In times of high inflation, it is sometimes pointed out that loans are then easier to repay. Because money loses value due to inflation. But can debt be “inflated away”?
The advertisement for incurring debt can be read on the website of a German real estate financier. “As a real estate borrower, you generally benefit from rising and sustained inflation as the real value of the debt falls,” it says. Something like this is an argument that you come across again and again: If inflation is high, the amount of the loan remains unchanged, but the sum is worth less. In real terms, the amount of debt decreases and loans become easier to repay. They allowed themselves to be “inflated away”, so to speak.
The idea is correct at first glance: If money becomes worth less, the same applies to debts. But does this make them easier to repay? “The invoice is often made without interest,” says Thomas Kehl, founder of the financial portal “finanzfluss.de”. “Only when interest rates are lower than inflation can debtors benefit from inflation.”
Banks charge interest above the inflation rate
A reality check on current loan offers: In September, consumers had to pay an average of around 8.5 percent interest on new consumer loans. Inflation in the same month, however, was 4.5 percent. Interest rates are therefore significantly higher than inflation.
Because interest rates rise with inflation. This applies to real estate loans as well as consumer loans. These interest rates are based on the key interest rate of the European Central Bank. When inflation rises, central banks raise key interest rates to get prices back under control. “That’s exactly what we’re seeing right now. Higher interest rates mean that consumers pay more for a loan than before,” explains Thomas Kehl. In other words: The interest rates on a loan develop in a similar way to inflation: upwards.
More and more Germans are over-indebted
In order to still benefit from inflation, people’s incomes would have to rise faster than their money loses value due to inflation. “If income increases at least at the same rate as inflation, then you can compensate for inflation,” says Kehl.
But despite rising wages, Germans’ purchasing power is falling. An evaluation by the Economic and Social Sciences Institute (WSI) in September shows: Although wages increased by an average of 5.6 percent in the first half of the year, consumer prices rose by an average of around 7.4 percent. This resulted in a decline in average real wages.
This means that debtors have to pay their loans with less available money. This is finding this difficult for more and more people in Germany: More than 5 million adults in Germany were considered over-indebted last year. This means that they will not be able to pay their bills for a longer period of time.
Growing national debt
Many countries are also heavily indebted, and some deficits are rising faster and faster. In the USA, debt has increased by almost half since 2019. In the European Union, public debt increased by around 30 percent during this time. Greece, Italy and Portugal have the highest debts in relation to economic output across the EU. As interest rates rise, debt service becomes more expensive for them. Germany currently has to spend around nine percent of its budget on its interest burden, the USA around 13 percent. A risk?
“The USA is not the only one where debt sustainability is becoming a problem,” says Karsten Junius, chief economist at Bank J. Safra Sarasin. Interest costs also rose in the euro area at a time when spending on defense or demographic and ecological change were increasing. In some countries, interest rates have risen above possible growth rates. In the medium term, budget surpluses are necessary to keep the debt level constant in relation to economic output. It is therefore likely that more countries will break EU fiscal rules.
Dependence on investors
Debt is also a growing problem for the United States: the USA is dependent on foreign investors. And these investors – such as central banks of other countries such as China – were always happy to take advantage: US government bonds are among the safest in the world. Until now, no one doubted that the world’s largest economy would repay its debts.
But fewer and fewer investors are currently lending money to the USA through bonds. The consequences: Prices fall, bond yields rise – and financing costs become higher. The USA is issuing more and more bonds to pay the interest on existing ones, in order to continue spending money instead of saving. In other words: more and more debts have to be paid more and more expensively.
As the owner of the world’s reserve currency, the dollar, the USA could now print more money and stop this development. But that would mean one thing above all: more inflation. So this is exactly the phenomenon that is currently being combated.
IMF calls for savings
Institutions such as the International Monetary Fund (IMF) are therefore warning debtor countries to save money. The IMF has calculated that if countries reduce their spending by one percentage point of economic output, inflation would fall by half a percentage point.
They could also reduce their debt and thus their interest burden through higher economic growth. But that is difficult. The IMF expects Germany to experience a recession this year, i.e. a decline in economic output. The Monetary Fund predicts economic growth of 2.1 percent for the USA and five percent for China.
Conclusion: Whether with or without inflation – debts have to be paid, by consumers and states alike. For consumers, this means that if income does not rise with inflation, it may become more difficult to pay off a consistently high debt rate with less available money. States either have to save more or stimulate the economy more in order to pay off their debts or at least not to increase them further. A difficult undertaking in times of crisis and war. Debt remains one thing above all: expensive.