Saturday, December 03, 2011

Different Logic For Creditors & Debtors

I recently pointed out why inflation isn't as good for debtors as is commonly assumed. Only if and to the extent it raises nominal income more than it raises the nominal cost of non-debt payments will it really help debtors and improve their ability to repay the debt and meet the debt payments. In most cases it will, but not in all cases, and even in the cases it do the gain is much smaller than is commonly assumed.

By contrast, inflation is unequivocally bad for creditors whose investments lose value basically proportionate to inflation. Some readers may object that creditors are subject to the same possible negative effect of relative price changes as debtors, but while that is true in the sense that it is possible that some relative price changes caused by inflation could make some creditors gain from inflation in other contexts (for example if they apart from holding debt securities also own oil stocks) that is not relevant for the analysis of the effect on creditors in their role as creditors.

To the extent that higher inflation has raised the after-tax nominal interest rate they receive this is not applicable  but given that a loan with a fixed interest rate has already been made or given that the central bank prevents such an increase in nominal interest rates higher inflation is bad for creditors.

The case is different when it comes to the effect of higher real growth. Higher real growth is very positive for debtors because either their nominal income is increased more than their cost of living or their cost of living is reduced more than their nominal income. Either way, their debt burden is reduced as they have more money left for debt payments.

By contrast, higher real growth has no direct positive effect at all on creditors. To the extent it reduces defaults or (in the case of variable interest rates on loans they have made) persuades the central bank to allow real interest rates to increase it could however have an indirect positive effect. However those effects is only indirect and relatively small in the case of fixed interest rates.


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