By Nathan Tankus, a writer from New York City. Follow him on Twitter at @NathanTankus
It is commonly argued that inflation erodes debts. However, the usual defenses amount to little more then circular logic. Take this for example from Paul Krugman
In major economies, very few debtors have received a break. And far from being inflated away, the burden of debt has been aggravated by falling inflation, which is running well below target in America and near zero in Europe.
The source of the confusion here is that it is popular do divide key economic variables by abstract measures of the prices across the economy (such as the Consumer Price Index). This makes sense sometimes but in other situations become nonsensical. Debt is one such example. In the United States most people have debts denominated in U.S. Dollars. A useful proxy for the burden of debt is the ratio between an individual’s or sector’s nominal debt to its nominal income.
The burden of this debt falls when they can refinance at a lower nominal interest rate, their nominal income rises or they default. In most discussions the “real value of the debt” is discussed while still talking about nominal income (or at least being unclear about the measurement of income). It is basic math that dealing with such a ratio you have to divide the numerator and the denominator from the price level to stay consistent. However, from that point of view it becomes clear the exercise is nonsense.
This is most obvious when you think about a rise in the price level driven by falling productivity in a key sector, like oil. Lets say the productivity of a large swath of oil fields suddenly falls markedly and as a result oil prices rise. Since energy is an input into nearly all production this would hit firm costs strongly (abstracting from hedging). If these increased costs were passed on in prices, the usual argument would claim that the burdens of debts has fallen. The problem is that most of the economy hasn’t seen its nominal income increase and thus the burden of debt hasn’t fallen for them.
To the individual borrower what matters is not the value of their debts denominated in some baroque concept like the Consumer Price Index, what matters is the value of their debts in dollars. In fact for the individual the burdens of their debts can fall when the price level falls because it shrinks the amount of money they need on a monthly basis to live and can thus devote more to debt service. The problem arises when deflation in prices leads or is a symptom of deflation in incomes.
Some will object that Krugman and many others are simply using increases in the price level as a proxy for increasing nominal income. The problem with this is that they never connect their arguments about inflation to income levels. Because of the mortgage crisis the burden of debt is largely borne by households. As Yves showed over five years ago the corporate sector has been in persistent surplus for many years. A rise in prices may increase incomes in the corporate sector but this could easily translate into larger mark ups, not higher household income. Further Krugman has been arguing for years for policies to stoke higher inflation in order to reduce the burdens of debts and thus allow people to spend more, creating jobs and leading to rising worker incomes. This is putting the cart before the horse.
Only policies and institutions that directly intervene into the wage setting process (such as labor regulations, minimum wage laws, public employment programs and unions) can guarantee nominal worker incomes rise. Increased demand from goods and services through expansionary fiscal policy can indirectly help support wage growth but increasing demand for goods and services doesn’t always translate into rising workers incomes. Incidentally this is why stagflation has historically been so politically destructive. Those whose nominal incomes stagnated relative to inflation so the burdens of their debts increase and were jealous and/or angry with those workers who could fight to have their nominal wages automatically increase with a measure of inflation like CPI.
Just as the inflation rate the elderly experience is much higher than the average American, the burden of debts individuals experience- or even most economic sectors experience- can be very different. It is much more useful to sidestep the price level issue all together and instead look at nominal income, nominal debts, the growth rates of each and the nominal size of debt service payments. Accelerating rises in prices can increase gross incomes for some sectors but there is no mechanism to distribute rises in income within the corporate sector or among households.
If we want to reduce the burdens of debts for certain sectors we need to reduce their nominal value or increase nominal incomes to those sectors directly through policy, whether that policy is expansionary fiscal policy or debt writedowns.