"Life Cycle" Hypothesis of Saving: Aggregate ... - Arabictrader.com

284 Miscellanea
I would like to focus on the problems created by inflation in connection with
various types of lending contracts, especially long-term amortized contracts such
as in home financing.
Consider first the case of debt instruments of the pure balloon type (to repay
with accrued interest at the end of the loan): these could be short-term, one-period
instruments or zero coupon bonds. This instrument happens to be totally unaffected
by the rate of inflation, as long as it is fully anticipated and there is no
money illusion. The nominal interest rate increases, and hence also the terminal
balloon payment, for a given amount borrowed, but this extra payment is fully
made up by the loss of purchasing power of the terminal payment; so in real
terms, leaders and borrowers pay and receive at each point the same real amount
independent of inflation, even though they contract in nominal terms at the
nominal rate. The outcome is what some seem to have in mind when talking about
neutrality. But suppose instead the instrument is again a balloon type but paying
periodic interest. In this case, the periodic payment will go up to the extent that
interest rates rise because of inflation. As a result there will be a higher initial
real payment stream. However, the payment will gradually decline in real terms
as the price level rises. And when the terminal balloon payment comes due it will
be lower in purchasing power than the amount received with the difference paid
out of the overpayments of the early years. Thus inflation is seen to change radically
the nature of the contract, requiring in particular, an earlier repayment (front
loading) and with the difference being large if inflation is large. One might object
that the original real contractual path could be retrieved by substituting the initial
nominal contract with an alternative one, or by an indexed contract. Unfortunately,
indexed contracts are generally unacceptable to lenders and possibly borrowers.
As for alternative nominal contracts, what would be required is for the
lender to lend additional nominal amounts in the early phase to permit the borrowers
to pay the extra interest; but this negative amortization is hardly what
“conservative bankers” want to engage in, given their nature and their inability
or unwillingness to distinguish between a nominal and a real payment.
The situation gets to be much more unwieldy in the case of fully amortized,
level payment fixed rate instruments, such as the traditional mortgage, which has
been the standard way of financing housing for many decades. In the absence of
inflation the traditional mortgage possesses some very desirable characteristics:
it enables the debtor to repay his loan—including accrued interest—fully within
a preestablished time with payments constant in time in real terms. But the same
instrument in the presence of inflation loses all these nice properties (except the
fixed term). The source of the problem is that the payment is constant in nominal
term; hence, it must decline in real terms, as the price level rises at the rate of
inflation. Thus the repayment schedule must be tilted forward with an overpay-