Question about inflation/deflation and debts

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Hashi
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Question about inflation/deflation and debts

Post by Hashi »

So I can understand that during a deflationary period that the amount you earn goes down and prices go down proportionately (for the most part) and then the opposite is for inflation. What I don't understand is why your expenses, say your mortgage, electricity, gas etc stay the same. Why aren't these adjusted with inflation/deflation?

So if you earn 500 for the month, and have 400 in expenses, then if there's deflation your pay might drop to 450 while prices drop accordingly. But your expenses stay at 400 dollars. So no one wants a deflation. But during an inflation, your pay might jump to 550 and your expenses stay the same, so you're actually a little better off now. But surely there has to be an issue with this? There's gotta be some trickle down effects if the prices for goods and services goes up with your pay but your expenses every month stay the same. Surely that means someone, somewhere, is not getting the amount of money they should be? Wouldn't that make even mild inflation a bad thing in the long run?

Thank you in advance friends
ggrotz
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Re: Question about inflation/deflation and debts

Post by ggrotz »

Hashi wrote:What I don't understand is why your expenses, say your mortgage, electricity, gas etc stay the same. Why aren't these adjusted with inflation/deflation?
Because people can only deal in concrete absolutes when it comes to contracts, which what a mortgage is. If a house value goes from $100000 to $50000, you still have to pay the $100000 because you agreed to that much when you contracted out for the mortgage. Electricity and gas, however, are adjusted according to cost and profit motive. The cost is primarily based on quality consumed, but the rate per unit changes pretty regularly as costs change - the cost of obtaining the product, the cost of delivering the product (lines and pipes aren't cheap, especially when it comes to maintaining them). If you need a more visible example, look at the cost of automotive gasoline, which fluctuates pretty wildly, but steadily has increased with time as inflation has occurred.
Hashi wrote:So if you earn 500 for the month, and have 400 in expenses, then if there's deflation your pay might drop to 450 while prices drop accordingly. But your expenses stay at 400 dollars. So no one wants a deflation.
Pay is independent of expenses. Employees might balk at working for a company by refusing to accept a certain amount of pay because they can't meet their expenses (the main defect of the Republican party's economic policy is that it misses this). If the employment market is good, wages will go up, along with the costs of goods, resulting in an inflation. However, the employment market in the US is not good, coupled with increasing prices. So we in the US have an effective deflationary trend in lower and mid level salaries (and extreme inflation in the upper level salaries), and an inflationary trend in products (mainly due to production costs, coupled with government regulations, most prominent of which is the Affordable Care Act or Obamacare). People basically have been able to buy less and less since the 1980's.
Hashi wrote: But during an inflation, your pay might jump to 550 and your expenses stay the same, so you're actually a little better off now. But surely there has to be an issue with this?
Expenses won't stay the same. If there's an inflationary trend in wages, the costs of the goods/services the employees produce will increase to pay for it (the money has to come from somewhere).

TL;DR the main thing you miss is that wages and expenses are independent in terms of inflation/deflation, but there are causal relationships between the two. Wages, in the aggregate can not go up without the costs of goods going up in the aggregate. But the costs of goods can go up in the aggregate for other factors besides wages.
Hashi
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Re: Question about inflation/deflation and debts

Post by Hashi »

Given that, wouldn't inflation be a good thing in terms of your house price? Your house price stays the same but you now have more currency to pay it off with. As someone with a mortgage, isn't inflation exactly what you want? Does it really matter about the state of currency if your currency can purchase the same amount today as it did tomorrow, even if it takes twice as many units of currency to do so? If today you can buy one apple for 1 dollar, but tomorrow it's 10 dollars for the same apple, if your pay increased by the same amount, what's the difference? Your trading in an equivalent percentage of this currency your working for the same apple.
bobby 55
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Re: Question about inflation/deflation and debts

Post by bobby 55 »

Hashi wrote:Given that, wouldn't inflation be a good thing in terms of your house price? Your house price stays the same but you now have more currency to pay it off with. As someone with a mortgage, isn't inflation exactly what you want?
Good lord no. Wages never seem to increase the same percentage as inflation. With inflation you have less money after cost of living expenses so you couldn't put more towards paying off your house. Just look at Australia over the last few years and see how tough the fixed income peeps have been doing it. Imagine their pain if inflation was at, say, 10%.
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gamer0004
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Re: Question about inflation/deflation and debts

