Does Inflation Provide An Incentive For People To Go Into Debt?

One of the hottest topics within left wing economics is the effect that capitalism has on wealth distribution. Put simply, the fact that the rich get richer and the poor get poorer, and this so-called ‘wealth gap’ seems only to widen over time, and to put to death the lie that free market capitalism somehow creates the best allocation of resources for all concerned.

Even in New Zealand, this is a problem. It has often been reported that 10% of kiwis own approximately 60% of the nation’s wealth. This statistic, often at or around this level, seems to repeat itself on every Western nation on the planet.

Yet as hot as it is to talk about the wealth gap, it is totally unappealing to look at the underlying causes of the wealth gap – the subtle factors that drive an ever-increasing redistribution of assets in favour of people who already own assets and who adopt specific economic strategies.

Inflation and regressive taxation are two subtle, but highly effective ways in which wealth is drained from low net worth and low income folks. We discuss regressive taxation in other articles – today we are are going to concentrate on inflation.

Inflation plays an important role in the evolution of inequality. This subtle, often-talked-about-but-seldom-understood phenomenon not only drains the value of your savings and your wages, but also puts less-than-obvious incentives in place for high income and high net worth folks to go further into debt in order to fund more house, business and stock purchases, thus pushing them further out of reach for low income folks.

In an ‘ordinary’ world (by which I mean a world largely free of inflation, such as Britain during the years 1870-1913), there would be little incentive to assume large quantities of debt. This would be because debt attracts interest, and interest would need to be met until the debt is repaid in full.

The only circumstances in which people would be willing to assume such debt would be if they were confident, or at least optimistic, that the money they borrowed would be able to generate higher returns than the interest cost, plus any other associated loan costs.

In our world, however, it is not quite so simple. On the one hand, you still have to pay interest on the debt. But on the other hand, you have inflation eating away at the value of your debt, and cutting into the ‘real’ interest rate that you have to pay. Not only that, but because people perceive your dollar to be such a bad investment (given that it erodes in real value over time), they tend to put a higher premium on stable assets that at least give the appearance of going up in value, such as property. What this means is that while your dollar goes down in value (in real terms), your house goes up in value (in real terms), and meanwhile the value of your debt (in real terms) diminishes, AND the cost of your interest payments are in part offset by inflation.

So what do I mean by the phrase ‘in real terms’? Everything turns on this. Fortunately for me, it is canon in the study of economics to talk about the ‘real value of interest’ (although the concept has always seemed slightly abstract to me).

What follows may be a bit ‘Economics 101’ – so if you’re well versed in this area feel free to skip ahead.

If I visit the BNZ website right now, there’s a big title on the site’s home page that reads “4.79% p.a. fixed 2 years home loan special.” What does it mean? Simply that if I buy a house today, and agree to finance it through the BNZ, and agree also to receive a ‘fixed’ interest rate for the next two years, then the BNZ will generously confer upon me the interest rate of 4.79% for that duration.

But what does it really mean, if we accept that the current rate of inflation in New Zealand is 2.7%? (The actual rate for this past year is 1.3% – however 2.7% represents a more realistic 10 year average.)

The Fisher equation (see below, crudely reproduced from memory in a hand-drawn MS Paint file) teaches us how to calculate the real interest rate.

Using this formula, we come to a real interest rate of 2.03% ((1+0.0479)/(1+0.027))-1=0.0203. That means, as I meet the repayments on my interest, and as the general price of goods and services goes up over time, the net amount that I have to pay in ‘real’ interest is 2.03% on my loan.

A much faster, although less accurate, method of calculating the real interest rate is simply to deduct the rate of inflation from the rate of interest. In this case it would yield 2.09% (4.79%-2.7%) – a little off, but not enough to be enormously significant unless you’re borrowing millions of dollars.

This little equation, which you might learn in your first year of economics, has a big effect on the level of debt individuals are prepared to assume.

However before demonstrating an answer to the question above I must launch into my own qualification of the analysis based on nothing more than my own scruples and cavils.

