The purpose behind this analysis is to indicate whether Japans and the US`s debt and deficits are unsustainable and when the trend in deficits could cause a loss of confidence and rapidly increasing borrowing costs. PDS is a way to tell if America and Japan are becoming Greece.
The PDS is a tool used to define sustainable deficits for economies and a way to monitor public finances. This analytic framework, which can be expressed as an equation, measures whether national debt and deficits are sustainable, when the trend in deficits could cause a loss of confidence and rapidly increasing borrowing costs for a given country.
The key factors in the PDS are borrowing costs (B), real output (R), inflation (I), taxes (T) and spending (S).
Real output plus inflation (R+I) is the total value of goods and services produced in an economy, also called nominal gross domestic product (NGDP)
Taxes minus spending (T-S) is called the primary deficit. The primary deficit is the excess of what a country spends over what it collects in taxes. In calculating the primary deficit, spending does not include interest on the national debt. This is not because interest expense does not matter, in fact it matters a lot. However, the whole purpose of the PDS framework is to illuminate the extent to which a given economy can afford the interest and ultimately the debt. Interest is excluded from the primary deficit calculation in order to see if the other factors combine in such a way that the interest is affordable. Interest on the debt is taken into account in the formula as B, borrowing costs.
An economy’s deficits are sustainable if the economic output minus interest expense is greater than the primary deficit. This means the economy is paying interest and producing a little extra to pay down debt. But if economic output minus interest expense is less than the primary deficit, then over time the risk occurs that the deficits will overwhelm the economy.
What matters is not the debt and the deficit level, but the trend as a percentage of GDP. If the levels are trending down, the situation is manageable, and debt markets will provide time to stay on the path. Sustainability does not mean that deficits must go away, in fact, deficits can grow larger. What matters is that total debt as a percentage GDP becomes smaller because nominal GDP grows faster than deficits plus interest.
Expressed in the form of an equation, sustainability looks like this;
If (R + I) – B > |T-S|, then a economy`s deficits are sustainable. Conversely, if
(R + I) – B < |T-S|, deficits are not sustainable.
The PDS by itself does not explain which actions to take or what ideal policy should be. What is does is allow one to understand the consequences of specific choices. PDS is a device for conducting thought experiments on different policy combinations, and it acts as the bridge connecting fiscal and monetary solutions.
For example, one way to improve debt sustainability is to increase taxes. Alternatively if taxes are held steady but spending is cut, then the primary deficit also shrinks, producing a move towards sustainability.
Another way to move towards sustainability is to increase real growth. An increase in real growth means more funds are available after interest expense, to reduce debt as a percentage of GDP.
USA as an example:
B = 2.4% Interest rate on 10 Year T NO
R = 2.9% (GDP annual growth rate)
|T-S| = 2.8% (US Budget deficit)
I = 0% (Inflation rate)
(R +I) – B < |T-S|
2.9 + 0 – 2.4 < 2.8%
0.5 < 2.8
The current state for the US economy shows that real growth plus inflation minus interest expense is less than the primary deficit, which means that debt as a percentage of GDP is increasing. This is the unsustainable condition. Again, what matters in this model is not the level but the trend.
Japan as an example:
I = 0.5% (Inflation rate)
B = 0.47% (Government Bond 10Y)
|T-S| = 7.7% (Budget deficit)
R = -0.9% (GDP annual growth rate)
(R +I) – B < |T-S|
(-0.9 + 0.5) – 0.47 < 7.7
From the PDS framework we can draw the same conclusion for Japan as for the US. Real growth plus inflation minus interest expense is less than the primary deficit, which means that debt as a percentage of GDP is increasing. The only difference between the US and Japan is that the trend towards unsustainability is growing at a much faster paste for Japan compared to the US.
The purpose behind this analysis is to indicate whether Japans and the US`s debt and deficits are unsustainable and when the trend in deficits could cause a loss of confidence and rapidly increasing borrowing costs for both countries. PDS is a way to tell if America and Japan are becoming Greece.
From 2006 to 2012 Greece`s government debt to GDP ratio rapidly increased from 100% to 170%, which led to a dramatic spike in the borrowing cost for the Southern European nation.