Does deflation hurt debtors?

It makes sense to assume that the deflation occurs AFTER the debtor's costs have been incurred. The whole point of the loan is that there is a lapse of time between when the costs are incurred and when revenues are gathered. If the debtor's costs were incurred at the same time as revenues were gathered, he woudn't need the loan in the first place!

Going back to our example, I will purchase my 100 bushels of seed grain IMMEDIATELY after getting the loan; otherwise I'm incurring interest penalties for no reason. If I didn't need to pay for the grain until the harvest, I wouldn't need the loan in the first place. So the objection fails to resuscitate the deflationist argument.

All these considerations, however, suppose the deflation is unanticipated. Anticipated deflation does NOT harm debtors.

Here's a final example showing how anticipated deflation works (Cases 2 & 3 show unanticipated deflation.)

Case 4: Anticipated deflation

Wheat is $10/bushel.
But both the creditor and I expect prices to fall 10% over the year.
Therefore, the creditor is willing to offer a loan at only 8% nominal interest. (We'll see that this is the interest rate that makes the creditor's real return the same as in Case 1.)
So I take out a loan at 8%/yr in Jan 1998, payable Jan 1999, for $1,000.
The loan allows me to buy 100 bushels.
I plant the 100 bushels.
10% deflation lowers the price of wheat to $9/bushel.
I harvest 1500 bushels
I sell the 1500 bushels for $13,500.
Now I pay my creditor $1000 + 8% = $1080. (Which is $1200 in constant 1998 dollars, so the real interest rate is still 20%, just as in Case 1.)
That leaves me $12,420. Correcting for deflation, I have $13,800 using constant 1998 dollars, the same as in Case 1. Anticipated deflation doesn't hurt debtors.

Return to main Notes page.

This page maintained by Steven Blatt. Suggestions, comments, questions, and corrections are welcome.