Here we run into a small problem with the calculation of an inflation ‘rate’. Using a singular rate for inflation always bugs me, because it presupposes a certain level and type of expenditure, based on a set of purchasing habits that may in no way reflect your actual purchasing habits.

One big problem is that the Consumer Price Index (one of the most common measures of inflation) does not factor in the increase or decrease (lol) in the cost of buying a house.

Which means that so long as the typical kiwi relying on the Consumer Price Index to figure out the real cost of interest never aspires to purchase a property at any point in their lives it’s 100%, well, mostly, well, more or less, accurate.

But for all the rest of us it’s an arbitrary statistic that in no way reflects the true increase in the cost of buying stuff.

Furthermore, past results do not equal future results and inflation rates tend to fluctuate over time. Just because inflation was 2.7% over the last ten years does not mean it will be the same this year. So basically everybody’s attempt to calculate the ‘real’ interest on their debt is screwy, because nobody knows what future price changes will occur over the life of the loan.

In short, you are dealing with some rotten egg numbers. (These rotten egg numbers are themselves a by-product of inflation. For so long as inflation exists, there will always be uncertainty regarding the real interest cost of debt, and this will lead even sophisticated investors to make a range of bad decisions.)

Now back to the main thrust of my article. Let’s look at some specific scenarios in which inflation creates an incentive for individuals or businesses to retain or increase their level of debt.

Student loans are a classic example of a loan that is bitten deeply by inflation, thus creating a very serious incentive to avoid paying off the loan in anything other than the most low-oomph mandatory minimum repayments.

For student borrowers who continue to live in New Zealand after they finish their studies, the government applies a 0% interest rate to the balance of the loan in order to give them a chance to, you know, feed and clothe themselves in an increasingly unrewarding economic culture for graduates.

The problem this creates is that, since the termination of an incentive scheme several years ago where repayments exceeding $500 were met with a bulk discount on the principal of the loan, there is now very little reason to repay the loan faster. Based on the method of calculating real interest rates in my MS Paint file above, the real interest rate on a student at 0% would come to -2.63% per year ((1+0)/(1+0.27)-1). And so the real balance of the loan erodes by an average of 2.63% per year, or $789 on a $30,000 balance.

By doing nothing, apart from NOT repaying your loan, you are effectively saving yourself nearly $800 per year in present value dollars.

Whereas, if inflation were nil, then such borrowers would experience no long term benefits for postponing their loan repayments.

On a semi-relevant side note, rumour still surrounds my year group at university regarding a person who took the full amount of their student loan and invested it in the Australian Stock Market.

That person made spectacular gains (these being the years leading up to 2008) and financed the investment with an interest free loan paid for by the New Zealand government and ultimately the taxpayer.

So it should come as no surprise that student loan debt balloons year after year.

I don’t want to have a go at students here. Getting inflation to erode your student loan is economically rational and if there’s one thing we have learned from economists and capitalists it is that if something is economically rational it is always morally justifiable.

Credit cards are probably the least affected of each of these categories, because even in the example of the balance transfer scenario given above, inflation takes a fairly long time to have a meaningful effect on the value of your loan balance. Not to mention that the eye-wateringly high levels of interest that are attached to the cards typically dwarf any interim erosion of your debt through inflation.

That said, it is likely you will wait until the end of the balance transfer period, purely in the hopes of watching inflation eat into your loan just a little bit. You will do this, even though the fees associated with a new credit card are likely to surpass the marginal benefit you gain from taking advantage of the interest free period.

Or not. It is up to you. But the above scenario would constitute a fairly rational (and moreover, fairly tempting) use of your available resources.

I wanted to throw this one in, because it will become relevant to another topic I want to discuss in later articles, around the nature of malinvestment and the pricing of capital assets.

In this case the erosion of the real interest that is caused by inflation not only affects whether you go into debt in the first place, but how you structure that debt in order to minimise the risks against your business.

Whether you choose the high interest rate unsecured option, or the low interest rate secured option, is really up to you. But I suspect many people would be tempted by the significantly lower real interest rate of the secured finance option (3.11% as opposed to 5.06%) even though the unsecured option is probably the wiser one for a growing business.

