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Economics/Debt to GDP ratio


was reading this paper - "Sustainability and bargaining benchmarks for the sovereign debt to GDP ratio", and it says on page 8 "the lower inflation regime entails a higher sustainable debt to GDP ratio".
Isn`t it the opposite normally true, inflation helps to lower debt to GDP ratio?
Another question, I found this paper because I was trying the find the reason for the limits on government deficit of 3% of GDP and debt 60% of GDP imposed by the European Union Growth and Stability Pact. Although I think I got the reason for the value of 60% from the paper, I failed to find an explanation for the 3%. I would appreciate if you could help me with this.
Thank you in advance
Best Regards

This is a really great question, because this issue is much more complicated than it first appears.

The short answer is ignorance.  They choose 3% and 60% as generally arbitrary numbers that are more politically motivated than economically motivated.  They know they want to reduce their debt but they don't really know how, other than to spend less, an action that has become to be known as "austerity".  That's not a very good answer, though, so let's look at it in more detail.

First let's look at national debt and budget deficits.  As you probably already know, since it sounds like you've done your homework, a budget deficit occurs when a government spends more money in any given fiscal year than it generates in revenues.  In order to make-up for the excess spending, they sell debt (e.g.: bonds, bills, notes) to investors.  The amount of debt sold to account for that year's fiscal deficit contributes to the total national debt.  The government must then pay back the principle balance plus interest for all national debt.

Now, here's where it gets a little trickier.  Not all debt is bad; it depends entirely on what you do with it.  The goal of any expenditure is to generate the highest return on investment possible.  For an individual, they put their money into accounts and investments.  For a business, they put their money into investments or equipment.  For a government, they put their money into infrastructure and public services.  In each case, they are attempting to generate revenues.
An individual generates returns by accruing interest on their accounts or by selling their asset investments once they've appreciated in value.
Businesses will sell their asset investments once they've appreciated in value, or sell the goods/services that their equipment produces for revenues.
Governments earn revenues by collecting taxes, so they increase their revenues by investing in projects that will generate national value, thereby increasing the total amount that people and business are being taxed on.

In other words (example):
If government A has only an income tax (both individuals and businesses) of 10% and its people make $1 million total, then the government will generate $100,000.
If government A invests in public infrastructure thereby increasing the nation's production potential and increasing total income to $2 million, then the government will generate $200,000, a 100% increase in tax revenues without actually increasing tax rates.

The problem is that most government don't actually do this.  They make spending and taxation decisions based on political and personal motives, rather than economic ones, resulting in negative returns on investment for their fiscal policy, and leading to larger debt and interest payments than their GDP can sustain, because the spending isn't actually being used to improve GDP.

Now that we've gotten that out of the way, what's the role of inflation in all this?  Again, it really depends.  Inflationary pressure comes from 3 primary sources.
Cost-push inflation: This happens when the cost of operating increases, especially when the driver of the cost increase is something that is broadly used in production like oil or food.  If government debt is used in a way that reduces costs, then it can alleviate cost-push inflationary pressures.  If it's used incorrectly, then the government will actually end up paying higher rates of interest than they generate in revenues, and may have to increase tax rates thereby increasing costs.

Demand-pull inflation: This happens when aggregate demand exceeds aggregate supply, not only allowing businesses to increase prices through natural market negotiations, but also forces them to as they expand their own production potential by hiring more people or purchasing additional equipment/facilities, etc.  When used correctly, government spending can help to expand aggregate supply through technological and research investing, thereby increasing GDP at a rate faster than the differential in AD and AS, relieving inflationary pressure.  If don't incorrectly, government spending will actually increase AD even further, while also depreciating the currency and increasing demand for domestic exports, contributing to economic bubbles and volatility through artificially high inflation.

Monetary inflation: The result of monetary policy.  I'm not even going to touch on this one, because if you need to use fiscal policy to offset your monetary policy, then whoever is in charge is an idiot and the best option would be to just fire them.  Out of a cannon.  Into orbit.  Mars' orbit.  Maybe Saturn's.  Somewhere far away.

