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The Detrimental Impact Of Low Inflation On Debt Dynamics

Since the 1970s, oil and labour shocks made even orthodox Keynesian economists more concerned about the costs of inflation. These costs were eventually recognised because an increased foreign competition became the rule inside and outside major Oecd countries. Once it was realized that inflation does not simply reflect domestic spending but is also - and possibly more - due to production costs reflecting also imports, it became harder continuing to see inflation as a mere indicator of a higher demand volume, then implying - more or less immediately - a higher output level.

Stylized facts evidence in the G-7 countries shows instead that prices lead countercyclically real GDP because they reflect also productivity patterns that are necessarily lower when the economy does not grow fast enough. In this respect, recent evidence in the EU and in other Oecd countries definitely shows that current inflation is too low.

Why is this discussion relevant today? Because one of the European Commission major goals is limiting the increase in EU countries’ Debt-to-GDP ratios, which obviously depend also on the denominator: the nominal GDP level, which is also affected by prices. When, as now in Europe, growth is generally modest and inflation also is modest (and mainly driven by base effects), even a little increase in the numerator - i.e. even a modest debt increase - is no longer offset by a nominal GDP denominator where growth and inflation are both too low.

Recently, Jens Weidmann, the Bundesbank Governor, said that Italy’s has failed to reduce its debt-to-GDP ratio, which remains consistently above 130%. On the other hand, the Bundesbank remains the central bank most concerned about inflation developments. At this point, my question is the following: Does the BUBA realize that if inflation is too low, the debt-to-GDP ratio would increase? Do they realize that reaching a target makes sometimes harder reaching the other?