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You are here: Home / Money / Stocks Part XIV: Deflation, the ugly escort of Depressions.

Stocks Part XIV: Deflation, the ugly escort of Depressions.

by jlcollinsnh 9 Comments

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!

lucky 13

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

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

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….

introductions

…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.

Related

Important Resources

  • Talent Stacker is a resource that I learned about through my work with Jonathan and Brad at ChooseFI, and first heard about Salesforce as a career option in an episode where we featured Bradley Rice on the Podcast. In that episode, Bradley shared how he reached FI quickly thanks to his huge paychecks and discipline in keeping his expenses low. Jonathan teamed up with Bradley to build Talent Stacker, and they have helped more than 1,000 students from all walks of life complete the program and land jobs like clockwork, earning double or even triple their old salaries using a Salesforce certification to break into a no-code tech career.
  • Credit Cards are like chain saws. Incredibly useful. Incredibly dangerous. Resolve to pay in full each month and never carry a balance. Do that and they can be great tools. Here are some of the very best for travel hacking, cash back and small business rewards.
  • Personal Capital is a free tool to manage and evaluate your investments. With great visuals you can track your net worth, asset allocation, and portfolio performance, including costs. At a glance you'll see what's working and what you might want to change. Here's my full review.
  • Betterment is my recommendation for hands-off investors who prefer a DIFM (Do It For Me) approach. It is also a great tool for reaching short-term savings goals. Here is my Betterment Review
  • NewRetirement offers cool tools to help guide you in answering the question: Do I have enough money to retire? And getting started is free. Sign up and you will be offered two paths into their retirement planner. I was also on their podcast and you can check that out here:Video version, Podcast version.
  • Tuft & Needle (T&N) helps me sleep at night. They are a very cool company with a great product. Here’s my review of what we are currently sleeping on: Our Walnut Frame and Mint Mattress.
  • Vanguard.com

Filed Under: Money Tagged With: economy

« Stocks — Part XIII: The 4% rule, withdrawal rates and how much can I spend anyway?
Stocks — Part XV: Target Retirement Funds, the simplest path to wealth of all »

Comments

  1. Mortgage Mutilator @ Mutilate The Mortgage says

    December 11, 2012 at 2:59 pm

    Yup, my grandma STILL hoards cash! It also looks like Australia will be at the very least slowly deflating over next year in regards to house prices. You’re not allowed to just walk away from your debts here though, so I don’t think we’ll have a big crash like you guys did… more likely a slow, drawn out deflation over many years like the Japanese have had recently. Hopefully it doesn’t end up with giant bread lines though!

    Reply
  2. Prob8 says

    December 11, 2012 at 8:59 pm

    Scary stuff. The recent economic debacle certainly makes you appreciate why depression era people horded cash – why they are still hording cash. An event like that has a lasting effect – a lifetime for many people.

    On another note . . . I like the pace you are setting with posts. Keep up the good work! I’m looking forward to your post on target date funds as I am looking to roll some IRA’s over in the near future.

    Reply
    • jlcollinsnh says

      December 12, 2012 at 7:56 am

      Ha! Just trying to wrap up some that have been “works in progress” before I leave for the next trip and return to my slothful ways.

      I will, however, put the target date fund post to the top of the queue. 🙂

      Reply
  3. Fatchance says

    December 12, 2012 at 11:23 am

    Damn good post today JL. I also am glad to see you posting at a rapid clip. I use your articles to teach my teenagers about money. They dont always like to hear it straight from their old man.

    Reply
    • jlcollinsnh says

      December 12, 2012 at 1:39 pm

      Thank you, sir!

      It’s wonderful that your kids are hearing this stuff early.

      Not sure when you started reading, but I started this for my own daughter. I wanted her to have this info available if/when she was ready. So far, she’s not ready to hear it from the old man either. 🙂

      Reply
  4. COMatt says

    December 12, 2012 at 2:39 pm

    Hey Jim,
    I was helping out a friend with investing/saving and such and I sent them to your website as I think it is the best beginner explanation of investing I have ever read. That is after reading over 50 books on investing and economics and about a million blog posts (maybe a few less than that:)). It turns out the best answers are very easy to find. In fact, I would bet a large sum that no matter how much I study and learn about finance and economics, I will not beat your methods. So, I have kind of stopped trying and started to learn about other things. Thanks for giving me more free time 🙂

    While helping out my friend I thought it would be great if there was an ebook or book form of all of your posts that one could read straight through. It would be short and as a consequence not daunting to inexperienced folks. I think it would be very helpful to people my age (20s). Do you have plans to make something like this?

    Also, I have been getting the buy a house itch lately. Too much Mr Money Mustache I guess. On one hand it feels like a huge commitment and seems like it will cut down on my freedom. But, the leverage and prices are so very attractive and I am worried I will miss that boat and regret it later. Can you tell me something on the contrary?