Post by gamer0004 »

This is why economists love to use the somewhat artificial distinction between the short and the long run. In the long run, if the total amount of money doubles, then prices double and incomes double. That is, there is no net effect in the long run (this is called the "neutrality of money"). Money is nothing but a numeraire.
In the short run, however, everything changes. Think about mortgages. Say there is no inflation at the moment and you buy a house for $200000, and agree to pay back the full sum plus 20% (240K) in 20 years. If inflation suddenly explodes to 10% per year, then 240000 after 20 years is worth only 240000/(1.1)^20=$35674 in today's dollars. To compensate for inflation, your pay would go up by 1.1^20 (assuming your wage is indexed, which they usually are), but your mortgage payments would not; hence the real value of the mortgage repayment becomes very small.
Inflation redistributes income from the mortgage lender to the borrower.

Of course, if this inflation had been expected (say, because inflation is already at 10% per year when you get the loan), the contract will likely stipulate that you will have to pay back not 240K, but 240000 compensated for 20 years of inflation, i.e. about $1.6 million (240000*1.1^20). Expectations matter. If there is great uncertainty about inflation, the contract may stipulate that the borrower has to repay the loan in real terms (that is, indexed against inflation). If inflation is quite stable at some low figure, the total amount which needs to be paid back may be increased by that total expected inflation.
Hashi
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Re: Question about inflation/deflation and debts

Post by Hashi »

These responses have been generous. This has helped me a lot, thanks.
DDL
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Re: Question about inflation/deflation and debts

Post by DDL »

I'm a bit confused as to why you think expenses are fixed?

Mortgages are frequently variable rate. Gas/Water/Electricity are all subject to inflationary increases. Food certainly is.

Your entire opening question asks why these things are fixed, and the answer is: they're not.
Hashi
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Re: Question about inflation/deflation and debts

Post by Hashi »

DDL wrote:I'm a bit confused as to why you think expenses are fixed?

Mortgages are frequently variable rate. Gas/Water/Electricity are all subject to inflationary increases. Food certainly is.

Your entire opening question asks why these things are fixed, and the answer is: they're not.

Well in The Undercover Economist Strikes Back, the author says: "Imagine borrowing 300, 000 to buy a house and slowly repaying the money on a monthly basis. Normally, with a small amount of inflation, that monthly repayment would gradually come to represent less and less of a burden. Your salary would be rising, the prices of all the other products you bought would be rising, but the monthly repayment would stay the same in nominal terms and in comparison to everything else, it would be shrinking...But with deflation prices begin to drop. Your wages are a price, so they are falling. Of course the price of food, clothing and fuel are falling, too. But your mortgage repayment never changes. It is taking up a larger and larger portion of your monthly salary"

And in Guide to Investing in Gold and Silver, Everything you need to Know to Profit from Precious Metals Now, the author says: "Even though prices are falling to match income, debt isn't; it's nominal, which means it's a fixed number"

So that's what I was referring to.
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Re: Question about inflation/deflation and debts

Post by AEmer »

What you describe are effectively two different mechanisms.

One is a debt, which is essentially a future obligation that is negotiated nominally _right now_. The other is goods and services which you can expect you will need in the future, but which you do not need right now, therefore you typically do not negotiate for them right now.

It's essentially the difference between making a bank loan and using it to buy all the rice and gas you need for the rest of the year, and buying it slowly over the rest of the year as you need to use it.

During high inflation, buying the stuff you need for the rest of the year with borrowed money is incredibly smart; you just borrow 20k now, buy everything you need, then if the inflation is high enough, it will be very easy to pay the money back a year from now. Same thing goes for houses.

Incurring debt before high inflation is effectively lucky; doing it before deflation is effectively unlucky.

Larger institutions have so called rolling loans; that is, they have an outstanding amount of money which they do not posses. They need to borrow it every day; if they can't borrow it, typically, they become insolvent, but typically, someone is always willing to lend them the money for a day, for the right price. These loans are over such a short term that inflation and deflation has a very small effect on them.

OK. So why don't we come up with a new type of loan where I can borrow, say, 10k, and in a year, I agree to pay that 10k back _adjusted for inflation_ ? It would effectively be the same as a rolling loan. The nominal value of the loan would adjust in accord with inflation, meaning I would (theoretically) pay back almost exactly the same amount of money as I had loaned.

