Sunday, March 4, 2012

The Eurozone’s balmy 0.5% deficit limit.

The EZ wants structural deficits to be no more than 0.5%, with a maximum total deficit for any country of 3%. (A “structural deficit” is the deficit that exists when an economy is at capacity.)

There is a simple flaw in the 0.5% deficit limit. You need the maths skills of a five year old to understand it. I’ve set it out several times before on this blog. But I’ll do it again.

The EZ, like most monetarily sovereign countries / areas, targets a rate of inflation of about 2%. (I’ll treat the EZ as a nation by the way.)

That means that the national debt and monetary base of the nation will shrink at 2% a year unless the debt and base are regularly topped up in nominal terms. And that means enough deficit to effect the topping up. So let’s do some back of the envelope calculations so as to see how big the deficit needs to be to effect this topping up.

Say the debt and base are 50% of GDP. Given the 2% rate of inflation, the deficit needs to be 1% of GDP, (50% of 2%). Which is DOUBLE the above 0.5%!!! But it gets worse.

Assuming economic growth of let’s say 2%, yet another 1% worth of deficit is need (50% times 2% again).

So the total structural deficit needs to be 2% of GDP, not 0.5%.

Or have I missed something?


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