    That is: Can you think of any reasons why the low rates and prices may not be that great of a reason to buy a house and I will be fine if I wait? The housing industry does a very good job of getting people into houses, I guess:)

    I hope your life is going splendidly,

    Reply
    • jlcollinsnh says

      December 12, 2012 at 5:27 pm

      Thanks Matt….

      …that is high praise indeed, especially as that is precisely my objective. Hope you pass the blog along with your recommendation.

      Regarding an eBook, I am exploring the idea of doing exactly that. Wouldn’t be all the posts, but rather just those focused on The Simple Path to Wealth and demystifying investing and the stock market. I hope to turn my attention to it early next year. While most of the basic material is written, it is still a formidable project organizing it and rewriting so it flows as a book. In fact, I just had a conversation today with a fellow who has published several.

      As to buying a house, it is a very personal decision entailing many confusing factors only you can sort thru.

      That said, it is pretty easy to “run the numbers” so you can see just what it will cost or save you v. renting. I show you how here:
      https://jlcollinsnh.com/2012/02/23/rent-v-owning-your-home-opportunity-cost-and-running-some-numbers/

      Reading your comment I get the feeling you don’t especially want to own a house. It is more that you think today’s market and interest rates offer a unique opportunity you don’t want to miss. If I’m right about that, run the numbers. Unless they say owning is overwhelmingly cheaper than renting, relax and enjoy your freedom.

      For those who really want a house, now is probably a better time to be a buyer than most.

      But for those who are just thinking they ‘should’ buy a house, it is the tail wagging the dog. No point in buying anything, houses included, you don’t really want/need just because it is a ‘good deal.’ That’s the psychological ploy marketers use all the time: “There will never be a better price/opportunity to buy than now!!”

      The money you keep invested will do just fine not tied up in a house. Especially if renting is less expensive and you have the discipline to save the difference.

      Hope that helps! Oh, and as it happens my life is going splendidly. Thanks for asking. Hope yours is too!

      Reply
  5. chronicrants says

    January 24, 2013 at 2:05 pm

    Thanks so much for writing about this! I’m honored that you followed up on my question 🙂
    For the first time, I feel that I understand deflation. FINALLY! Thanks for making that happen.

    Reply
    • jlcollinsnh says

      January 24, 2013 at 5:23 pm

      My pleasure CC….

      and thanks for asking. Questions like yours help me understand what folks find confusing and in what they have an interest. Great help to this blog!

      Reply

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      • Closing up for the Holidays, see you in 2014
      • Betterment: a simpler path to wealth
      • Case Study 6: Helping an ill and elderly parent
      • Stocks -- Part XX: Early Retirement Withdrawal Strategies and Roth Conversion Ladders from a Mad Fientist
    • ► November (3)
      • Death, Taxes, Estate Plans, Probate and Prob8
      • Case Study #5: Zero to 2.6 million in 25 years
      • Case Study #4: Using the 4% rule and asset allocations.
    • ► October (3)
      • Republic Wireless and my $19 per month phone plan
      • Case Study #3: Let's get Tom to Latin America!
      • The Stock Series gets its own page
    • ► September (2)
      • Case Study #2: Joe -- off to a fast start!
      • Chautauqua 2013: A Week of Dreams
    • ► August (1)
      • Closing up shop plus an opening at Chautauqua, my new podcast, phone, book and other random cool stuff
    • ► July (1)
      • They Will Kill You For Your Shoes!
    • ► June (4)
      • Stocks -- Part VIII-b: Should you avoid your company's 401k?
      • Shilpan's Seven Habits to Live More with Less
      • Stocks -- Part XIX: How to think about money
      • My path for my kid -- the first 10 years
    • ► May (5)
      • Why your house is a terrible investment
      • Stocks — Part XVIII: Investing in a raging bull
      • Dining with the Ghosts of Sarah Bernhardt and Alfons Mucha
      • How we finally got the house sold
      • Stocks — Part XVII: What if you can't buy VTSAX? Or even Vanguard?
    • ► April (4)
      • Greetings from Prague & a computer question
      • Swimming with Tigers, a 2nd chance on the Chautauqua, a financial article gets it wrong and I'm off to Prague
      • Storage, Moving and Movers
      • Homeless, and a bit on the strategy of dollar cost averaging
    • ► March (4)
      • Wild Turkeys, Motorcycles, Dining Room Sets & Greed
      • Roots v. Wings: considering home ownership
      • How about that stock market?!
      • The Blog has New Clothes
    • ► February (5)
      • Meet Mr. Money Mustache, JD Roth, Cheryl Reed & me for a Chautauqua in Ecuador
      • High School Poetry, Carnival, cool ads and random pictures that caught my eye
      • Consignment Shops: Best business model ever?
      • Cafes
      • Stocks -- Part XVI: Index Funds are really just for lazy people, right?
    • ► January (5)
      • Social Security: How secure and when to take it
      • Fighting giraffes, surreal landscapes, dancing with unicorns and restoring a Vanagon
      • My plan for 2013
      • VITA, income taxes and the IRS
      • How to be a stock market guru and get on MSNBC
  • ► 2012 (53)
    • ► December (6)
      • See you next year....until then: The Origin of Life, Life on Other Worlds, Mechanical Graveyards, Great Art, Alternative Lifestyles and Finding Freedom
      • Stocks -- Part XV: Target Retirement Funds, the simplest path to wealth of all
      • Stocks -- Part XIV: Deflation, the ugly escort of Depressions.
      • Stocks Part XIV: Deflation, the ugly escort of Depressions.
      • Stocks -- Part XIII: The 4% rule, withdrawal rates and how much can I spend anyway?
      • How I learned to stop worrying about the Fiscal Cliff and you can too.
    • ► November (2)
      • Rent v. owning: A couple of case studies in Ecuador
      • So, what does a month in Ecuador cost anyway?
    • ► October (4)
      • See you in December....
      • Meet me in Ecuador?
      • The Podcast: You can hear me now.
      • Stocks -- Part XII: Bonds
    • ► September (6)
      • Stocks -- Part XI: International Funds
      • The Smoother Path to Wealth
      • Case Study #I: Putting the Simple Path to Wealth into Action
      • Tales of Bolivia: Calle de las Brujas
      • Stocks -- Part X: What if Vanguard gets Nuked?
      • Travels in South America: It was the best of times....
    • ► August (1)
      • Home again
    • ► June (4)
      • Yellow Fever, closing up shop for the summer and heading to Peru y Bolivia
      • I could not have said it better myself...
      • Stocks -- Part IX: Why I don't like investment advisors
      • Happy Birthday, jlcollinsnh; and thanks for the gift Mr. MM!
    • ► May (6)
      • Stocks -- Part VIII: The 401K, 403b, TSP, IRA & Roth Buckets
      • Mr. Money Mustache
      • The College Conundrum
      • Stocks -- Part VII: Can everyone really retire a millionaire?
      • Stocks -- Part VI: Portfolio ideas to build and keep your wealth
      • Stocks -- Part V: Keeping it simple, considerations and tools
    • ► April (6)
      • Stocks -- Part IV: The Big Ugly Event, Deflation and a bit on Inflation
      • Stocks -- Part III: Most people lose money in the market.
      • Stocks -- Part II: The Market Always Goes Up
      • Stocks -- Part 1: There's a major market crash coming!!!! and Dr. Lo can't save you.
      • You can eat my Vindaloo, mega lottery, Blondie, Noa, Israel Kamakawiwo 'Ole, art, film and a ride on the Space Shuttle
      • Where in the world are you?
    • ► March (7)
      • How I lost money in real estate before it was fashionable, Part V: Sold! and the taxman cometh.
      • How I lost money in real estate before it was fashionable, Part IV: I become a Landlord.
      • How I lost money in real estate before it was fashionable, Part III: The Battle is Joined.
      • How I lost money in real estate before it was fashionable, Part II: The Limits of the Law.
      • How I lost money in real estate before it was fashionable, Part I: Impossibly Naive.
      • You, too, can be conned
      • Armageddon and the value of practical skills
    • ► February (6)
      • Rent v. Owning Your Home, opportunity cost and running some numbers
      • The Casanova Kid, a Shit Knife, a Good Book, Having No Regrets, Dark Matter and a bit of Magic
      • What Poker, Basketball and Mike Whitaker taught me about Luck
      • How to Give like a Billionaire
      • Go ahead, make my day
      • Muk Finds Success in Tahiti
    • ► January (5)
      • Travels with "Esperando un Camino"
      • Beanie Babies, Naked Barbie, American Pickers and Old Coots
      • Selling the House and Adventures in Staging
      • The bashing of Index Funds, Jack Bogle and a Jedi dog trick
      • Magic Beans
  • ► 2011 (22)
    • ► December (1)
      • Dividend Growth Investing
    • ► November (2)
      • The Mummy's head, Particle Physics and "Knocking on Heaven's Door"
      • "It's Better in the Wind" or why I ride a motorcycle
    • ► October (1)
      • Lazy Days and School Days
    • ► July (2)
      • The road to Zanzibar sometimes goes thru Ecuador...
      • Johnny wins the lotto and heads to Paris
    • ► June (16)
      • Chainsaws, Elm Trees and paying for College
      • Stuff I’ve failed at: the early years
      • Snatching Victory from the Jaws of Defeat
      • The. Worst. Used. Car. Ever.
      • Top Ten reasons your future is so bright it hurts my eyes to look at it
      • The Most Dangerous Words Your Customer Can Say
      • How not to drown in The Sea of Assholes
      • What we own and why we own it
      • The Ten Sales Commandments
      • My ever so formal and oh so dry CV
      • How I failed my daughter and a simple path to wealth
      • The Myth of Motivation
      • Why you need F-you money
      • My short attention span
      • Why I can’t pick winning stocks, and you can’t either
      • The Monk and the Minister

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