The answer to this is, well...I don't think it's a popular way of borrowing money because there is no real market for it. Such a loan would be hard to compare to a traditional set-interest-rate loan, or even to a daily refinanced loan, because it is hard to determine inflation with a high degree of accuracy. So such a loan isn't very easy to deal with mentally. So it's unpopular.

I could definitely see it being useful during a deflation, but I don't know whether or not this type of loan is offered anywhere, let alone if it is legal.
DDL
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Re: Question about inflation/deflation and debts

Post by DDL »

Also worth noting that the interest on a loan factors inflation into account. Even "interest-free" loans have interest, it's just pegged directly to inflation.
AEmer
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Re: Question about inflation/deflation and debts

Post by AEmer »

@ DDL

Curious. I didn't realize it was common to market loans that way; I think that is probably illegal in Denmark, as I presume the 'interest' is defined to be nominal dues per bank year here, and it is illegal to use it in another manner.

@ Myself

I actually think there is a further quirk to it.

My last post just kindof said 'it's unpopular because it's little understood'... but generally a loan is a mechanism whereby one party allows another party to use his resources, and then the other party is supposed to repay those resources with a little bit extra on top. The reason for this is that the investor assumes the risk, which is a job that requires very little work, but which ultimately could cost him his entire investment.

In other words, one party assumes all of the risk, but is paid for that; the other gets a lump sum up front, but has to provide a service back as well as the return of the sum.
If the loan was regulated in accord with inflation, then suddenly the risk is no longer just located with the investor: Now the loaner suddenly has the risk of income lost to inflation.

It won't really make the calculation much simpler for the investor; yeah, he may be more willing to invest in more things because he has less risk, but the investor doesn't really have the option of sitting on the money anyway: He will always be looking to invest! and he will always be looking to take a certain kind of risk!

On the other hand, the calculation becomes far more complicated for the loaner. Suddenly he doesn't just have to assess things in nominal numbers before he takes the loan: He has to take a random factor into account as he borrows money!

So the financial product is more complicated, and less safe. So the interest has to be lower to be as appealing...but the investor doesn't really gain much by offering such a service, because he is already dealing with the exact amount of risk he wants to take.

In summary:

Risk belongs with the investor, not the loaner. You don't push risk unto the loaner, because he is not good at managing risk, unlike the investor. Since inflation is a risk, it naturally belongs as a factor for the investor, not the loaner.
that guy
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Re: Question about inflation/deflation and debts

Post by that guy »

In Australia there are two kinds of home loans I am aware of: Fixed rate and Variable Rate. Variable Rate loans are the more common and work exactly as DDL described. The Reserve Bank of Australia looks at the current state of the economy (which has a correlation with inflation) and sets their interest rate at an appropriate value. Banks are free to set their interest rates at whatever they like but any bank can borrow from the reserve bank at the rate the reserve bank dictates and then attach a small markup before lending to homebuyers. As such competition means that all variable rate home loans tend to have similar interest rates that move roughly in line with the inflation rate. As such the monthly cost of mortgage repayments is essentially linearly dependent on the inflation rate.

Fixed rate loans have a fixed inflation rate for a fixed term. For a 1 year fixed rate loan, the bank would basically try and guess what the average interest they would hope to earn over the course of the year was and set the interest rate of the loan to something like that. So if the current interest rate was 4% but they projected that interest rates would be at 6% in a years time they might offer a 1 year fixed rate loan at 5%. I believe they have some pretty hefty exit fees to stop people from switching to a variable rate if the interest rate drops unexpectedly.

I tried to find some solid data to counter bobby 55's claim that real income is reducing in Australia due to inflation. Unfortunately I can't find any data on growth in nominal income. However, every employer I have worked for has conducted annual pay reviews in which the great employees might get a large pay increase and the average employees just get a percentage increase roughly in line with CPI (Australia's measure of inflation). The government also conducts annual reviews of minimum wage which would be along similar lines. From what data I can find (which admittedly is so ambiguous or tenuous as to not even bother referencing here) it actually looks as if average real income has been increasing in Australia. Try taking a look at http://www.indexmundi.com/g/g.aspx?v=74&v=71&c=as&l=en and graph inflation against unemployment. I make the assumption here that low unemployment means a greater demand for labor which should result in higher wages. You can see a clear correlation between drop in spending power (indicated by rise in unemployment) and drop in inflation, during the global financial crisis in 2008-09
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