Monday, May 18, 2009

How we can overcome deflation...

Thinking about some of my past posts - calling out for allowing deflation to occur - it occurred to me that I might have missed one aspect - loan contracts. So I did some more thinking and here's what I came up with...

Nearly ever economist will tell you that deflation is bad. Yet (as much as they want to ignore it) it is a part of a healthy economy. However, our economy structures loans in a bad way - one that always assumes inflation. This is most evident both in the Great Depression between 1929 and 1944 as well as in our present economic climate where the housing market literally forces people to give up their homes because the market value is lower than the mortgage and they either (a) have to sell for some reason in the immediate or near term, or (b) they simply cannot afford to pay the mortgage any longer due to financial troubles.

So the question becomes - how can we allow for deflation while at the same time not undermining our current system?

The solution may be simpler than one thinks - allow for deflation in the loan contracts through some relatively simple clauses:

i. All the contracts have interest rates. Apply the growth in the interest during inflationary periods.
ii. When in a deflationary period, the interest rate drops sufficiently to account for the difference in value due the deflation.
iii. Any lost inflation per #ii is not counted against the borrower by the lender.

Basically - if inflation is 5%, then the loan contract's interest rate applies. However, if deflation kicks in, then the 5% interest rate might either change or go away entirely. (While one might like it to drop below zero, it would probably be hard to get buy in from lenders if it did, unless it was a dramatic deflation. And by dramatic I mean something like 15% or greater deflation, not simply 1-2%.)

Now why does this work? Valuation of the currency. The lender is still receiving more value back than what they paid out. For example, if a lender lent out $100 at a 5% interest rate, that would net them $105 if paid. If deflation kicks in at %5, then the $100 is only worth $105.26 ( 100*100/95) just because of the deflation. If the borrower paid back the $100 without any interest, they would have still made their %5 back due to an increased value in the currency. However, if they continue to charge the 5%, then they would receive $110.53 (105*100/95) - e.g. 11%, thus making the loan unaffordable to the borrower as it ends up charging 6% more than it should have.

Some will say "well tough luck you took a gamble with the loan - that's life". True, you did take a gamble but so did the whole financial institution, based on a flawed assumption - that deflation will never exist. Why not involve deflation in the assumption - that it will exist because it does in real life - and adjust the gamble based on that?

This little change - of prorating the interest rates for deflation during the life of the loan - will allow deflation to occur in a safe and harmless manner for loan providers and borrowers.

Ultimately this benefits both lenders and borrowers. For lenders, it will mean less people having to walk away from a loan when deflation occurs. For borrowers, it means having a better financial stability to continue paying the bills in a deflationary period.

Lenders can start by including language for this in new loan contracts. Borrowers can start by pushing for this kind of language in new loan contracts. For both, it means less time spent in bankruptcy courts during those deflationary periods. And either Lenders could extend this to existing contracts, or the gov't could mandate it for all existing contracts.

Aside: My guess is that this would only really need to apply to large loans (e.g. card, houses, commercial, etc.) that are required for the economy to continue. Small loans (e.g. credit card, etc.) should probably be able to do without this, though likely would get it too just to make things fair overall.

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