Evand and Thommo,
I understand the point you've both made and its a good one. The banks are not in the business of losing money. But that's only because they lend at a margin on what they borrow money at. So they always make their spread.
But the point of inflation is that it does inflate away your debt in "real" terms. I know you understand this as its the basis of the Time Value of Money.
i.e. FV = PV*(1+i)^n
where FV = Future Value, PV = Present Value, i = inflation and n is the number of periods.
So, if we have a loan with a Present Value of $200K and hold it for 10 periods of 3% annual inflation then the Future Value of this loan would be $268,783. But we get that loan for only $200K! If we don't "pay" for this inflation then we're getting a discount of $68,783 on its future value price.
But the point you're making is we pay for that inflation through our interest rate. This is only partly true though. Since interest is only charged on the principal sum which is not indexed to inflation. Lets assume the bank charges 5% interest on the loan and makes a 2% spread above inflation of 3%. This may work in year one, but in year two the FV of that loan has increased in line with inflation but the interest is still only charged on the principal sum of $200K. In time the value of that loan increases exponentially in line with inflation whilst the loan amount which the interest is calculated on remains fixed at the level it was when borrowed in the past.
In fact, after 18 periods the interest charged at 5% does not even cover the inflation rate increases in the value of that money at 3%. i.e. After that period of time, the interest doesn't even cover inflation.
And this ignores the fact that all the other elements like rent increasing at the rate of inflation come into play as well. On a pure and simple time value of money analysis, inflation does erode the value of your fixed principal sum loan.
Cheers,
Michael