Inflation and Consumer Debt: Truth and Myth

March 30, 2009 by  
Filed under Debt and Credit

inflation_truthPersonal finance writers frequently comment on how inflation will affect the average consumer. This topic has received a lot of attention in recent months (including here on Tough Money Love) as our government pours money into the economy. Our central planners have openly conceded that inflation must be a secondary concern until negative employment and GDP trends are reversed.

The Theory: Inflation is Good for the Consumer in Debt

A common theme of the “inflation and the consumer” writings is that inflation is actually beneficial to consumers who are in debt. The standard theory is that inflation devalues the dollars that are being re-paid. Thus, the borrower gets to spend the lender’s dollars at full value and then repay them after they have lost value because of inflation. The higher the inflation rate, the better the deal for the borrower.

Not so fast my friends. The theory is good but it may not be universally beneficial.

Inflation and Debt Truths and Myths

First, the “inflation is good for the debtor” theory assumes that all of the debt is at a fixed interest rate. Fair enough. For most mortgages and car loans, this is the case. But if that debtor has any adjustable rate debt, those debt repayments will likely go up with inflation.

But the real problem arises on the income side. More specifically, if your income does not increase annually with inflation (at least to some extent), your victory over long term debt may be a Pyrrhic one. Let’s see if Mr. ToughMoneyLove can prove his point.

Assume that in 2009 you have a monthly income (after taxes) of $3000. Of that, you must use 33% or $1000 to pay off debt, such as a mortgage loan. You also have monthly living expenses (food, insurance, utilities) of $1500. This leaves $500 each month for discretionary spending, such as saving, investing, and fun stuff, like a vacation. This is your real consumer spending “power”, meaning that you have complete authority over whether to spend it or not, and what to spend it on.

Now roll forward to 2010, after a year of 6% inflation. Your debt payments remain at $1000/month but your monthly living expenses have increased by 6%, to $1590.  If your income has remained the same, the dollars you have left to spend on discretionary purchases have been reduced from $500 to $410.  And that $410 will only buy 94% of what it could buy in 2009 for the same goods and services, a double whammy. So now your consumer spending power has decreased from $500 to approximately $385 (measured in 2009 dollars) because of inflation.

Yes, it’s true that your debt payment in 2010 represents 38.6% of your monthly living expenses compared to 40% of your expenses in 2009. But what good is that if your discretionary spending power has decreased?

Now let’s assume that you receive a 3% raise in 2010. Your monthly income is now $3090. With the increased income, offset by the 6% increase in monthly living expenses, your discretionary spendable dollars are still $500.  ($3090 -$1000 – $1590 = $500)  Taking into account that the costs of discretionary goods and services have also increased by 6%, your spending power (in 2009 dollars) has decreased to $470.

Now you can see where I am heading with this. Debt or no debt, inflation cannot benefit you as a consumer unless your income also steadily increases. The amount of increase in income you need each year to maintain your discretionary spending power will depend on a number of different factors.

To be fair, we should also look at this scenario for a consumer with no debt because he or she is a renter. Instead of paying $1000/month towards mortgage debt, the consumer is paying $1000 in rent for 2009. If we assume that the rent also increases by 6% in 2010, this consumer’s discretionary spending dollars decrease from $500/month to $350.   So this consumer would be comparatively better off in spending power with the fixed rate mortgage debt.

But to be really fair, we also have to consider the discretionary spending power of a consumer with no debt at all because he owns his home (or a car) outright. I don’t have to run those numbers do I?

Final Words about Inflation and Consumer Debt

I think the big risk in promoting the beneficial aspects of inflation on long term debt is that some consumers may be wrongly influenced into taking on more debt. They will not appreciate that their discretionary spending power will nevertheless decrease with inflation, unless at least some annual increases in income are assured. In our present economy, that is not a reasonable expectation, particularly if we hit a hyper-inflationary spell.

If you are already in debt (which you cannot repay immediately) and you are confident that your income will increase as inflation increases, then by all means pray for inflation. Otherwise, I suggest that you think about the problem a little longer.

I’m probably overlooking some aspect of this analysis. If so, I am confident that one of you readers will tell me.

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9 Responses to “Inflation and Consumer Debt: Truth and Myth”
  1. TMN says:

    I pretty much agree with you here. Wages automatically increasing with inflation is a myth. The real increase comes from increasing your productivity by expanding your skill set and finding ways to automate parts of your job and add value. A job with no efficiency improvements will lose money year over year as it gets edged out by jobs that can improve.

    That said, I don’t think we have to worry about inflation for a while. The amount of money that disappeared when the debt bubble collapsed is absolutely staggering. Even with the government printing money as fast as they can, it’s not going to amount to more than a tiny percent of the amount that evaporated into thin air in the past six months.

    Pick any ten Fortune 500 companies and I’d put good odds that the amount lost from their combined market caps is over 1 trillion, and that gets closer to 2 trillion if you focus near the top of the list. And that’s not even counting real estate or commodities speculation. We’ve been building up a whole bunch of imaginary wealth since the early 80s, and it’s all come crashing down on our heads. I don’t think the government could cause inflation if they wanted to, at this point.

