The economic crisis for dummies (pt.2)

And so, for another crash course on the economy and what to do about it, we turn our focus today to the deficit.

Our independent and trusted economist is Randy Clayton, CFP. He is the founder and a principal of Clayton Financial Services, Inc., a financial planning and investment advisory firm formed in 1984. He is also coincidentally my father.

“A country’s debt is not easy to explain. There is public debt, sometimes referred as the national debt, and then there is external debt which governments owe both citizens and foreigners. Most economists attempt to compare a country’s total (public and external) debt in relationship to what that country produces (GNP). This would be similar to comparing a family’s total debt in relationship to what that family earns annually. Let me give you an example;
John and Mary Doe have a combined annual income of $ 100,000 (US$).  Their total debt (including car loans, mortgages and credit cards) total $ 37,000. Most financial experts would say that the Doe family has low, manageable debt. The United States has a debt that is equal to 37% of what is produces (GNP). The EU appears to have debt equal to approximately 30% of it’s GNP, and Russia is about 31% of its GNP. These debt numbers and GNP numbers come from the respective governments and should be viewed with some skepticism, but nevertheless help explain concepts. But the bottom-line is that none of these economies are “in trouble”.
Trends are important. Over the past five years the US has spent approximately 500 million more per year than it took in from various sources (the main source is taxation of its citizens). This 500 million (and interest) gets added the national debt. If a country is growing output, which translates to income (GNP), then an increasing debt is acceptable. If the economy slows (slower that it’s debt increases), as is the case with both the US and EU, then there is the potential for longer term problems because interest on the debt has to be paid, typically through increasing taxes and or fees. Russia’s economy is currently growing faster than both the EU and US because of oil revenues, so as long as oil prices remain high, debt doesn’t appear to be a concern.
During periods of slower economic growth, the annual deficit tends to get larger, which in turn means the national debt grows. During periods of faster economic growth, annual deficits decline because the government takes a share of that growth (in the form of higher tax revenues).
Typically increasing taxes have the potential to slow a country’ s economic growth, and lowering taxes can stimulate it.  The same is true with interest rates.
Each country attempts a balancing act of higher versus lower taxes (revenues), faster versus lower economic growth, higher versus lower interest rates, and higher versus lower government spending (annual deficits). The job is extremely difficult because political parties get involved with government spending, essentially trying to buy votes, and because global competition can impact what a country can produce to generate income. In addition, different economies in the world expand and contract at different times (although there are some correlations), which may result with one economy lowering interest rates while another is raising interest rates. Since there are some correlations (interdependence) between economies, lowering rates in one economy may negate the impact of raising rates of another.

But that’s another issue……”

Check out our last economics for dummies like me entry here where we discussed whether or not we were in a recession.