Does deflation hurt debtors?
It's true that deflation increases the real value of each dollar the debtor
earns--but it also decreases the number of dollars the debtor earns. These
two effects, for the average debtor, exactly cancel. At the same time,
deflation increases the real value of each dollar the debtor has to pay
his creditor, while the number of dollars the debtor has to pay remains
CONSTANT. So deflation really does hurt debtors.
The mistaken argument: "Although deflation increases the value
of each dollar the debtor pays it also increases the value of each dollar
the debtor keeps."
The rebuttal: But deflation also decreases the number of dollars the
debtor keeps, while the number of dollars the debtor pays is unaffected.
Why does deflation reduce nominal profits? Because the price of whatever
the debtor is selling falls during deflation.
For example:
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Case 1: Stable prices.
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The price of wheat is $10/bushel.
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I take out a loan at 20%/yr in Jan 1998, payable Jan 1999, for $1000.
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The loan allows me to buy 100 bushels.
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I plant the 100 bushels.
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I harvest 1500 bushels.
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I sell the 1500 bushels for $15,000.
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I pay my creditor $1200.
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That leaves me $13,800.
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Case 2: Deflation
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The price of wheat is $10/bushel.
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I take out a loan at 20%/yr in Jan 1998, payable Jan 1999, for $1000.
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The loan allows me to buy 100 bushels.
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I plant the 100 bushels.
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10% deflation lowers the price of wheat to $9/bushel
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I harvest 1500 bushels.
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I sell the 1500 bushels for $13,500.
Let's pause here to notice that the Deflationist argument is right
that the dollars I earn are worth more than in Case 1: each dollar is worth,
by assumption, 10% more. However, because of that same deflation, I earn
10% fewer dollars. So, at this stage of the game--before I pay off the
loan--deflation has, contra the Deflationist, neither harmed nor helped
me. Using constant 1998 dollars, I have $15,000, the same as in case 1.
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Now I pay my creditor $1200.
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That leaves me $12,300. Correcting for deflation, I have $13,666.67 using
constant 1998 dollars, less than the $13,800 I earn in case 1. Deflation
made me worse off.
A plausible objection: "Sure, deflation decreases the debtor's nominal
revenues, but is also decreases the debtor's nominal costs. Shouldn't you
take that into account in calculating real profits?"
In terms of our example--suppose the deflation occurs after I take out
the loan but before I buy my seed grain:
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Case 3: Deflation reduces costs
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Wheat is $10/bushel.
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I take out a loan at 20%/yr in Jan 1998, payable Jan 1999, for $1000.
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10% deflation lowers the price of wheat to $9/bushel.
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So now the loan allows me to buy 111.1 bushels of seed grain.
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I plant the 111.1 bushels.
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I harvest 1666.7 bushels.
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I sell the 1666.7 bushels for $15,000.
Notice that now the pro-deflation argument's point holds good. I've
earned the same nominal revenues as in Case 1, but higher real revenues.
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Now I pay my creditor $1200.
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That leaves me $13,800, the same nominal amount as in Case 1. But, correcting
for deflation, we see that my real profit is $15,333.3--GREATER than Case
1. It looks like the deflationist is vindicated--deflation can HELP debtors.
Nevertheless, this case is not a significant proof that deflation can help
debtors. Can you see why?
Think about it before you continue.
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