Generally speaking, a higher debt/GDP ratio will result in higher rates of inflation as a currency is devalued via higher interest rates on debt required to attract investors, lower demand for goods, increased spending on goods as a result of interest payments causing resource inefficiencies, etc.  Again, that's because government's are bad at managing their assets resulting in negative ROI, so a larger proportion of total debt is contributing to national devaluation, rather than positive GDP growth.  If a government is actually good at what they've been tasked to do, then the debt they incur will still contribute to GDP growth at a faster rate than total debt, because of the positive ROI (which, by the way, allows governments to pay-off their debt, compared to blind austerity, which simply dries-up cash flows without consideration for ROI).

Will inflation actually influence GDP?  Sometimes, sure.  Inflation devalues a currency internationally, causing a nation's exports to become cheaper relative to other nations, increasing demand for exports.  If the inflation starts with higher wages, labor-based stimulus spending, or certain types of expansionary monetary policy, then people will buy-up surplus inventories and push businesses to expand production in order to meet higher rates of demand.  It can also lower GDP, if you're not careful.  During a boom cycle, specifically, increasing money supply when the economy is already in full employment and expanding broadly can result in unsustainable growth bubbles.  Not only does the devaluation of currency increase the velocity with which money moves (meaning that people are spending greater volumes) while prices remain sticky, our exports also become cheaper relative to other nations as inflation devalues our currency in international exchanges, causing an increase in demand for our exports.  This forces companies to greatly increase their production potential using long-term investment for an economic condition that is temporary, which will result in surplus production potential after that bubble ends, forcing companies to then fire people to cut costs, resulting in higher unemployment and debt problems as people who counted on that income to pay-off debt they've incurred default, causing lost revenues for companies, and potentially triggering the early stages of a bad recession.  This is, of course, in addition to the resource inefficiencies that result from the artificially high domestic demand that causes nations to trade on currency fluctuations rather than comparative advantages.  These inefficiencies also result in long-run loss of competitiveness as costs increase from factor price disequilibrium.

Inflation can also increase or decrease the debt variable in this ratio.  Too much inflation can cause investors, traders, and even businesses to demand higher returns in order to account for the higher rates of inflation causing their currency reserves to devalue in real terms, making things more expensive and contributing more greatly to debt.  It can also decrease the ratio if the inflation contributes to demand more greatly than the nominal/real adjustment in debt, causing GDP to increase faster than inflation.

So, in short, it's not the size that matters, it's what you do with it!  The 60% and the 3% are most likely based on linear cost analytics, as most household budgets perform, which says that they make $x and to pay off their debt in Zyears, they must keep the deficit below y%, rather than actually being concerned with ROI at all.  That's how the world's governments do it.


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Michael Taillard


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Economic Consulting: American Red Cross; US Strategic Command -- Economics Lecturing: Bellevue University (Bellevue, NE) Huijia College (Beijing), OPII Schools (Omaha), Madonna University (Livonia), Schoolcraft College (Livonia), ZomBCon (Seattle), Zombiefest (Lincoln) -- Media Appearances: Dead Man Working (2012 Movie documentary), The Heartland News (Omaha local news outlet)

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Economics and Modern Warfare: The Invisible Fist of the Market (Palgrave Macmillan) -- 101 Things Everyone Should Know about Global Economics (Adams Media) -- Corporate Finance for Dummies (Wiley) -- Psychology and Modern Warfare (Palgrave Macmillan) -- Analytics and Modern Warfare (Palgrave Macmillan)

PhD (Financial Economics; honors) -- MBA (International Business Finance; honors) -- Grad School Certificate (International Business Management; honors) -- BS (International Business Economics; honors) -- AA (Business Administration; honors) -- Certificate (Chinese Language and Culture) -- Trade School (Transportation Logistics; honors)

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