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:
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?