UK Debt & Deficits: Nominal GDP is the Elephant in the Room
The UK’s fiscal debt and deficit targets are again in question. The well-worn story goes that there can be no deficit reduction without growth, and growth is zero-to-negative, so there can be no deficit reduction. Well, OK, but it is nominal GDP growth which we care about. Tax revenues follow nominal GDP, and it is nominal GDP which is the denominator in the debt/GDP ratio. David Beckworth has illustrated how clearly this plays out in the Eurozone.
Real GDP growth is almost irrelevant in this context. A few years of 1980s-style 8-10% nominal GDP would (given continued moderation in public spending growth) eradicate the deficit in just a few years, even if there was no associated real GDP growth. So economists who only ever talk about the real GDP numbers, and draw conclusions about the deficit or public sector debt/GDP, miss the elephant in the room.
On this subject I am fascinated by the game theory of fiscal vs monetary policy, and loved this 1996 paper by Simon Power and Nick Rowe on policy coordination, courtesy of Lars Christensen. It seems remarkably prescient. We clearly do not have well coordinated policy at the moment; the Treasury is “trying” to run smaller deficits, but the Bank of England keeps suppressing NGDP growth so as to avoid overshooting its inflation target too much. And because the Bank “moves” (sets policy) every month, the Bank wins, and the Treasury loses – to oversimplify a bit.
Here’s a graph showing how badly the Bank has performed against the OBR‘s forecasts for NGDP growth used in the fiscal plans. The OBR keep revising their forecasts down, and are currently expecting 3.3% NGDP growth for calendar year 2012. To hit this starting from the sub-2% annualized growth rates seen in Q1 and Q2, a sharp jump will be required in Q3 and Q4.
A scary prospect here is the negative feedback loop. The OBR become more pessimistic about the supply-side over time as their growth forecasts are missed, and lower their estimate of potential output. This requires the Treasury to consider more of the deficit “structural” and less “cyclical”, and tighten the fiscal stance. When this is done by raising indirect taxes it pushes up inflation, as happened in 2011 with VAT and numerous smaller duty changes. The Bank of England then see higher inflation, downgrade their own estimate of potential supply capacity, and presume we don’t need more demand stimulus.
Inflation targeting done badly is really, really bad.