  2. SJ says:

    I think the debt only works if it holds value.

    If my debt is a mortgage vs. a renter…
    Or if my debt is a car instead of renting/leasing…

    TMN: your comment about increasing productivity is kind of interesting, it was an idea i was tossing around; as you improve your job spending must increase. fun stuff…

  3. MasterPo says:

    I agree with you.

    But don’t under estimate the myth coming out of DC these days of needing to put inflation on the back burner to get the economy going. Fears of inflation will derail any recovery because the markets and business know the only cure for inflation is a rise in interest rates.

    Wait until we have those lovely double-digit interest rates like in the Carter years. Funny how things come around again.

    Buy gold.

  4. Rick Beagle says:

    President Carter may have sucked, but he had it right. Too bad we all fell in love with the smooth talking man from California, because life sure as heck would be a lot better now.

    Consider the later years:
    1) I don’t recall…..
    2) Here is your (insert prestigious award here) Mr. Carter.

    Funny how the right still think he had it wrong, despite all evidence to the contrary.


  5. MasterPo says:

    Can you seriously look me in the eye (so to speak) and say double-digit interest rates were a good thing?

    Exactly what “evidence” is there?!

    Me and my family did a heck of a lot better under Reagan then under Carter!

  6. Rick Beagle says:

    This is terribly off topic, and I realize that I started it. So let this be my last posting on the subject; feel free to post your response.

    No, double digits interest rates were not a good thing, however the solutions provided by Reagan did far more long term damage than the short term discomfort we were suffering under.

    Please note, I am terribly biased. IMHO anyone who uses his political power to keep hostages held in Iran until minutes after his inauguration is inherently evil and corrupt. You and your family might have done well, but look at where we are now. And yes, he was the devil that set us up for this fine fall.

    As for “evidence”, do a freaking google. Heck, even historians credit his social and economic policies as doing more harm for the long term of this country than perhaps any president in history. Of course, that was before the second Bush….


  7. MasterPo says:

    Well Rick, we’ll have to wait and see. Your new boy here is making such a mess that Carter will look like an economics sophmore. Let’s wait and see what spending like a drunk sailor, high inflation and high interest rates will do for the future of the country.

    ps- Who would have thought the leaders of France, Germany and other Europeans would be telling an American President not to spend like water?!

  8. kitty says:

    I have to second MasterPo. We were poor refugees from the Soviet Union when Reagan came to power, and we sure benefited from Reagan.

    I do remember Carter and the double digit inflation. About the only good thing about it was that it ended, and that some smart people (not me, I was a poor refugee then) managed to lock in 18% rate on government bonds for 30 years.

    Rick – it depends on which historians you read. Many economists believe Reagan benefited the economy tremendously. As to the mess we are in, pray tell me was it Reagan who repealed Glass-Steagall? Was it Reagan who decided to promote home ownership by stimulating borrowing? Was it Reagan who invented mortgage-backed securities, CDOs, or credit default swaps? Was it Reagan who decided to gave home loans to anybody with a pulse who is competent enough to be able to sign at the dotted line? Was it Reagan who exempted 5 major firms from leveraging limits?

    Incidentally, until 1999 most of the US debt was owned by Americans. It’s only after 1999 long time after Reagan that Americans changed from mostly lenders to mostly borrowers.

    Back on topic. I do agree that variable interest loans is not a hedge against inflation as the rates go up with inflation. I do believe that longer term fixed interest loans can be. One thing I think which is missing from the discussion is investment opportunities for the money you have on hand. Higher inflation leads to higher interest rates including rates banks pay you on your CDs. Let’s say you have 200K and 200K mortgage at tax deductible 4.5%. At this point banks are only paying 2-3% (on which you have to pay taxes) so you cannot get safe investment with the same return. But what if 2 years from now, you get a Carter-like inflation with a bank CD paying you 13%. If you paid off your mortgage, you now have no cash. If you still have a mortgage, you can put your money in a bank and earn a lot more money than you have to pay.

    Imagine locking 9% before Carter, then investing your money in some municipal bonds paying you 18% or more. You could just take some of this income and pay your mortgage with it.

  9. MarkRSM says:

    Dear Friends,

    If you work for the govenment and you get COLA then you will get a benefit, if you are on SSA you get a benefit. This the main issue with government debt, as it is impossible for the government to reduce their spending in the US by inflation, as most of their costs are adjusted by inflation.

    So if we have a lot of inflation, the private sector will be forced to bear the burded of inflation for all. Inflations is the result of a country demanding more goods than they produce, like the US has a 650B trade deficit so we should seem inflation. But as much countries will except our money in trade, it has not happened, yet.

    But if it does it means that our goods would get cheaper and imports are more expense. This means we will export more, and import less. As it takes time to change the amount of production of any good, this means we will have less goods for each person, so our standard of living will drop.

    As government employees will get a COLA, they will maintain their standard of living while private sector employees standard of living will drop about 45 percent greater than they should to make up for the steady standard of living for the government.

    So get a job inthe government and debt works, work in private industry, you better stay out of debt.

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