Question

We have learned from this course that the real value of the debt is eroded by inflation and may be overestimated because of it and other factors. Discuss whether you feel that the debt will be a major concern during your working lifetime and retirement why or why not?                             

Answer 1

Debt is very useful financial instrument which can help an investor build wealth over time. However one must aware that he has to repay his debt on time. When one is not able to repay its debt obligations due to whatever reasons, debt trap can be created and that would be very difficult to escape.

Debt can be categorized as good debt for example mortgage loan and student loan, value of underlying is appreciating in nature. However there is bad debts such as auto loan, credit card etc. underlying of which is depreciating in nature and this would lead to a debt cycle.

Debt Cycle

A debt cycle is created when constant borrowing leads to ballooning of debt, increased interest burden and eventually risk of default. When consumer spend more than what he earns, than he creates interest cost burden and this would turn into bad debt cycle. Hence, sometimes interest cost become so much expensive, than one need to get more debt in order to repay its interest cost and this would increase the debt level at much faster rate. Sometimes out of habit, consumers pay minimum payments of their credit card and create burden of expensive interest rates on their credit cards.

Debt restructuring is god sometime to repay high interest bearing debt with low interest bearing debt. But when debt is required just to keep up with accelerated consumption level, things become dicey.

Role of inflation over value of debt:

Inflation plays one of the important role to reduce the value of debt for countries or firms, because inflation means increase in prices of products which would lead to increase in revenues and more liquidity for companies to pay-off its debt. Same would be applicable for individuals when wages are linked with inflation. And this would leads to reduce in debt burden.

Interest Rates

Higher inflation trigger higher interest rate to curb excess borrowing and eventually to reduce the demand in market till prices of product come back to normality. So borrower would avoid taking debt at higher rate. Hence, real value of debt reduces with inflation if one has higher repayment ability to get away from its interest cost burden.

Example:

In a scenario when there is increase in real income i.e. wages are increasing at a rate higher than inflation rate, then consumer tend to take more loans and repay the interest which is manageable cause higher disposable income. And as increase in wages continue to out-phased inflation rate, it become much easier to repay debts. Hence, inflation and rising income assist to reduce the value of debt.

Macroeconomic view:

Rise in inflation would erode the real value of debt. Country that holds debt in its own currency has an incentive to reduce its debt burden through inflation. If a foreign country holds significant amount of share in other country’s debt, tendency to use inflation for reducing the debt burden is a critical factor. However, shorter debt maturities and inflation linked debt would limit the country’s ability to reduce its debt burden through inflation.