with the reporting of Australian debt in the lead up to the Intergenerational Report: but here I refer you though to Michael Harris’s excellent piece on a number of conceptual and philosophical errors that people often make and to Sam Hurley’s piece on why we need to have a broader conception of what matters to future generations than just the net present value of future deficits.
(*Assuming interest accrues at an economically equivalent rate with these new longer years.)