Monday, August 22, 2011

Why Inflation Doesn't Necessarily Benefit Debtors

One common argument for more inflation is that it helps debtors by reducing the real burden of debt. And because reducing the real burden of debt supposedly makes it easier for debtors to repay their debt, inflation might not be so harmful even for creditors as the direct loss from inflation is to a large extent compensated for by a reduction in formal credit losses.

There is a limited degree of truth in this as it is possible for inflation to benefit debtors if it doesn't reduce real income. Assuming a positive, non-existent or only marginally negative effect on real income, inflation does benefit debtors. However, this assumption is often not applicable.

That most economists see the positive effects of inflation for debtors as something that is obviously and universally true comes from their implicit adoption -in this context- of the naive monetarist view of inflation. The naive monetarist view of inflation is that if you increase money supply by x% then all prices and everyone's nominal income will increase by exactly x%.

But that is not how the inflation process works in the real world. In the real world, some prices increase faster and quicker than others, while some prices aren't affected at all. Exactly which prices increases and which prices don't, and how much specific prices increases depends on the specific circumstances of each time and place, but generally speaking, prices of things that are traded in financial markets (like commodities) increases more and sooner than other because they are the most flexible ones, while more rigid prices including in most cases wages increase less and later.

But what does that insight have to do with the issue of the effects of inflation on debtors? The answer is that if the prices of necessities like food and fuel increases while the debtor's income is flat, the debtor will have less, not more money, for debt service payments, meaning that inflation will in this case reduce the ability to handle debt.

If someone has say $200 per month left after debt service payments and all necessities and bills are paid, and if the cost of living then rises by $400 while income is unchanged, then it is obvious that it will be more, and not less difficult to meet debt service payments.

Or assume that oil prices rises substantially. This will certainly raise the rate of price inflation in for example Greece, but because this means that the Greeks will have less money for other things (Greece is an oil importer), including debt service payments, the Greek debt crisis will worsen.

Even if nominal income increases, inflation might still increase the burden of debt if the increase in the cost of payments except debt service payments is greater. Thus, inflation will make it easier for debtors to handle their debts only if it increases their nominal income more than it increases the nominal cost of non-debt service payments. If not, inflation might make it more difficult for debtors to handle their debt.

That condition will be met for most people in the world as a whole, but for a substantial minority of people including majorities in some countries it will not be met. And the people who see a big real increase in income from inflation may not be debtors.


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