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Economic Deflation and Inflation - The Advantages and Causes

By Edited Nov 13, 2013 3 1

Do you know what economic deflation and economic inflation are and did you know that there are several advantages and disadvantages to both? If you’ve ever listened to Federal Reserve chairman Ben Bernanke speak on economic policy, you would understand that deflation is his biggest fear and he will do everything in his power to prevent it. However, I feel that Bernanke doesn’t seem to understand that there are actually some advantages to deflation, which I will explain in further detail below. Deflation might be bad for people with debt, but it’s not bad for everybody - good deflation is possible. After reading this article I think you will better understand the current economic predicament the world – and specifically the United States – is currently in, and give you some ideas for investing going forward.

What Are the Causes of Deflation?

When you think of deflation, think of the Great Depression. Falling prices of just about everything - stocks, housing, food, wages, etc. 

Deflation occurs technically when the price of inflation falls below 0 percent and below (meaning that goods and products will start falling in price). The unemployment rate of a country drops and it can be quite severe, reaching levels of greater than 20 percent. 

In these ways, deflation is a bad thing. But is it always "bad" for a country to have deflation?

It depends who you are really. If you are a person in debt, deflation is your worst enemy. If you are a person who saves, deflation is your best friend. Also, stuff becomes much more affordable in price, so if you have some savings you can buy a lot more things! That is one advantage of deflation - things become more affordable and the value of your countries currency gains in value. 

Deflation and Debt – Why Bernanke Absolutely Won’t Let Deflation Happen 

People that are heavily in debt (such as the current USA government and most of the US population, with credit card, student loan and mortgage debt) are crushed in a deflation because: the money supply drops, prices drop, and most importantly WAGES drop and unemployment rises.

However, the one thing that doesn’t drop are your debt payments! (Since these are FIXED payments).

To explain, say you earn $2,000 a month in salary and you pay $600 on your mortgage, $200 on utilities, $300 on food and $200 entertainment expenses per month. 

If a severe deflation like the great depression occurs, two likely scenarios would happen - In a severe deflation, economic activity comes to a screeching halt and you could either get laid off from your job or take a big pay cut. Either is likely.

Let’s say you get your salary cut to $1,400 month. In a deflation, the cost of utilities, food, and everything else would drop, too. But the cost of your mortgage debt and credit card debt would not, since you are paying a fixed interest rate and making fixed payments. 

This is why a deflationary scenario at present day would be an absolute nightmare because the majority of the US population has a ton of credit card debt, student loan debt and mortgage debt. A deflation would make this debt extremely difficult to pay off. Interest rates, which is basically the cost of borrowing money, would skyrocket. 

According to ConsolidateCredit.org, the total consumer debt per household now averages $16,046! And this doesn't even include student loan debt (average college student graduates with $20,000 of debt) and mortgage debt. Many people in the US also have little to no savings, compounding the problem.

If deflation occurred, people would get laid off or take pay cuts, making debt payments very, very difficult. The result would be even more foreclosures and bankruptcies than we currently have today and a scenario that would possibly be even worse than the great depression.

Even Worse - The USA Bankrupt? 

I believe that in a major deflation today the USA government would also potentially go bankrupt.

This is because the USA currently runs a budget deficit and their interest payments on their debt sits at over $400 billion, with a total national debt of over $16 trillion - more than our gross domestic product.  

Us Debt(126758)

If deflation occurred, tax revenues would tank, and in all likelihood, the USA would not be able to pay its bills, or would have to cut almost everything in its budget just to service its debt payments!

Now you understand why Ben Bernanke is firing up the printing presses in the form of “Quantitative Easing” – he fears deflation would led to a full blown “Greatest” Depression which would see major banks collapse, as well as the US government. It's a scenario that he simply won't let happen.

So there are several "advantages" to deflation, and these are mostly for savers. And there are definitely "disadvantages" to deflation, mostly for people with debt.

Investing for Deflation – What are the Advantages? 

I believe inflation is going to get bad but if you think I’m wrong about inflation and think that deflation is what is coming, then that’s fine. If I am wrong, here’s how I think you should invest for deflation:

*People might not realize this but there were a number of people who made out very, very well during the Great Depression. These were people who had ample savings and no debt, and then used their savings to purchase assets on sale at the peak of the depression. (Although they probably weren't very popular with their friends...)

