Seven Myths. Nay: Seven Follies (II)

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I have not read about it in a while but IIRC it goes like this: In a deflationary environment the entrepreneurs' debt burden is increased (in real terms) and they go broke, worsening the depression/deflation.

And in an inflationary environment, with fix rates, ... the lenders go broke!

Whereas, with adjustable rates, the situation is the same as now:

Assume, then, that this inflationary miracle happens: all prices and wages increase of, say, 10% a year for the next two years, housing prices stabilize or raise of, say, 2% and output does not fall. What will happen to financial markets and to banks in particular? Banks, per se, may not care: they are owed nominal loans and owe nominal quantities to depositors and investors, hence as long as those nominal dollars come in from the borrowers the nominal dollars can go out to the lenders/depositors. But, and hereby lies the trap, those lenders are us and we are not as dumb when we act like lenders as we (apparently) are when we act like borrowers. Reason is: interest rates can adjust for inflation, and can do it real quick. Let’s not forget that most of those loans are ARMs, i.e. Adjustable Rate Mortgages, and that Libor, Euribor and all the rest will not sit still out there, should inflation reappear. At which point, you understand, we are back to square one: a 10% inflation implies a 10% increase in nominal rates, which will match the 10% increase in nominal incomes and the real situation of homeowners who are now having troubles to pay their debt will remain exactly the same!

Actually, in a deflationary environment you can go to your lender and recontract the value of the loan, which is what lots of people in the US are doing ... Banks are getting the point (partially: Citibank, for example, is willing to re-contract on your mortgage's principal only after you skip a few payments! Talk about incentives! Who said that bankers know what they are doing and that's why the deserve the big salaries they earn?) and that's what you would expect. Note that, in the case of houses, the deflation has already happened and that's why, in fact, lots of people decided to default: they were upside down. The bubble we had before, that was "inflation", local, but inflation.

To put it differently: there is no monetary solution to real problems.

and that Libor, Euribor and all the rest will not sit still out there, should inflation reappear

ONLY IF governments will source the funds necessary for reflating the economy by issuing debt instruments. Should they decide that their interests are aligned to the debtors' (a category to which in the West they do belong, in part by owing trillions to people they don't even claim to represent, such as Asian sovereign and private investors), and starts printing money, then the real interest rates might well be driven into negative territory for an extended period of time. It happened already, when Nixon on August 15, 1971 shut the gold window "to defend the dollar agaist the speculators" (ha ha!) and those sneaky unpatriotic types who weren't buying American products -- also stung with an extra 10% tariff for good measure.

Of course, the foreign governments did not stay idle and started monetizing their debt as well, and we all got the wonderful seventies.

So, why couldn't it happen now?