Deficits and growth of GDP

June 24, 2007

According to the conventional wisdom of the past few years public sector deficits are supposed to crowd out private investment and reduce overall economic growth in all circumstances.

But the latest OECD data on growth and public sector balances shows that it is not so.
The following table makes it clear that one cannot draw this conclusion.The reality is much more complicated.

Factors like the stage of development of the country, the level of real interest rates that is the nominal rate less the inflation rate and the level of unemployment(generally speaking countries at earlier stages of development like China and India with large rural populations will have the challenge of absorbing surplus workers from the agricultural sector as the country develops rapidly) and capacity utilization all must be factored into the equation.

What is interesting is to see how many countries with positive growth rates and moderate to low levels of unemployment and low or even negative inflation are running public sector deficits without noticeable harm to their economies.Growth is still quite positive, inflation low and interest rates also low.

I suspect that so long as the real rate of interest is kept low, deficits are very stimulative of both economic growth and job creation. Whatever crowding out occurs is strictly the creation of the central bank and its decision to raise interest rates excessively.Absent this crowding in rather than crowding out is the norm.

Cntry grwth   budg.bal.       infl.rate       unempl.   interest
        rate                                               rate         rate

China 11.1     -1.3               3.4             9.8           3.05

India   9.1       -3.4               6.7             7.6           8.52

Japan   2.6       -4.4               -0.1           3.8           0.60

US       1.9     -1.7               2.6             4.5           5.25

UK       2.9     -2.8             2.5             5.5       5.82        

Italy     2.3       -2.6             1.6               6.5       4.15

France   2.1     -2.9             1.1               8.2       4.15

Greece   4.6     -2.2             3.1               9.0       4.15

Czech
republic   6.1   -4.1             2.3               6.4         2.92

Israel     5.4     -1.0             -1.3             7.7         3.77

Mexico     2.6   -0.2             3.9               3.6         7.20

Taiwan     4.3   -2.3             nil                 4.0         3.2


All numbers are percentages. Source: The Economist June 16, 2007 and OECD. Interest rate is the short term 3 month treasury bill rate and inflation is the consumer price index. A negative sign indicates a deficit.