Accumulation of budget deficits results in the accumulation of government borrowings. It is important to look at a country’s debt to GDP and interest payments to GDP ratios.
As long as an economy grows at a rate greater than the real interest rate, it can service its debt, but if real growth rate is lower than the real interest rate, a government’s debt to GDP ratio may worsen because the debt burden (real interest times real debt) may grow at a rate greater than economic output and tax revenues. When the price level increases, the real value of outstanding debt may fall, but if the price level decreases (i.e. there is deflation), the debt to GDP ratio may increase.
Reasons why we should not be concerned about high fiscal deficits and debt to GDP:
- The scale of the problem may be overstated if the debt is owed internally to fellow citizens.
- Debt is used for capital investments or enhancing human capital, which should lead to an increase in future output and taxes.
- Fiscal deficits required tax changes which may update and streamline tax laws.
- The private sector may act to offset fiscal deficits by increasing savings in anticipation of future increase in taxes (called Ricardian equivalence).
- If employment is currently low, fiscal deficit may spur an increase in output and employment.
Reasons why we should not be concerned about high fiscal deficit and debt to GDP:
- High debt must be financed with high taxes which reduces investment and long-term growth
- Central banks may have to print money to fund deficit which runs the risk of hyperinflation.
- Government borrowing may crowd-out private investments by causing a higher interest rate, particularly in the long-run.