Friday, December 7, 2012

Inflation and Government Deficit Accounting for the 1970’s

Let’s do a simple example of what Robert Barro meant by this:
one-to-one effect of expected inflation on nominal debt growth
as a follow to my and Brad DeLong’s critique of Donald Thorton who noted that the nominal value of government debt rose by an average of 2.1% of GDP during the 1970’s and that this nominal deficit showed variability. The 1970’s also had high and volatile inflation. During this decade, the GDP deflator doubled, which means the inflation rate average 7%. The nominal interest rate on long-term government bonds averaged 8% implying an average real interest rate equal to 1%. Our example will assume that GDP equals $5000 billion and the normally stated deficit equals $100 billion (2% of GDP). Let's also assume an initial debt/GDP ratio = 34% so the debt begins at $1700 billion. If the nominal interest rate is 8%, then nominal interest expense alone is $136 billion so the non-interest portion of the government accounts represents a $36 billion surplus. Now if you protest that we must also include interest expenses, economists such as Robert Barro and even Milton Friedman would note that real interest expense is what matters for the increase in the real value of government debt. In our example, real interest expense only $17 billion. So when Brad writes:
Why 1970--when nothing happens to derange either the pattern of deficits as a share of GDP or the trajectory of the debt-to-GDP ratio--rather than 1980, when the election of Ronald Reagan does change the pattern of deficits and the trajectory of the debt-to-GDP ratio?
We can read this as noting the path of the real value of the government debt. My problem with Thornton’s paper and the blog post from Tim Taylor as the money illusion distortion in the reporting of deficits during high inflation was widely discussed during the late 1970’s and should be part of any economist’s recognition when discussing fiscal policy during this era.

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