"We can/cannot live above our means." Tick the right response.
It is the literal truth that "pay later" need never become "pay now" as long as old credit card debt can be repaid from new credit card debt. No musical chairs, no Ponzi scheme, no fraud is involved. As long as such parameters as interest rates, income-to-debt ratios and income growth remain within the right range, we can go on and on, spending more than we earn.
But can this be really true? Output must equal input, expenditure must equal revenue; how can consumption permanently exceed production? Plainly, for a single economic agent alone in an inhospitable environment, it cannot. But if he interacts with a fertile Nature, or with other persons, interesting and instructive possibilities open up. They have obvious relevance to a burning problem of our day, the catastrophic or at least catastrophic-looking budget deficits that dominate the economic landscape. Some alternative cases may be worth a brief review.
Case 1. Economic agents know what they are doing.
Case 1a. A fisherman lives off a stock of 100 fish that reproduces itself and grows by 3 per cent each year. The fisherman eats 103 fish in the year. He is aware that he consumes the growth potential. He can raise his consumption to 104, knowing that it will have to start declining in the distant future.
Case1b. Walter and Li each have capital yielding 100. Walter consumes 103, borrowing 3 from Li who consumes 97. With each maintaining his consumption, Walter will have mortgaged all his capital to Li in 33 years. With compound interest, this will of course happen sooner. Walter will have nothing left to live on. The parties will have to "restructure" the debt. At some point, they will both be aware that something of the sort will probably have to happen.
Case 2. Economic agents are largely unaware of the effects of their actions. Since Keynes, economists have become fond of pointing out that what is true of the individual economic agent need not be true of an entire society; thrift, for instance, may be a virtue for the individual but a vice for society.
Case 2a. GSP is 100, of which 75 is consumed. Households save 7 and corporations 18. Of the total saving of 25, investment in fixed capital and stocks absorbs 20, net exports 2 and the budget deficit (i.e. government dissaving) 3. The national debt is 100. The year's deficit is added to it, raising the debt to 103. However, since GDP is also rising at 3 per cent p.a., the ratio of debt to GDP remains a constant 100 per cent. Of the annual growth of 3 per cent, 1.5 per cent is real and 1.5 per cent is due to inflation. With inflation no higher than this, the debt can probably be financed with the 10-year rate of interest at 4.5 to 4 per cent. These numbers are probably close to the situation of most major Western economies as of 2011-2012, and suggest that, as the saying goes, the worst is not inevitable. Though governments would still be living above their means, the course of these economies could be self-sustaining.
Case 2b. Like the flutter of a butterfly's wings in chaos theory, a relatively minor event in 2007 is magnified by self-fulfilling prophecies into a collapse of confidence in the financial system in 2008, and GDP falls from 100 to 95. Consumption sinks to 70, household saving is 10, corporate saving 15 and net exports zero. Gross capital formation falls to 13 and the remainder of 12 is the budget deficit. The "output gap" between potential and actual GDP, 5 in the present example, would be higher if the deficit were lower, and vice versa, though the relation between the two is, of course, not one of simple addition or subtraction. At all events, it must be recognised that the budget deficit is to some extent (and some would say, completely) redeemed by the "output gap" being smaller than it would otherwise be. It is equally clear, though, that a double-digit deficit is not sustainable for more than a very few years, and must be followed by years of corrective action that everyone approves in principle but will ferociously oppose in practice.
Case 2c. For an average Western European economy, a national debt of 100 per cent or more of GDP is a zone of acute danger. Japan's national debt will probably cross the 200 per cent mark this year or next. One must conclude, perhaps unjustly, that the Japanese must be unaware of what they are doing.
The national debt of a country is owed either to its own residents or to foreigners, and is denominated either in the home or in foreign currency. These variables permit four possible combinations. Three are currently topical. Greece owes most of its debts to non-residents (including very rich shipping magnates with their accounts in London or Cyprus), and the debt is mostly denominated in euros which the Greek state cannot print. The next-worse situation is that of the United States of America. It owes far too much of its debt to non-residents—perhaps 2 trillion dollars to East Asians—but all of it in dollars, which it can always reimburse by printing new dollars, new Treasury bills and Treasury bonds to replace the old. The best combination is that of Japan, all of whose debt is in yen and all of it is owed to Japanese residents. If the worst comes to the worst, the Japanese government can always repay its creditors by levying on them whatever taxes it takes to do so. Meanwhile, there is no pressure to repay. The Japanese state these days raises medium-term loans at 1.5 per cent p.a. (The extraordinarily low rate is the market's way of saying that it expects deflation to be resumed.) At such conditions, even a national debt of 200 per cent of GDP is sustainable.