The Debt/GDP Ratio Is NOT Useful. What You Need To Know 2
What are measures of stock and flow, and how are they pertinent to understanding the limitations of the Debt/GDP ratio?
A simple way to conceptualize stock vs flow is to think of filling up a bathtub with water from a running faucet.
Stock is the volume of water in the bathtub, and flow is the volume of water being added to the tub from the faucet.
Should the tub’s stopper not be in place, thereby allowing water to flow out at a faster rate than it is being added in, then the measurement of flow will be negative.
For those inclined to less abstract parallels, a company’s balance sheet is a stock measurement, as it provides a snapshot of its financials at a single point in time.
Its income and cash flow statements are flow measurements, as they measure changes to the company’s financials.
Since stock and flow inherently measure different things, they can’t really be compared to each other.
That is, stock measurements need to be compared against other stock measurements, and flow with flow.
If this confuses you, think of the unstoppered bathtub.
Would it be more informative/appropriate to compare the outflow of water with the amount of water in the tub, or with the inflow of water from the tap?
Naturally, the inflow of water is the better comparison, since if the inflow is larger than the outflow, the net change to the volume of water in the tub is positive. Should the other comparison be used, that is, the outflow of water with the volume of water in the tub, one would reach the incorrect conclusion that the volume of water is decreasing.
The same concepts apply to a country’s (or for that matter a company’s or individual’s) financials.
Total debt is a stock measurement, while GDP is a flow measurement, and comparing the two doesn’t really provide an accurate picture of a country’s ability to sustain its debt.
A better measure would be to calculate the ratio of government tax receipts against interest payments.
Both are flow measures and their ratio will show if a government is generating enough revenue to cover its interest expense for the fiscal year.
The corporate equivalent of this is the interest coverage ratio, which takes a company’s operating income divided by its interest expense. Again, 2 flow measures are being compared to each other, money coming in from operations vs money going out as interest payments.
To be continued…
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