And thinking about the size of a country's national debt. The first thing we want to do is to establish a benchmark of comparison. So with a drum roll please, let's roll out the yardstick of the debt to GDP ratio. The reason economists like to compare the size of a nation's public debt to its gross domestic product is simple. In the abstract, a $5 trillion national debt, is a very large number. However, such a debt would pose a far more crushing burden to a small nation such as Thailand, than it does to say, the United States or China. Accordingly, comparing the debt to the GDP gives us a measure of a nation's ability to produce, and therefore its ability to pay off its debt. It's not just the debt to GDP ratio that we have to think about when assessing the nation's debt burden. It's also important to distinguish between the real and nominal budget deficits. This distinction is important, because it allows us to measure how inflation in any given year actually reduces the effective burden of the debt. To see this critical key point, let's define our terms, and then do an example. The real deficit in any given year, is the actual or nominal deficit, adjusted for inflation's effect on the debt. In particular, the real deficit equals the nominal deficit, minus the inflation rate, times the total debt. The key concept here is that while a country may add to its budget deficit in any given year, inflation in that year, will erode the value and therefore the burden of the total debt. So, if the nominal deficit in your country is $100 billion, inflation is 10%, and the total debt is $5 trillion, what's the real deficit? If you said minus $400 billion, you're right. Here's the math. The inflation rate of 10%, times the existing debt of $5 trillion, is $500 billion. Now subtract this from the nominal deficit of $100 billion, and you get a real deficit of minus $400 billion. And here's the key point. Even though your country is running a nominal budget deficit, inflation has actually eroded the value and therefore burden of the total debt. This suggests that one way the government of any nation can lower the burden of the national debt, is by increasing the inflation rate. A strategy known in public finance as inflating the debt. Perhaps needless to say, this is a controversial strategy to reduce the debt. And a cynical one as well if you happen to be one of the bondholders, stuck with a bond that has been eroded by inflation. One must also hasten to add here, that such a strategy can only work if the inflation is unanticipated. Otherwise, bondholders will demand a higher interest rate to compensate for the anticipated inflation, and thereby drive up the nominal deficit through higher interest payments. So, the dance of public finance goes. In our next module, we will look at an even more interesting element of budget deficits. As we specifically distinguish between the structural versus cyclical components of the budget deficit.
