‘Leaning against the wind’, debt deflation, and the Riksbank

Lars E.O. Svensson, 10 October 2013

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A dangerous thing concerning debt is what Irving Fisher (1933) called ”debt deflation.” It is usually described as deflation causing the real value of nominal debt to increase. Loan-to-value and loan-to-income ratios also increase, since the debt is fixed in nominal terms but the nominal value of assets and income fall. This may hurt the economy through bankruptcies, deleveraging, and fire sales.

  • But the important thing with the concept of “debt deflation” is not deflation, that is, negative inflation. The important thing is that the price level becomes lower than previously anticipated.

This implies that real debt and loan-to-value and loan-to-income ratios become higher than anticipated and planned for. Everyone has probably not realised that this is something that the Riksbank has caused with its “leaning against the wind” policy, by neglecting the objective of price stability and conducting a monetary policy that has resulted in inflation below target.

The majority of the Riksbank Executive Board maintains in their latest policy decision and in the minutes that “although a lower repo-rate path could lead to inflation attaining the target slightly sooner, it could also increase indebtedness and thus the risks to economic development in the longer run” (the minutes from the meeting on September 4, 2013, summary).

As I have shown in Svensson (2013) and summarised in a previous Vox column, the majority is wrong when it says that a lower policy rate would increase household indebtedness. It has misunderstood how the policy rate affects real debt and the debt ratio (the debt-to-income ratio).

  • A lower policy rate would reduce (not increase) household real debt and the debt ratio. This is because it would increase the price level and nominal disposable income faster than total nominal debt.

This effect is small, however. A 1 percentage point lower policy rate during 1 year leads over the next 4-5 years to about 1% lower real debt and debt ratio than without the rate increase. Thereafter, real debt and the debt ratio slowly rise back to the level they would have had without the rate increase. But a larger effect on household debt and the debt ratio arises because the Riksbank has, over a long period, neglected the objective of price stability.

  • The Riksbank has, over a long period, conducted a leaning-against-the-wind policy that has led to average inflation substantially below the inflation target of 2%. This has led in the medium and long run to a substantially lower price level and nominal disposable income than if inflation on average had been kept on target. Then real debt and the debt ratio have become higher.

As we can see in Figure 1, the price level in Sweden has now fallen significantly below the level it would have been at if inflation had been on average 2% since 1997. In this context, the Riksbank stands out among the other central banks that have had inflation targets for the same length of time. The other central banks have kept average inflation on or very close to their targets, as I have shown in another Vox column. For instance, in Figure 1 we see that the Bank of Canada, which also has an inflation target of 2%, has kept average inflation almost exactly at 2% since 1997.

Figure 1. The CPI in Sweden and Canada compared to the CPI for 2% inflation since 1997

Source: Statistics Sweden and Datastream.

That the price level in the medium and long run becomes substantially lower than if it had increased by 2% per year has substantial consequences for real debt and the debt ratio. Since 1997, long-run inflation expectations have been anchored at 2%. As actual average inflation has become much lower, the price level and nominal disposable income have now become substantially lower than borrowers anticipated when they took out their loans. It means that the real value of the loans and the debt ratio has become substantially higher than the borrowers anticipated and planned for.

Figure 2 shows by how much the real value of the loans has increased. The increase in the real value in July 2013 of a particular loan, compared with if inflation had been on average equal to 2%, is measured along the vertical axis. The horizontal axis shows the date the loan was taken out. The earlier the loan was taken out, the higher its real value tends to be in July 2013.

We see in the figure that a loan that was taken out in the beginning of 2003 now has a real value about 9% higher than the borrower anticipated when the loan was taken out. This is also a substantial redistribution of wealth from borrowers to lenders, that is, from mortgage holders to banks.

Figure 2. Percentage increase in the real value in July 2013 for a loan, compared with if inflation had been 2% and depending on when the loan was taken out

Source: Statistics Sweden and own calculations.

The fact that the price level has become lower than if inflation had been 2% also implies that the borrower’s nominal disposable income has become correspondingly lower.

  • This means that the debt-to-income ratio in July 2013 for a loan taken out in the beginning of 2003 has also become 9% higher than if the Riksbank had kept average inflation on target.

9% is a big increase. The debt ratio for this loan has probably increased by even more than 9%, since the Riksbank’s tight policy, especially the last few years, has led to lower real disposable income than if average inflation had been 2%.

Thus, the Riksbank, by neglecting the objective of price stability for a long period, has caused real debt and the debt ratio to be substantially higher than if average inflation had been kept on target. “Leaning against the wind” is counterproductive as a way of limiting household real debt and the debt ratio.

References

Fisher, Irving (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica 1, 337-357.

Svensson, Lars E.O. (2013),“Leaning Against the Wind’ Leads to a Higher (Not Lower) Household Debt-to-GDP Ratio,” working paper.

Topics: Monetary policy
Tags: debt deflation, Leaning against the wind, Riksbank

Visiting Professor, Stockholm School of Economics; Research Fellow, CEPR