Deflation Is No Picnic

November 19, 2008

You don't have to be an economist to understand why. Deflation happens when less money chases fewer goods.  Because deflation is occurring, consumers delay purchases and sit on the sidelines. As a result, demand drops further, so deflation accelerates. It's the classic deflationary cycle.

Deflation has only happened on a major scale a few times over the past 200 years in the Western world, but in each case, it's been accompanied by an awful, brutalizing economic downturn. Is that causation or correlation?  I have no idea.  But I don't particularly want to live through the next major deflationary cycle to find out.

It's also true that, while deflation punishes reckless borrowers, it also enriches the rich at the expense of the middle class and the poor, as the rich typically hold the largest piles of currency assets. And you see large bouts of unemployment during deflationary cycles, as the real cost of paying employees rises.

I'm actually in the camp that thinks deflation is not a real long-term danger here. The massive deleveraging and credit crisis is certainly having a deflationary impact.  Per the invaluable Wikipedia, it even sounds a bit like the start of the U.S.' deflationary cycle in 1836, which was an economic downturn unmatched besides the Great Depression.

But governments around the world have cranked up the printing presses full speed, and are running them 24-7, pushing as much liquidity into the system as humanely possible right now.  From the folks I speak with, the most likely outcome is a dip into deflation followed (once the deleveraging stops) by a significant inflationary leap. 

Where does that leave investors?  Well, those TIP bonds might be pretty attractive in a bit.  Maybe gold.


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