Inflation or deflation: what is more devastating?
Ask any economist and the resounding answer is: Deflation.
Almost none of us, even baby boomers, has personally experienced the effects of deflation. It would take someone who grew up during the 1930s Big Depression to know that, and that means they would have to be at least in their 90s right now.
Since it has been drilled into us from adolescence that inflation is a fearsome beast, and since we have all personally experienced the horrible effects of inflation, it is not easy to develop the mindset required to deal with deflation. However, we should.
World War II is widely believed to have been due to the rise of gruesome tyrants, of which Hitler personifies, but how did Hitler rise to power in the first place? After a period if hyperinflation followed by a long period of deflationary spiral that saw enough out of work people become radicalized in their political views.
Witness Japan in the 1990s. The country had a credit contraction that lasted some five years (we are approaching that milestone), with property values dropping for 18 consecutive years, and the stock market swooning from 40,000 all the way down to 7,000.
Another parallel with the Japanese situation is that a declining stock market induces investors to flee to the relative safety of government issued obligations, which we are recently experiencing, with investors dumping gold in favor of 10 year U.S. Treasurys.
Due to the 2008 real estate collapse, the U.S. economy has lost a numbing $25 Trillion for the last 10 years, while housing starts have clawed their way back to their 1992 level. People familiar with the Elliot Wave Principle concerning deflation would nod in acknowledgement when Robert Prechter, the Chartered Market Technician who warned of the dangers of easy credit and an impending housing collapse in the 1990s, proclaims that stocks are now in Wave C down into 2016-2018.
Concentrating on the CPI to forecast inflation or deflation can be a mirage. Property values have gone down by a third, the S & P Stock Index has foregone of 20%, while the Reuters-Jefferies CRT Commodities Index has dropped by a third from 2008, and another 15% just since April of this year.
Sir Mervyn King, Bank of England Governor, has for some time predicted a steep fall in inflation and surmised that deflation just may rear its ugly head by the end of 2012. China is also chiming in, with Wu Qing, finance researcher at the State Council’s Development Research Centre, making the case in February for deflation unless extreme measures are quickly enacted.
Deflation can quickly feed on itself and become a vicious circle as consumers stop spending and wait for future better bargains, depressing corporate profits along with the job market.
How to Survive Deflation?
In a deflationary environment, cash is king, as it gains value without even having to earn any interest.
Therefore, it is advisable to accumulate as much cash or near cash as possible, e.g. via dividends, and keep the accumulated funds in the most liquid form possible. If the CPI goes into negative territory, that means that dropping asset values are starting to overwhelm the rising prices that still exist in certain sectors, then it is time to head for the exit. Inflation or deflation: what is more devastating?