Below is an article I wrote that was published as a guest post at Free Money Finance last month, August 2010. It generated much discussion and debate, so I thought I would share it here at Squirrelers
Many of us who take an interest in personal finance understand the concept of “a dollar today is worth more than a dollar tomorrow.” We realize that the present value of money today exceeds the present value of the same amount of money at some point in the future. This is due to inflation, which erodes the purchasing power of money over time. Looking at it another way, if you buy a cup of coffee for a dollar today, it might cost you more next year – say, $1.05.
Lately, the financial news has brought us discussion of a completely different concept: deflation.
When you first think about it, deflation sounds like a good concept, in that it’s the opposite of inflation. A dollar tomorrow will be worth more than a dollar today, even if stuffed under the mattress. Pretty good deal, eh?
No. In reality, deflation is not good for the economy, and the effects can wreak havoc with the ordinary investor’s portfolio.
Downward-trending prices may seem great initially, but this leads to pressure on businesses. The response is often a reduction in workforce, which in turn causes a reduction in demand as incomes drop. That’s not good for stocks. Thus, the spiral begins.
Governments may try to lower interest rates to stimulate spending and counteract these deflationary effects. Looking at our current interest rates, they are at remarkable lows compared to long-term averages. The issue is that there is only so far these cuts can go.
Japan saw remarkably low interest rates for years, as it has been in a longer-term deflationary cycle. That country was rocked by a sharp decline in real estate prices about 20 years ago. Does that part sound somewhat familiar to those of us here in the U.S?
Now, I can’t predict whether or not this will be long-term economic cycle we are in. Who knows, we could very well be headed for an inflationary period after a few years.
Regardless, I suspect that while extended deflation may not by any means be a sure thing, it’s certainly a real possibility at this point.
In light of this, it’s interesting to consider what would be a good hedge vs. deflation. Some people are proponents of gold as a hedge; I had a recent discussion with a friend who suggested gold. This same friend correctly called the real estate collapse, despite many people – including me – thinking he was way off base. I’ll give him credit – he was right. The thinking is that if the money supply increases, inflation could be around the corner. In that case, gold would be a hedge.
That said, my take is that thinking purely about deflation, the following are good defenses:
1. Cash.
2. Short-term Government Bonds
My questions are as follows:
1. Do you think we are beginning a period of deflation that is at least short-term, if not greater – or are these fears unfounded?
2. If deflation takes hold of the economy, how would you reallocate your investments? Would you hedge with cash/short-term government debt, gold, or other vehicles?
I will be honest, I am completely clueless as to where this nation is headed economically. It seems like rules keep breaking, and the past is not necessarily a predictor of the future.
I just keep plugging away and investing mostly in stocks/bonds. I have been hesitant to dive in with gold because of the high prices. I considered silver at one point, but never pulled the trigger.
Everyday Tips – It’s certainly hard to predict, I agree. The price of gold makes me take pause, as I’m wary of bubbles. I have focused a bit more on cash of late.
Time preference holds true even under deflation, though we need to qualify which type of deflation we’re talking about. Monetary deflation happens to mess things up a bit, but is an unfortunate consequence of huge credit buildups. A healthy economy with a stable currency would experience general price deflation, as the total amount of goods & services in the economy steadily increases. Under price deflation, for any venture which has a rate of return greater than the rate of expansion of the economy, it will still be profitable to borrow money to get those dollars today, rather than tomorrow.
However, this discussion is purely academic. I don’t believe we’ll actually encounter significant across-the-board deflation. Those with their hands on the levers of the printing press are scared to death of deflation, and I don’t think deflation is politically acceptable to them nor any of the arm-chair economists with significant influence over government policy. Based on my reasoning, I fully expect inflation down the road, regardless of what technical indicators might be telling you today (and there is plenty of inflation visible even today; just not across the board).
Invest It Wisely – Yes, nobody wants deflation. What about “quantitative easing”? Ultimately, a response to deflation can be printing more money, I agree. If inflation is in fact what might happen further down the road, we’re looking at gold once again. Is this fully priced into the current market value of gold? All very interesting…
I do believe certain sectors of the economy have deflated or are experiencing it. It is also appears region-specific. However, it is very difficult to predict what the economy is doing in absence of data. It is hard to predict what it is doing with data too 🙂
Roshawn – yes, it’s all hard to predict. If I had a crystal ball, I probably wouldn’t be blogging here:)
When I think about this kind of stuff, my head hurts. I wouldn’t be any more surprised if we had, no inflation, serious deflation, or serious inflation. I’m sure if you look, there’s a scholar or two that’s touting each one of these theories right now.
In the end, I try to manage the things I can control regardless of the above outcome. Those are:
-my employ-ability – keeping the skills current and adding new skills every year
-my spending – paying off debt so that if I hit a rough spot, I don’t lose everything
-my savings – (this is the most at risk of inflation/deflation effect) – my thinking lately is to invest in a business that I can control vs an outside entity. If you’re selling something that people need, you can theoretically continue to do that regardless of what the $ is worth. And if it’s a service, then you’re even more insulated because you have low overhead. Of course the tough part is trying to do that while still working and supporting a family.
