In Part XII: Bonds, reader Chronicrants commented:  “I’d love to see more on deflation. I’ve always been confused about it and about it’s consequences. It seems like it would be a good thing, and yet….”  Great point, and what better topic, I thought, for unlucky number 13 in this series!

Unfortunately, I forgot that was my plan and Withdrawal Rates got spot #13.  Sigh.  It’s tough getting old.

When deflation has come up in my previous posts it has been the ugly escort bringing Depressions to the Ball.  Indeed here in the USA we have had four depressions since our founding in 1776:  1818-21, 1837-43, 1873-96 (the duration record holder) and the one we think of most often:  The world-wide depression of 1930-33.  In each case deflation was there, walking side-by-side holding depression’s hand.

So what the heck is deflation anyway?  Simply put, it is the lowering of prices and the increasing of the value of money.

Hmmm….  As Chronicrants says, “It seems like it would be a good thing…”  In many cases, it is.  Let’s take a closer look.

Good Deflation.

One of the dynamic benefits of our economic system is the steady lowering of prices thru technological innovation and increased productivity.  Perhaps the clearest example of this in recent decades is the rapid fall in prices and improvement of products in the electronic/tech world.  The laptop or TV that was $2000 a few years back can be had now for $500.  People never tire of pointing out that we carry more computing power in our phones than that on the Apollo moon missions.

Apollo Launch

Not Apollo, but here’s also a great sound track/video of a Space Shuttle launch.

As a percent of average earnings, the cost of food, housing and transport are all lower today than 50 years ago.  Yet thru innovation and productivity gains, the companies that provide these things are doing better as well.  Our money buys more of all these things and is thereby worth more than it was.  This is deflation, and it is a good thing.

Ugly Deflation.

Deflation turns ugly when prices drop for reasons other than increasing innovation and productivity.  This occurs during economic downturns.  At first, this too can be a good thing, but the danger is slipping into a Deflationary Spiral. It looks something like this:

Unemployment rises — Demand for goods slows — Prices come down — Profits drop — Companies cut production — Unemployment rises faster — Demand for goods slows further — Prices fall — Profits drop — Companies cut production — and on.  A few cycles of this and companies start folding and bread lines start growing.  The cycle can start with any of these points along the line.  It becomes a vicious circle that’s very tough to break.

Bowery Bread Line

Photo from:  Old Photo.com

The collapse of our housing bubble a few years back brought us to the edge of this abyss.  The antidote is a nice healthy dose of inflation and that’s exactly what the Federal Reserve has been trying to reignite.  It does this by lowering interest rates (now effectively zero) and pumping cash into the system.  The idea is this will break the cycle and get companies ramping up and people spending again.  It is an attempt to reverse the psychology.

The Psychology of Deflation.

Franklin Delano Roosevelt, the 32nd President of the United States (1933–1945), famously said, “The only thing we have to fear, is fear itself.”  He was talking about the psychology that threatened to mire the country in its deflationary depression.  Our housing crisis gives us an excellent tour of this in action.

Let’s suppose you were in the market to buy a house in 2005.  Prices had been rising for years and the pace was accelerating.  Every where you turned those who had bought were bragging about their gains.  If you waited, a year from now you might be paying 10-20-30% or more for that same house.  That not only raises your cost, it represents lost profit in your mind.  You are filled with an urgency to ink a deal.

Of course, you are not alone in this thinking.  Every time a house goes up for sale, scores of other people, driven by the same psychology, are competing with you for the privilege of buying it.  Meanwhile sellers, also realizing that their house is increasingly more valuable, become more reluctant and scarcer.  Up the prices go.  Endlessly, or so it seemed.

What we had was an Inflationary Spiral.  Just like with tulip bulbs in 1637, this bubble expanded till it burst.  Then, on a dime, the psychology reversed.

At a certain point, people just couldn’t afford to buy houses at the price levels they’d reached.  In fact, in this case with all the easy money that had been lent, many new owners couldn’t afford to own them in the first place.  Suddenly, houses went up for sale and no buyers showed up.  Prices softened.  Owners started to see their values drop.  They became more willing to sell, hoping to get out before prices dropped further.  Fewer houses sold, even as more came on the market.  Supply quickly outpaced demand.  Prices dropped again.

Potential buyers, of course, also saw this happening.  It didn’t take long to realize that now waiting to buy paid off. The house you looked at today would still be for sale tomorrow and for less.  Fewer people were able to buy and those that were, effectively got paid to wait.  If you’ve been wondering why real estate brokers are so eager to declare home prices are rising again, it is this.  Until buyers start to believe prices will be higher next year they’ll hesitate to buy now. Until then, housing is locked in this Deflationary Spiral.

The danger is, of course, that housing is a huge part of the economy.  When housing sales slow it spills into the sales of lumber, appliances, furniture, windows, HVAC, flooring, garden equipment and a raft of other stuff, along with the jobs related to them.  As those drop, other segments of the economy dependent on them and the folks that work for them get pulled down.  If enough get caught in their own whirlpools, the entire economy enters the deflationary spiral.  Next thing you know….

…Mr. Deflation is introducing you to Ms. Depression.

Deflation winners and losers.

As we’ve already seen, we all win thru the deflation of prices thru technological innovation and increased productivity.  And it’s not hard to see the losers in a deflationary spiral:  Companies fold, people get thrown out of work, investments collapse.  But even these ugly deflations have winners.

Remember, deflation is the lowering of prices and the increasing of the value of money.  Deflationary spirals simply accelerate this process.  You win if:

• You hold cash.  This is why your depression era grandparents (or great grandparents) hoarded cash.  Deflation means cash buys more, it increases in value.
• You hold bonds.  As you know from Part XII: Bonds, when you buy bonds you are lending your money. Deflation means that your money buys more when you get paid back at a later date.  Providing, of course, the bond issuer survives the depression and has the money to pay.  Default risk.
• You are on a guaranteed fixed income.  Those on Social Security and fixed pensions would benefit as their income buys more goods and services.  Interestingly, Social Security has provisions to raise benefits in response to inflation, but none to lower them in times of deflation.  Same is true of most pensions.

Now before you go out and sell everything and stuff the money in your mattress, it is worth noting the Federal Reserve is working overtime to reignite inflation.  There is an old saying on Wall Street:  “Don’t fight the Fed.”  It is good advice.