A Fable of Two Countries
By Arnold Kling
Once, there were two countries, I and U. Each had GDP of $100. Each had nominal GDP growth of 4 percent.
Country I was a good country, with government debt of only $60, taxes of $20, and spending on everything other than interest payments of only $19.
Country U was a bad country, with government debt of $80, taxes of $20, and spending on everything other than interest payments of $25.
Oddly enough, the bond market vigilantes were mixed up. They charged a high interest rate (7 percent) to country I and a low interest rate (2 percent) to country U. Thus, country I’s ratio of debt to GDP kept growing and growing. Interest on the debt was $7, other spending was $19, and taxes were only $20, so it had an overall deficit of $6. Its GDP only grew by $4, so its debt rose by $2 more than GDP. Country I had a sovereign debt crisis.
Country U did not have a sovereign debt crisis. Yet.