I wish I had a good answer.
Sandy L – I have noticed the same thing. Economists have been all over the place here, and have had almost opposing viewpoints. I have heard about imminent inflation, long-term “Japanese-Style” deflation, and other scenarios. Hard to predict, no question. Personally, I’m not saying deflation will happen, but think that it’s at least more of a realistic possibility than at other times. That said, since I wrote the article – and it was published on FMF – the chance of an extended period of deflation seems less likely. But not out of the question.
Yes, I think it’s smart to control whatever you can. And yes, doing it while supporting a family is a challenge. I know this personally:)
It’s really hard to predict where the economy is going. I have to agree with the rest on the fact that certain sectors may have experienced periods of deflation already but I don’t think that it would be a full blown deflation for the economy. And it’s good to bring up the deflation issue in Japan as I think that would be a good economic case to study.
Ken – yes, it’s tough to predict. Signs are there for the potential of an extended period of deflation, though I would say they have dissipated a bit over the last month. Japan was once supposed to be a very big, visible threat. Now, 20 years later, it looks like a much different story in the aftermath of deflation. I would like to be an optimist, and say that this won’t happen here. We’ll see!
Whenever I read about deflation it makes sense. Whenever I read about inflation that makes sense too! May be that makes me a confused and stupid person 😉 I have given up reading about them and just do what I can in my control. Better myself professionally and personally, keep saving, cut spending and give as much as I can. Beyond that I have no idea 🙂
Suba – I think the approach of controlling what you can is very wise. It’s often wasted energy to worry excessively about things out of control. With respect to Macroeconomic factors, I think that while we can’t control the big picture, we can make some educated guesses as to what might be coming next. Thus, we can best position ourselves for what’s coming up. Easier said than done, obviously! Especially when economists are all over the place with what’s coming up.
1. I hope not. It is within the realm of possibility but only if the government makes bad decisions. And I really hope they don’t make bad decisions. We’ll see what happens after midterm elections.
2. Probably more into cash.
Nicole – I see it that way too. I hope not, but if so, I’m increasing the allocation to cash.
Hopefully the government will take measures to either reduce or prevent the chance of deflation!
Ray,
Thanks for stretching our thinking on this issue. I am like Sandy…it makes my head hurt! And I agree with Invest it Wisely…long term deflation seems unlikely as long as the Feds have a printing press. I think the best financial decisions are to continue to learn, increase our skills, and stay out of debt. Those are things I can comprehend. One thing I have done is relocate some of my mutual funds to a house flip. Is this wise? We will see.
Joe – I like your list of financial decisions. Always good to continue to learn and increase skills. As far as staying out of debt goes – I wholeheartedly agree!
This takes me back to my days in grad school. Our professors would through these questions out and then point out how most theories falter in reality because the people in control are irrational and short-sighted. That being said, I believe that we will experience more deflation (some sectors have experienced significant deflation already), but it will not be enough to destroy the economy. As Kevin said, the people with their “finger on the button” will print money like mad in order to stop deflation! So, short term deflation which gives way to inflation.
Of course, since true wages and productivity won’t be able to keep up (due to easy access to credit), deflation will have to be a reality at some point in the future – we just keep putting it off hoping for another miracle.
Khaleef, I know what you mean about taking it back to grad school. When writing this post, I was thinking about this, and was partially inspired by a conversation with a friend from grad school. It’s tough to say what will happen, as economists have been all over the place. The opinions that readers here tend to have is that the printing press will come into play if needed. We’ll see. I hope that we don’t fall into any kind of an extended period of deflation.
All you have to do is look at gold, commodities and the federal deficit. A lower dollar is on the way, but not deflation. The gov needs inflation to deal with its problems. Don’t let the quantitative easing and artificially low interest rates fool you.
Perhaps we could think in terms of both inflation and deflation. Inflation in the things we *need*, versus deflation in the goods we merely *want*.
A batch manufacturing business with no backlog will take on a project a very low rates just to cover variable cost (labor). That is cost deflation for the buyer. Similarly, an unemployed high-skill worker may by necessity work in a lower-wage occupation than previous, just to make enough to meet the bills (wage deflation or at least stagnation).
Food prices are in turn affected by commodity prices. Wheat, rice, sugar, soybeans. All seem to be heading higher.
For some people who aren’t considering dollar as their currency, deflation is somehow a good thing for them. They even conclude that the local currency is going strong because of the increase in dollar conversion. As an accountancy graduate, it’s really important for us to see the significance of this issue because it might affect our decisions about money matters. To answer your question, I would rather invest in business. I don’t really believe on those stock investment or similar kind of investment since I can’t totally control the companies performance. For me, it’s the most important factor for every businesses.