Assume the central bank keeps the inflation rate steady and equal to the nominal interest rate. Under these monetary conditions, a government can push the primary fiscal balance (the difference between spending and taxation net interest payments) into surplus and drive down the public debt ratio even if the fiscal austerity causes a recession.
Answer: True
The answer is True.
The mainstream framework for analysing the so-called "financing" choices faced by a government (taxation, debt-issuance, money creation) - the government budget constraint - is written as:
Which you can read in English as saying that Budget deficit = Government spending + Government interest payments - Tax receipts must equal (be "financed" by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.
While the mainstream textbooks think of this relationship as a financing constraint, in fact, in a stock-flow consistent macroeconomics, this relationship will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been corrected added and subtracted.
So from the perspective of Modern Monetary Theory (MMT), the previous equation is just an ex post accounting identity that has to be true by definition and has no real economic importance.
For the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).
That interpretation is inapplicable when applied to a sovereign government that issues its own currency.
But the accounting relationship can be manipulated to provide an expression linking deficits and changes in the public debt ratio.
The following equation expresses the relationships above as proportions of GDP:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP. A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The real interest rate is the difference between the nominal interest rate and the inflation rate. If inflation is maintained at a rate equal to the interest rate then the real interest rate is constant.
In that case, the debt ratio will change according to the difference between the real GDP growth rate and the primary budget balance. If g = 1 (real growth 1 per cent) and the primary budget deficit was 1 per cent of GDP, then the public debt ratio would remain unchanged.
A growing economy can absorb more debt and keep the debt ratio constant or falling.
Equally, the public debt ratio can still fall even if real GDP growth is negative (recession) as long as the primary surplus is larger than the negative real GDP growth rate.
So if r = 0, and g = -1, a primary surplus equal to 2 per cent of GDP would see the public debt ratio fall by 1 per cent.
Thus the answer is True.
The reality is that in times of recession, a primary surplus will in all probability lead to a negative real GDP growth rate of a much larger proportion and so the public debt ratio rises, defeating the purpose of the austerity.
Similarly, a nation running a primary deficit can reduce its public debt ratio over time or hold them constant if growth is stimulated.
Further, you can see that even with a rising primary deficit, if output growth (g) is sufficiently greater than the real interest rate (r) then the debt ratio can fall from its value last period.
Depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.
Clearly, the real growth rate has limits and that would limit the ability of a government (that voluntarily issues debt) to hold the debt ratio constant while expanding its budget deficit as a proportion of GDP.
The following blog post may be of further interest to you: