Deflationary Forces

Deflation is the latest hot topic in the economy. I have to admit I don’t know what deflation looks like. There has not been a period of generally falling prices in my lifetime. But we may all get a firsthand look at deflation in the near future. After 60 years of inflation in the United States, if we do get an extended period of deflation, we may have trouble adjusting to the new kind of thinking that deflation requires.

Most economists are still saying that deflation can’t happen here. Japan has been through a decade of deflation, but the real estate bubble and banking crisis that provoked deflation in Japan are not present in the U.S. Still, there are reasons to believe that deflation could arrive soon and could last for years. Why? Just as spending drives prices up, causing inflation, saving drives prices down, causing deflation. With the Baby Boomer generation now earnestly saving for retirement, we are about to witness the largest episode of saving in the history of money. At the same time, productivity gains and technological innovations continue to drive prices of specific products downward. People are paying off credit cards and mortgages, and businesses are borrowing less because they do not need expensive new equipment. Less debt means the money supply is shrinking and this too may drive down prices.

If we do have a prolonged period of deflation, you will need to change most of your money strategies. For example, if you want to get rich you’ll find that work is more important than investing — imagine that! To get you started, here is a list of dos and don’ts for deflationary times.

  • Do pay off any debt as quickly as you can. With deflation, the money you pay back is more valuable than the money you borrowed. Even interest-free loans are no bargain in deflationary times.
  • Do postpone purchases. The longer you put off buying something, the less you will have to pay. It’s almost as if the whole world has turned into an after-Christmas sale.
  • Do make money by working or trading. These are the only two reliable ways to make money during deflation. You cannot expect to make money just by owning the right things.
  • Do innovate. If you want to strike it rich during deflation, just about the only way to do so is by inventing or introducing something new and valuable. Of course, these innovations will drive prices down further.
  • Do take care of yourself. If everyone follows these deflation strategies, it will actually make deflation more severe, but if you take care of yourself financially, deflation won’t hurt you.
  • Do invest in yourself. Invest in things that you can personally control. Learn new skills that will advance your career. Keep fit and healthy and reduce your future health care expenses. Buy a house and a car if you have been renting or leasing. Install an efficient showerhead to save hot water.
  • Don’t try to make money by investing. All the things you would think to buy as investments will tend to lose money as prices fall. This includes stocks, bonds, real estate, precious metals, and mutual funds. It is better to have money in the bank than to own a portfolio that is declining in value. Diversification won’t help when everything is declining. A faster and safer way to make money is by working.
  • Don’t borrow or lend money. If you borrow money, you might have trouble paying it back. If you lend money, you face a higher risk that the borrower will not be able to repay the entire amount. Corporations that are already fully leveraged face bankruptcy if deflation reduces their revenue.
  • Don’t assume that your income will increase. When prices are falling, there are no automatic pay increases. Your salary could stay the same for years, or if you lose your job, your new job might pay less.
  • Don’t raise prices. A business risks losing all its customers if it tries to raise its prices while competitors are lowering theirs. Instead, look for ways to cut costs.
  • Don’t put off selling things. As soon as you are sure that you no longer want something, sell it. The price you get now could be more than what you would get next month.

It may seem like a strange new world, but perhaps it is not so strange. The computer industry has seen prices fall every year for 30 years. People have learned from the computer industry to save money by postponing purchases as long as possible. Perhaps it won’t be too hard to adjust to declining prices in the rest of the economy.

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