What is deflation and why it matters to you?

The word “deflation” has been getting tossed around a lot lately in the media.  I have been getting emails from readers that are confused as to its meaning and the consequences of its existence in our economy, so I thought I would answer everyone’s questions –

What is deflation?

Deflation is when the price of goods declines.  Doesn’t sound like such a bad thing, right?  Actually it’s terrible for our economy because of the side effects it creates: deteriorating profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. Deflation, if it goes unchecked can lead to economic depression.

What causes deflation?

Deflation is caused by a reduction in the supply of money or credit which we have seen since 2008 when the Great Recession began.  That year stocks, commodities and real estate plummeted.  Hundreds of thousands of Americans lost their jobs due to companies downsizing.  Banks stopped lending and credit card companies closed their doors to new clients. 

How do we try and prevent deflation?

To counter deflation, the Federal Reserve increases the money supply and deliberately induces higher prices, trying to spark inflation.  Our government did just that by instituting the TARP program, cash for clunkers, a tax benefit for homebuyers, and by dropping interest rates to historical lows of 0% - 0.25%.  However, even with all of this stimulus we haven’t seen any signs of inflation.  Inflation is key to sustain a recovery because rising prices will lead to businesses increasing profits, which will in turn take some of the depressive pressures off wages and debtors of every kind.

Where should I put my money during times of deflation?

In deflationary times, conservative investments are suggested, such as money markets and fixed income securities.  Having your wealth in cash is also recommended because the value of the dollar will rise.  Remember the basic law of supply and demand; deflation occurs when there are too few dollars in circulation, and if we have too few dollars in supply, than the demand will be greater, thus pushing the value of dollars higher.

How long do deflationary cycles last?

They can be relatively short lived or last for decades.  Unfortunately, there are many economists who see the USA going down a similar path as Japan.  Japan has been in a deflationary period for 20 years and no matter how much stimulus their government has instituted or how much they have lowered interest rates to try and stimulate inflation, they have been unsuccessful.

What is my opinion is on whether or not we are headed into an era of deflation?

In my opinion, the key to this answer lies with the banks.  The government has (for the most part) given the banks hundreds of billions of dollars.  They did this not only to make the banks healthy and solvent but in the hopes that banks would in turn lend money to the people.  Banks have failed to do this out of fear of another future economic calamity.  Small businesses employ 70% of non-public workforce and without the flow of credit they cannot hire or grow. 

If banks continue not to lend I do believe we will go into a deflationary spiral that will be difficult to recover from.  The government will try and do everything in their power to prevent this but they don’t have much in their arsenal.  They have already dropped interest rates to all time lows and doled out millions in tax stimulus.  However, I believe we will see exotic examples of quantitative easing from the government sometime in the near future. 

It is my hope that banks start opening their doors to qualified lenders.  That way homes will be purchased, businesses will hire, and the economy can effectively grow once again.  If this happens more money will be created, which will in turn lead to inflation and though that will keep the value of our dollars lower, we will be able to increase our exporting which will in turn make us a wealthier country.