Saturday, December 20, 2008

Falling Prices (2) - Borrowers Punished?

The other concern of the columnists is that deflation punishes borrowers.

A prolonged period of deflation can have a pernicious affect on an economy. The other main reason why deflation can cause so many problems is that it serves to make debt more expensive. Here's why. If you borrow £1,000 at the start of the year to pay for a new sofa, the cost of the loan does not change throughout the year. It remains at £1,000. But the sofa is falling in price. So at the end of the year – when you are still paying back the loan – you have ended up taking out £1,000 to pay for a sofa now worth just £900 or £800. Think of it as negative equity on a grand scale, spreading itself into every corner of consumer credit. Of course, in theory there are some winners: savers (Harry Wallop, Daily Telegraph).
The curse of deflation is that it increases the burden of debts. Incomes fall: debts stay the same. This way lies suffocation…. The great credit bubble of the last 20 years has pushed debt levels in Britain, the US and other Western societies to unprecedented highs… Our sensitivity to debt deflation is therefore greater (Ambrose Evans Pritchard, Daily Telegraph).
This is twisted thinking. The curse of debt has been replaced by the curse of deflation. Evil is good. The lie is truth.

The commentators dislike deflation, because it rewards those who save and punishes those who borrow. Falling prices redistribute wealth – the wrong way (for the columnists). Savings appreciate, which is good for those who have saved. Income is transferred from those in debt to those who have saved. Income is transferred from borrowers and speculators to those who have been responsible. In the strange modern world of debt and leverage this is seen as bad.

2 comments:

Steve Scott said...

Ron,

Falling prices also affect somebody who paid cash for his house. He might have bought it for $100k, and had the price fall to $80k when he had to sell. On the other foot, deflation has caused many mortgage payments to go down because some interest rates are contractually tied to deflating market funds.

Deflation has also benefitted many borrowers because lenders in many cases realize that if a default occurs, the lender will be left with something less than its original price if there is little equity. Lenders have in many cases been willing to negotiate downward to save their own derriers. I'm not arguing against your case in general, I'm simply pointing out problems with the columnists' claims.

RonMcK said...

Thanks Steve

We do not know the future, so every decision carries risk. Inflation shifts that risk to other people. At least, the man who buys an asset for cash that then sells it later for a lower price harms no one but himself.

Businessmen are happy to buy plant and equipment that declines in price over time, because they produce something that can be sold to compensate for the depreciation in value. The problem with a house is that, it does not produce anything that can be sold to compensate for a decline in price, unless it is rented out. We should stop thinking about the house we buy to live in as an asset that will just increase in value over time. The reality is that houses wear and tear over time, so to be useful for economic decision making, their prices should reflect that reality.

If inflation stopped completely, we would also have to change our investment strategies. Buying an asset and just waiting for the capital gain would no longer be a viable strategy. That would be a good thing for the economy, as investors would shift to assets that are actually productive.