What’s So Bad About Deflation?

I’ve started to look closer into deflation.  I’m starting to become a believer.  Given that we are headed into a bout of extended “deflation”. What does this imply for us as investors in assets and holders of debt?  For a good definition of deflation I went to Wiki.  Here’s how Wiki defined deflation:

• Deflation is the opposite of inflation Therefore, under the usual contemporary definition of inflation, ‘deflation’ means a decrease in the general price level. Alternatively, the term was used by the classical economists to refer to a decrease in the money supply and credit; some economists, including many Austrian school economists, still use the word in this sense. The two meanings are closely related, since a decrease in the money supply is likely to cause a decrease in the price level.

• Deflation is considered a problem in a modern economy because of the potential of a deflationary spiral and its association with the Great Depression, although not all episodes of deflation correspond to periods of poor economic growth historically.

In a deflationary environment prices start to drop as was evidenced in yesterdays CPI data.  If you look at prices of most commodities, I think we could agree that prices in general are dropping, Oil, Gasoline, Steel, Aluminum etc.  The list is endless.  If you look at prices, you’ll see that most are dropping.  Retailers are dropping prices also. Why ?

Consumers are not buying.  The lack of demand is resulting from decreases in credit.  As prices continue to drop, consumers continue to wait for better prices and postpone purchases.  This lack of demand turns into a downward spiral.  The Fed tries to combat it by pumping money into the system, but it doesn’t work, because consumers hoard cash and wait for lower prices.

Eventually, prices will bottom and those that have been fortunate enough to hold onto their cash, will find that their currency will now have greater buying power than it did prior to the beginning of the bout of deflation (due to price declines).  It becomes a tax to borrowers. Borrowers are now forced to repay their loans with dollars that now have greater buying power. That’s painful.  That $2000/mos. mortgage payment would now buy 4 flat screens instead of just 1 flat screen.

• While an increase in the purchasing power of one’s money sounds beneficial, it can actually cause hardship when the majority of one’s net worth is held in illiquid assets such as homes, land, and other forms of private property. It also amplifies the sting of debt, since– after some period of significant deflation– the payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as a phantom amplification of a loan’s interest rate.

• Since deflationary periods favor those who hold currency over those who do not, they are often matched with periods of rising populist sentiment, as in the late 19th century, when populists in the United States wanted to move off hard money standards and back to a money standard based on the more inflationary (because more abundantly available) metal silver.  Most economists agree that the effects of modest, long-term inflation are less damaging than deflation (which, even at best, is very hard to control). Deflation raises real wages which are both difficult and costly for management to lower. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment.

Interest rates will continue to decline as the Fed will continue to try to stimulate demand. Cash is king in this environment.  In an inflationary environment it’s desirable to own assets which are increasing in value.  In a deflationary environment it’s desirable not to own hard assets, as they will decline in price.

• In a credit-based economy, a fall in money supply leads to markedly less lending, with a further sharp fall in money supply, and a consequent sharp fall-off in demand for goods. Demand falls, and with the falling of demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated.  Banks get assets which have fallen dramatically in value since the (mortgage) loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans (as in Japan, most recently). This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

Companies are forced to cut back on labor so that they can reduce costs to meet the declining demand.  Unemployment rises.

Deflation is an ugly scenario compared to the inflationary environment that we’ve become  accustomed to.  What steps can you take as an investor to protect yourself in a deflationary environment ?

• Own stock in companies that will not see declining demand - food / staples, health care, energy, utilities etc.  Own them after they have already suffered large declines in price.

• Reduce your ownership of hard assets - House, Land….etc.  They will decline in price.

• Reduce Your Debt by disposing of hard assets. - Don’t use cash to pay it down.  Rent R/E instead of owning it.

• Own Bonds in companies that will not see declining demand.

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