## Saturday, May 5, 2012

### The Inflation Adjustment of Debt

The typical inflation-adjustment of GDP takes the total dollar value of one year's output and converts it to the dollar value of another year. For example, if a basket of goods used to cost \$80 but now costs \$125, you take GDP now, multiply by 80, and divide by 125 to convert the current value to the value of that other time.

If for another year the basket cost \$115, well, multiply that year's GDP by 80 and divide by 115. (Basically, the arithmetic un-distorts output by one year's price level and re-distorts it by a different year's price level. When all the years are distorted by the same price level, economists call that "real" output.)

Using this method, GDP for any set of years can be evaluated as if prices had not changed. That lets you distinguish changes in prices from changes in the amount of stuff we produce, to get a more accurate picture of how output has grown over time.

The GDP Deflator is a series of numbers that are conversion values for a whole series of years. That's where you find values like my examples 80 and 115 and 125, but actual numbers for all the years. So that works.

The thing is, when you look at GDP you're looking at the value of one year's output. It makes sense to use the deflator number for that year when you do the calculation.

But when you look at debt and try to make the same conversion of values, there is a problem. Debt is typically created and accumulated over a number of years rather than a single year. If you look at the debt you have today and this year's deflator number is 125, that's probably not the right number to use for all your debt. Maybe you took on some of that debt last year or the year before that, or the year that the deflator value was 115, or maybe even the year the deflator value was 80. This complicates the calculation.

With GDP, the number is the total value of stuff created on one year. So the standard conversion works fine. But with debt, which accumulates over many years, the standard calculation must give a wrong answer.

In my next few posts, I will consider the inflation adjustment of debt.

Clonal said...

Art,

I think we discussed this before. What needs to be adjusted is the cost of servicing debt - which includes interest payments, service charges and the repayment of capital. This still leaves debt accumulation to be accounted for. The accumulated debt when adjusted for GDP will give you an idea of the potential shift of wealth and income from the debtor to the creditor. In other words, it would be a measure (sort of!) of changes in inequality

Clonal said...

Art,

You may also want to look at Scott Fullwiler's presentation -
What Should Economists Have Learned from the Crisis?

The Arthurian said...

Clo -- Yes, we most certainly did discuss this before. You introduced me to the concept of inflation-adjusting debt here... I was uncomfortable with the concept, but unclear why. Actually, I think some of my objections then were quite confused.

What it comes down to for me now, as my current series of posts attempt to show, is that the standard calculation used to inflation-adjust GDP (which is a flow) is perfectly appropriate for use also on *deficits* or on changes in debt (which are flows) but not for the multi-year accumulation of debt (which is a stock).

In response to your remarks above, let me be hesitant and careful, and say:

1. I think "the cost of servicing debt" is a current expense, so that it occurs in "nominal" dollars. It seems to me that inflation-adjustment of debt is irrelevant when the concern is "where do I stand now" with my debt obligations.

2. The accumulation of debt is assembled from borrowings made over several years. I think that for the inflation-adjustment calculation to be correct, each year's piece of accumulated debt must be adjusted separately, in order to properly account for the gradual decline of purchasing power in inflationary times.

3. Could you be more specific regarding the "adjustments" you note in your remarks? I bought a house just before some of that double-digit inflation in the 1970s, and as inflation increased my paycheck, my mortgage payment became easier and easier to bear. This strikes me as a 'shift of wealth and income' from the creditor to the debtor, not the other way around as you describe.