Deflation: You Can't Have Your Cake and Eat It Too

"What's so bad about deflation? I'd love to pay less for the things I buy." I'll admit, that thought has occurred to me lately. I'm glad that gas costs half as much as it did a year ago. I'd be singing a different tune, however, if I were in the business of selling gas. The trouble with deflation is that almost everyone is in the business of selling something. For every buyer who benefits from lower prices, there is a seller who suffers. It’s clear, therefore, that a general reduction in prices is not an unqualified boon.

The concept of deflation is difficult because few of us have ever thought about it. So let's start with inflation.

If inflation is running at 2% when you buy your house, you'll probably pay about 6% interest on your mortgage. If inflation increases to 10%, your lender will increase the interest rate it charges on new mortgages to 14%. The extra 8% interest is intended to compensate the lender for the additional 8% erosion that it expects (annually) in the real value of its principal.

What happens if you get your loan when inflation is running at 2%, and then inflation increases to 10%? In that case, you get a windfall. Your salary will start increasing at a higher rate, in accordance with the higher rate of inflation. (You'll spend more money for haircuts, but the barber will have more money to spend in your store.) Your mortgage payments will remain fixed, however, so they’ll take up a lower percentage of your income than you had counted on.

Of course, your salary increases aren't 'real'. After all, they ultimately result from the Federal Reserve's decision to print more money. We know intuitively that putting more money into circulation won’t make us all richer, but it can make some of us richer. We just saw that an increase in the inflation rate will make it easier for you to service your loan, so you'll be a clear winner. On the other hand, your lender will lose out in the deal because your 6% interest payments won’t even compensate for the 10% annual erosion in the real value of your loan balance.

In short, a sudden increase in inflation results in a significant transfer of wealth, from your lender to you.

Now let's consider the opposite case, where the inflation rate falls from +2% to -10%. As before, there will be a transfer of wealth, but this time, it will be from you to your lender. Your salary will decline at a 10% annual rate, making it increasingly difficult to service your mortgage. Conversely, your lender will be receiving 6% interest on its principal, even while the real value of that principal is increasing at 10% per year.

The problem gets worse. Because the value of your home is likely to be falling (just like everything else), your lender will be getting anxious about its collateral. If you default on your loan (an increasingly likely outcome considering the circumstances), the proceeds from a foreclosure sale may not be enough to pay off the principal. That will make your lender increasingly reluctant to extend new credit against your home. In short, while your creditworthiness is deteriorating and your likelihood of default is increasing, some banker will be losing his job because his employer isn't doing enough mortgage business.

And so on. There's more to the story, but by now it should be clear that deflation means more than discounts at Wal-Mart.