Last but not least, because mortgages are a great example of incentivised debt accumulation and also the most likely debt category to throw the economy into turmoil.

When a debt is secured by a property, it changes the game entirely. While the interest price of the mortgage is often (but not always) higher than the current rate of inflation (resulting in a real interest rate that you actually does cost you money in real terms), the amount of the real interest rate on many occasions is so insignificant relative to recent property price increases that it “seems” absurd not to assume that debt to buy that asset.

Let’s use the BNZ 4.79% two year introductory rate mentioned above. If one accepts the semi-logic of the Fisher equation, this would mean that you can use a debt with a 2.03% real interest rate to secure a property that may go up 15% in value.

This is the temptation that many serial property addicts face. They “know” that the property will go up in value, partly as a result of their mutual and shared speculation of the housing market. They also “know” that they will have to pay real interest and will often be prepared to make a cash loss on each new investment. Finally, they know in the back of their minds that one day the chickens will come home to roost and the person holding significant amounts of henhouse-debt (couldn’t quite make the analogy work here) will be the one to get clucked. Reliable calculations on when or how this could occur, however, are virtually unreachable, so in the short term it makes perfect sense to invest one’s life savings into a tiny scrap of equity on an otherwise encumbered low yield property.

So the ‘incentive’ to go into debt to buy a new property is not merely that inflation will eat into some of their interest expense. There is an extra incentive to buy property, even at very low returns, because they, along with the rest of the market, predict that prices will go up indefinitely.

But let’s not neglect the emotional satisfaction that accompanies property ownership. Owning a house (even a significantly mortgaged house) is “the Kiwi dream” (or so we’re told). Plus it gives you a rush to leave some of your fellow human beings in the dust, by raising the entry cost into the property market so high that many of your Facebook mates would be unwise to enter. They watch with rage as you apparently effortlessly get richer.

On balance, then, if one suppresses the knowledge of an inevitable realistic long term risk of a correction in house prices, then the pros associated with going into debt to buy property appear to outweigh the cons.

And as many investment decisions nowadays get made on the basis of watching others apparently get rich, and the concomitant fear of missing out, many new speculators enter the market with the same precise and highly executable strategy. Just as porn has rewired the teenager’s brain, inflation has rewired the property investor’s brain.

What downstream effects does this have, if more and more people are pulled in to the property market at increasingly eye-watering levels of debt with the same expectation?

To find the answer simply turn to page 2008.

And so we see that inflation provides incentives for sociopathic risk-taking behaviour. Not only does this incentivised sociopathy extend to the highest income folks, it also exports it to folks on low and middle incomes as they desperately attempt to clutch the property ladder.

Inflation is like a magic wand that turns just about any debt into a ‘Get Rich Quick’ strategy. Debt has powered the rise of many a NZ entrepreneur: some of the most recognisable names on our rich list are people who have followed this time-honoured tradition: think Sir Bob Jones and Graeme Hart. But so too has it claimed some victims – anyone remember the Rainbow Corporation?

Which only furthers my overarching hypothesis that in current, somewhat inflationary circumstances, entrepreneurs use specific strategies that manipulate inflation to their advantage. The greater the level of inflation, the better the advantage to these entrepreneurs.

Meanwhile hard working low income folks miss out.

Oh well. If you can’t beat them, attempt to join them, I suppose.

And that is just the fringe of the mullet. One shudders to think of all the complex derivatives that have found their way onto the financial markets as a result of the mere fact of inflation.

Therefore I ask you – in whose interests is it to have high levels of inflation?

And in whose interests is it to stop it?

The Critical Question – Cui Bono?

Who benefits from inflation? On the surface, it’s an economic by-product that seems to punish everybody equally.

But as we’ve seen in the scenarios above, inflation re-routes individuals’ risk-taking behaviour. It communicates the idea that those who take uncomfortable levels of risk receive massive rewards.

 

 

Ultimately, though, the true beneficiaries are the Reserve Bank, who get to justify their existence in the name of fighting it. More on them later.