There’s been some yapping lately by the talking media heads about inflation. Inflation, inflation, inflation. Everyone’s worried about inflation. Food prices are surging. Oil prices. Gas prices. They’re all rocketing up. I gotta tell ya, when an economy is in a recession (or heading there, depending on who you talk to) the thing you have to worry about is deflation. Inflation is basically the thing that makes our debt based society go around. It’s what allows stocks to grow each year and for corporate profits to increase year after year. But deflation, it’s the noose that restricts the airflow of the economy. The noose that kills the golden goose.
Check out this simple definition of deflation from Wikipedia.
…deflation is caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of (demand for) money going down (up) and the supply of (demand for) goods going up (down).
I’ll reword this and break it down; demand for money is going up and demand for goods is going down. Does this sound at all like the world we live in? Aren’t we hearing about car sales being off? (I’ve seen projections for them to be off by 30% this year over last year) And house sales? (Down at least 30% + and house prices are off 15% or so according to the most recent Case-Schiller report)
And just about every retailer you know of is cutting back on expansion and saying their same store sales have dropped off. People are taking refuge, and honor, in being thrifty, cutting back their spending and saving their money. Perhaps the demand for goods is going down?
Inflation (aka price increases) usually occurs because demand for goods is higher than supply. Because people feel wealthy and are willing pay the prices demanded. Because things are good. A current example of supply and demand is the food and energy markets.
About the demand for money; How many of you know someone who is hoarding cash right now? Or, is paying down their debt as fast as they can to be debt free, thus not buying things? Or how many people do you know who have stopped spending for trivial things, thus showing they value their money over these said objects? Perhaps the demand for money is going up? Do you think?
Or, even in an environment where a savings account pays less than .5% interest people would rather have that cash in hand “just in case”. Is it possible that there has been a consumer sentiment shift from just a few years ago?
If both sides of the equation are true does that make the statement true?
I mention this because if you aren’t outside the mainstream media when you get your news you’re in for a world of hurt because this will hit you and it will surprise you. You won’t be ready. But you have to be ready. If you aren’t, you’re looking at a Depression era level of destruction to your financial worth, and really, to your whole chance for survival.
If the economy does go into a deflationary cycle you have to be prepared. If you haven’t yet, read that wiki page. If tells you what you need to know to be prepared. If you are in debt when deflation occurs you will be paying back your debt with dollars that are worth more than they are today, not less like a normal inflationary environment. How would you feel paying off your mortgage with dollars that are worth 10% than they are today? And the year after 10% more? And then 10% more? Normally inflation eats up the value of a dollar so they are worth less each year we are paying on a debt than the year before.
If you are in business and you assume you can continually raise prices you will be hurting. Some industries are accustom to this, but what if GM has to sell their cars for 10% less next year to get them sold? And then the year after and the year after? Or, can’t sell them at any price because people are hoarding cash for the next batch of lower prices? That’s what happened during the Depression. Prices got ridiculously cheap for most things, but no one had any cash to buy them, and if they did they didn’t want to spend the cash anyway.
That’s the nature of a deflationary environment. Regardless of price no one is buying. But what should you do about it?
Well, get out of debt first of all. Cash becomes more important as prices go down, not just so you can take advantage of them but also so you don’t have to use an asset that is increasing in worth to pay for something (goods, house, car) which is declining in worth. Also, it’s a good idea to have cash available to buy things when they are on sale. It’s been said, “A recession is nothing more than a garage sale for the rich.”, and it’s so true. They are ready to step in when things go south while the rest of the people are all desperate to sell. More people have gotten rich buying in a depression/recession than buying in a rising market. And it’s a safer way to buy too.
Even though they are slightly inflationary right now, it’s a nice comfortable feeling to having some food stocks on hand so you won’t have to worry about any shortages.
Personally, almost all my investments are in cash. You can’t own stocks during a deflationary period because the profits of the companies’ will get crushed, and the direction profits are going dictate the direction of stock prices. Profits down, stock price goes down. It’s as simple as that.
Owning fixed income investments are also tricky because rates could go down further as the Fed gets desperate to stimulate the economy. Today they froze rates, to monitor inflation (right). Already there is a serious disconnect between the Fed Funds rate and the real rates being offered in the market. This means that the Fed is trying to stimulate the economy, but the banks aren’t buying it and they aren’t lowering their rates. That means less lending and that means less spending by us, the end consumer. (Even though the Fed Funds rate is really a benefit for banks to borrow from other banks, not for us to borrow from them)
Eventually the Fed will have to bring rates up to attract the investment they need to fund our country’s budget deficits. (Who are these people that keep buying Treasuries at 2% a year?) Depending on interest rates fixed income can be a nice place to be in a deflationary time. If things really go sideways, and no one wants to invest, rates will have to keep going up and up and up until they attract investors. This is what you need to watch for. Sitting on a nice pile of steady incoming cash flow while price go down opens up a lot of possibilities on further opportunities for this cash, which is appreciating. Not to mention serious price appreciation if you are sitting on long term securities if or when rates ever come down again.
My cash is in CDs because I’m able to have it insured by the FDIC if something happens (although I have my doubts that they can cover all the potential losses) and I can get a slightly higher rate than with Treasuries. I also am geographically diversified with them to spread out the risk over many different areas in the country.
The big thing is selling anything you want to sell now vs.. later. This is the opposite of how people act when their is hyper inflation. With hyperinflation people buy their goods as soon as they have the money because the goods will cost more, and the money will be worth less, the next day. But in deflation it’s reversed. Goods become less valuable. So if you are trying to sell your house, get it sold. If you want to sell a car, get it sold. Get that cash in your hand so you can enjoy it’s appreciation.
In the face of deflation people usually run to commodities for safety. Gold, Oil, Metals, Food stocks. I can’t talk much about them because I don’t know those markets. If you do, feel free. I can tell you that they’ve all had massive run ups in the past few years, and I personally stay away from areas with recent and rapid price appreciations because there’s too much downside risk.
I think it’s too late for a lot of these things to happen. I think the momentum has already been started. Housing started it but then consumers cut back on their spending to payoff their debts. People are maxed out, which means they will keep cutting back on their spending. If things go bad, they’ll start defaulting. So far we’ve only heard about subprime mortgages, but soon it will be cars and credit cards and prime mortgages. Unemployment is starting to rear it’s head and that will further push this snowball down the hill. Each job lost begats a portion of another job, which is a portion of another job. This continues on and the ones who are still working start hoarding cash in case they are next. On top of that, the banks are flat out tapped out for their cash. They’ve used their cash to make too many bad loans, and when these come home they will be starved for capital, until the capital dries up and they go belly up.
It’s time we all start thinking really seriously about this new future in front of us.
Fat Guy on a Little Bike 