Inflation and Consumer Debt: Truth and Myth
Personal 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
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.