Proposal: Debt Indexing During Deflation

by: Jakester

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?).