* Check out this chart below. As you can see from this picture, the stock market tanked during the height of the depression. This would have been the best time, perhaps in the history of the stock market, to swap your currency to buy stocks.  

Depression

How Does Gold Do in Inflation and Deflation?

The answer to this question depends on who you ask. I personally feel that gold performs well in both scenarios. However, I feel that gold performs best during inflation and hyperinflation.

During a deflation, gold may decrease in price (with everything else), however it still may be increasing in value at the same time (if everything else decreases in price faster than it does). So gold’s purchasing power can actually increase during deflation.

During the Great Depression, gold was actually a pretty good investment. But it’s important to understand that gold was actually money back then – meaning we were on a gold standard and you could exchange your dollars for gold. I believe that is why gold performed better.

We are not under a gold standard currently so I really am not sure how well or how bad gold would perform during a deflation in the future. But since I feel inflation is coming, I like gold going forward.

Inflation Investing(126757)

Investing for Inflation 

If you think I am right and think inflation is what's coming, basically what you are going to want to do is the exact opposite of the above.

You want to get out of your countries home currency as fast as you can because it will be losing value every year, and you’re going to want to purchase hard assets such as precious metals, oil, etc. Things like farm land, real estate and certain commodity stocks will do very well in this scenario.

Best Inflation Investments

My thesis for investing is that the US cannot possibly service their huge deficits without printing money to help increase tax revenue and keep jobs, and this will definitely lead to more inflation because of the expansion of the money supply.

Ben Bernanke is also a student of the great depression and will simply not allow a deflationary scenario to unfold. 

So we will get the opposite, which is probably not much better though – major inflation.

I am out of the US dollar and into hard asset investments such as precious metals, stocks that are related to hard assets, and soon I will buy some real estate. Even though I don’t think real estate is the best investment during inflation (precious metals are), I think house prices will still rise slowly this decade (but fall in value).

Inflation Linked Bonds and Savings – If you want to be conservative you can consider buying a inflation-protected bond, treasury, or an inflation indexed savings bond. These will at least keep up with the rate of inflation or close to it. 

I personally like gold and like gold stocks even more. While gold will protect your purchasing power, gold stocks have the potential to make you a lot more money and some gold stocks pay a monthly dividend. So you will receive a nice income plus you have the potential for major capital appreciation.

But remember that one day you are eventually going to want to sell your precious metals and stocks when they are valued much higher and buy stuff with them - it makes no sense to hold onto them forever!

Is Hyperinflation Possible in the US?

Hyperinflation is basically inflation on steroids – you would see a complete loss of confidence in your countries currency and prices would absolutely skyrocket.

The Zimbabwe inflation rate example is a popular one – the residents of the country were all billionaires on paper, but it didn’t buy them anything. 

The cause of hyperinflation is complex, but basically it can result if a country’s central bank prints too much money and the population starts to realize it. Then people would rush to spend their money because they know it’s literally losing value every minute!

I do unfortunately believe that this scenario is possibly in the US, but some don’t. The same investments that perform well during inflation would perform even better in a hyperinflation, but the consequences would be devastating. 

Major Points to Take From This Article 

I hope that you learned something from this article, but if there’s anything you should take from this I think it should be this:

* Inflation rewards debtors, while deflation rewards savers.

* The value of a currency tends to increase during deflation and decrease during inflation.

* The best investment during an inflation are anything BUT holding currency and include hard assets such as precious metals, food, land, etc.

* The best investments during deflation is most likely having savings in your countries home currency, because they tend to increase in value greatly during deflation as prices for most things tank. 

Thanks for reading this article on why deflation can be good and why I feel inflation is the most likely economic outcome of the future.

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Comments

Jan 18, 2013 8:34pm
bcassidy
An interesting example of hyperinflation is Germany post WWI. They had to pay billions of British pounds in reparations so they printed more money until the value of the money was so devalued that it was cheaper to burn the paper money as fuel than to buy wood to burn. Hyperinflation is surreal.

Interesting about deflation benefiting savers, had never framed it that way in my mind, cool!
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