Proposal: Debt Indexing During Deflation

One of the biggest problems in deflation is that servicing fixed interest rate loans becomes progressively more difficult. Take a $500,000 loan at simple 6% interest (leave amortization out of the picture). The monthly payment on this loan will be $2,500. However, as deflation enters the picture, the real cost of servicing this debt increases as the real value of that $2,500 increases at the rate of deflation and is part and parcel of the deflation debt trap. It's of course the opposite of what happens in an inflationary environment.

To protect both borrowers and lenders from the hazards of inflation and deflation, one solution is an adjustable rate loan. However, the level of interest rates may or may not be related to the real value of money at any given time and exposes the borrower (and to a lesser extent the lender) to possible huge fluctuations.

I propose (and it may have been proposed elsewhere but I am unaware of it) that all loan payments be tied to the real value of money. In times of deflation, an index should be used to maintain the real cost/value of loan payments. As an example, if the CPI (pick your index) has declined by 10% in the past six months, the interest portion of the payment on the above loan should be reduced by 10%. This will keep the debt service the same in real terms.

Likewise, why should a borrower benefit (and the lender suffer) from the effects of inflation? The cost of debt service should similarly be indexed to inflation. When a borrower takes out a loan and a lender makes the loan, why should both be forced in essence to gamble on the vagaries of inflation and deflation? By indexing the loans, we remove this inefficiency which probably adds to the cost of borrowing and remove the gambling component of the loan which both borrower and lender would probably be happier without.

Finally, to be fair, the indexing most work both ways. It cannot only be indexed for inflation or deflation but must be free to slide up and down with the CPI (again, pick your index; perhaps the price of gold?).

Comments

[Tradememe:]

IMHO, it's a good proposition. By removing the gambling component of a loan, we are going further away from a casino economy.

Jan 15 07:34 AM

[Lok Sang Ho:]

This is very sensible, but indexing should not be just for deflation periods. It is especially useful when there is uncertainty over the inflation or deflation outlook.

I have been proposing denominating debt in an "indexed unit of account" that stands for a unit of global purchasing power. See my website:

www.ln.edu.hk/cpps/wcu...

Jan 15 08:48 AM

[doctor dave:]

You must be kidding. Where did you think of this nonsense? How do you think of it.

Protect people against changes in price? Why not just give health care, cars, homes, and TV's and food to everyone too.

Interest rates on the loans protect people from price risk. That is the cost and time value of money...and its predicted by the marketplace. Moreover, if you don't want price change risk then save for it and buy it with cash? I can't even believe you think your idea is possible?

For example, you speak of "the real value of money". Huh? what and where is this value? Is it in the paper, on Bloomberg? in the WSJ somewhere?

The real value of money is whatever you and the person you are transacting with agree it is. I certainly don't want you or some government telling me (with an index or any other nonsense) what my assets are "worth". In fact, the dollar IS the real value of money!

Infaltion is part of the natural cycle of boom and busts and expansions and contractions-truly natural cycles of human existence. Without these things capital isn't allocated properly and risky ventrues would never be undertaken. Why would I give you money for your business if you can't raise your prices or can't benefit from overall price increase? Similarly, if i save money and don't spend moeny when the boom is ending then i can buy more things AND I can decide what projects to invest in during the recession or DEFLATION...

Worse, the idea of indexing...that somehow that would decrease borrowing costs???? then you talk about using gold as your index versus the CPI? what nonsense is that? gold doesn't hedge against inflation and never has (study the facts not the fantasy about gold). The notion you would use 2 indexes for pricing debt just adds more infrastructure and costs to borrowing...and obfuscates the facts:

1. a borrower is borrowing because they believe they can make more money off the asset. otherwise why borrow?
2. the lender loans because they want more for their money than 0% in a checking account.
3. the risks are priced by the rate and terms they agree upon.
4. there is no gambling going on!
Your proposal has already been tried...without costs and risks with responsibility and benefits we are left with what we've seen the past 10 years in the U.S.--risk taking with other people's money because everyone along the way believed the U.S. was gonna bail em out...guess what they did.
When you get up in the morning, figure out a way to add something to the world...more than you put in...not a way to give people something for nothing-that;s just laziness
-dr d

Jan 15 10:19 AM

[Jakester:]

Doctor Dave: There is nothing "natural" about inflation. It is caused by the issuance of credit and too much printing of fiat money. I'm not prohibiting the borrower or the lender from making money, I just want to remove inflation and deflation (which are exogenous from profit) from the equation. You can make a calculation of profit when you enter a transaction, but how do you know what the government will be doing with the currency ten years down the road. It may be printing money like crazy. How do you accurately factor that into your thinking? Is it done everyday? Certainly, but just as the Treasury sells Inflation-Protected securities (which I guess should be illegal in your scheme of things) why not allow the borrower and lender to in essence buy and sell inflation/deflation protected loans?

Jan 16 09:29 AM