07 Aug 2016 Debt and deflation

Cyprus is now well into its third year of deflation. According to the EU-harmonised consumer price index, prices fell by 0.4% in 2014, 1.5% in 2015 and by 1.9% in the first half of 2016. Deflation has negative consequences for a highly indebted economy as it tends to increase debt ratios, or at least stop them falling so fast. Let’s keep things simple to explain why.

Assume that the starting point for GDP in Year 1 is €100. This means (broadly speaking) that the economy generated €100 of value that year. If I also have a debt of €10 then I have a debt/GDP ratio of €10/€100 = 10%.

Now let’s assume that my economy grows in real terms that year by 3%. For real terms, think volumes (I sell 50 ice creams) rather than values (I sell €50 worth of ice creams). So in real (constant-price) terms my GDP has gone up to: €100 + 3% = €103. (On a calculator it is 100 x 1.03).

If my inflation rate that year was 2% then my GDP goes up (roughly) to 100 + 3% + 2% = around €105. (Calculator: 100 x 1.03 x 1.02). My debt ratio is now €10/€105, which is 9.5%, lower than my starting point of 10%.

But if inflation that year was negative, then my GDP number comes out roughly like this: 100 + 3% – 2% = €101. My debt is still €10, so my debt/GDP ratio is €10/€101 = 9.9%. My debt ratio has barely budged even though I had a strong real GDP growth rate of 3% that year.

And if we have both deflation and recession, as Cyprus did in 2013-14, then you might have a scenario like this: €100 -3% – 2% = €95 (roughly as the calculator is 100 / 1.03 / 1.02.) My debt ratio is now €10/€95 = 10.5%, and therefore higher than when I started.

Cyprus has a debt ratio of about 109%. Debt ratios above 100% get the unwelcome attention of rating agencies, especially when they are combined with a lot of bad bank debt. This is one of the reasons why Cyprus paid 3.8% to borrow from abroad a couple of weeks ago.

Spain, with a debt ratio still (only just) below 100%, currently pays only 1% despite its problems. The UK, with a ratio of about 90%, pays only 0.7%.

Deflation is also bad for investments and pensions. Germany is considered so immune from inflation that people actually pay extra to lend it money.  For example, if you lend Germany 100, you actually end up paying a little under 101 for the privilege.

You only make money if you can get rid of it earlier than maturity at a higher price than you bought it.