Joe Barbieri
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Joe Barbieri in Joe the Investor,

A Hidden Source of Inflation

Whenever there is discussion about inflation or standard or living, the causes of it are typically pinned on labour, materials and overhead for producing a product. There is another cost which is indirect but very prevalent when it comes to the cost or pricing of goods – the cost of debt. Consumer debt and government debt are widely publicized and monitored as indicators of economic health. What about producer debt?

Most businesses finance operations with debt because it is considered a tax expense. There is also this idea that using someone else’s money is better for business because it can free up your own resources, allowing you to produce more goods. What is not discussed is the effect that producer debt has on an economy. When a business borrows money to do something, the money always comes at a cost. Should that same business use cash that it has invested instead, the cost would be negative as the company is not paying to have access to money, and is earning interest on keeping the cash. The tax deduction of debt financing reduces the cost of the financing, but there is still a cost. A business will typically put this cost into their expense list and adjust the price of the goods and services upward to recoup the money spent from the consumer. The consumer sees this cost as inflation or rising prices.

What is the effect of doing this? If many businesses are using debt and all of them are passing the costs onward, this will result in higher prices for everything. Since debt is compounding, this will be on ongoing expense that has nothing to do with labour, materials or overhead. Does this matter? In some cases, debt will not be a major factor if the interest rate is relatively consistent and low. If the rate is volatile and high, this expense could create distortions in the business world because access to credit will favour large companies instead of smaller ones. This will create an additional barrier to entry which is outside the scope of the market where the good is sold. As an example, I could have a great idea for selling lemon juice, but I would have to borrow money at 10% interest to acquire scale of the lemon juice production equipment. A large company may be able to get the same financing at 2%, which would mean my prices would have to be 8% higher to break even. Since that amount of margin differential can be very high, I would not be able to be in business. Interest rates are low for mortgages and lines of credit, but if you are talking about loans for inventory, unsecured credit or private lending, interest rates can go as high as 60% annualized before the usury laws would limit what can be charged. This is obviously a wide range, and paying 50% more for your inventory, production equipment, supplies etc would be quite a disadvantage.

As you can imagine, changing interest rates can have an amplified effect on the inflation numbers. Higher interest rates would also lesson consumer demand and vice versa which would have an opposite effect on inflation, but this discussion would be outside the scope of this article.