Why is deflation bad?

ElliotWave ^

[Chet 99]

Email to a Friend

Why is deflation bad?

Great question! Sometimes our subscribers ask us "what's wrong with deflation?", and "why is deflation bad?" For those who are prepared, deflation can be a welcome development. The value of your money increases while the price of the things you want or need decreases. If everyone was prepared for deflation, many would welcome its coming and ask rhetorically why is deflation bad. For those who are prepared, deflation is a win-win.

Unfortunately, virtually everyone is unprepared for deflation, because virtually everyone has leveraged themselves to the hilt. Years of low- and no-interest financing schemes on houses, autos, furniture, electronics, etc. have created years of negative savings rates for Americans. Furthermore, many American households’ savings are tied up in investments that will go sour in deflation: i.e. stocks, bonds, commodities and real estate. As if a wipeout of life savings isn’t bad enough, declining prices (one of the effects of deflation), means lower profits for companies. In turn this means layoffs and increased unemployment. More on that when we discuss the price and economic effects of deflation and the deflationary spiral.

But just because you have a stable job and a cash reserve doesn’t mean deflation won’t rear its ugly head in your life. Say you not only keep your job but you get a promotion, and the promotion requires you to move. In order to acquire new residence, you must sell your house. In a deflationary environment, plummeting housing prices can make selling difficult, especially if you expect to make a profit. Many sellers are forced to sell at a loss, which further begets the effects of deflation in housing.

Thus the answer to "why is deflation bad" is that it’s not bad if you’re prepared for it.

[goodnesswins]

HERE...HERE!!!!

[Rudder]

Bring on the deflation. And I’m not worried when it turns into an inflation.

Yeah, that's the ticket. And the small construction business I have works well in either condition.

[ExpatGator]

The frugal shall inherit the earth.

[montanajoe]

Deflation is more likely because the asset bubble that is crashing is far greater than any “stimulus” that has been pumped into the economy so far. The folks on wall street have drained all the real wealth out of the us economy for themselves over the past 30 years and covered up their crime by inflating everything from housing prices to commodities. Unfortunately for the next 10 or 20 years the only way to go is down,,,

[ketsu]

You miss what the article says?

If you continue to make the same wage, and the price of goods goes down, well... you figure out.

I just asked this of my 6th-grader, and he got it right.

You never make the same wages in a deflationary spiral. That's the problem. If you have a bunch of hard capital(i.e. gold) then you're theoretically set, but then gubmint will make gold hoarding illegal and then you really are borked.

[tbw2]

1. Ammo.
2. Over the counter medicines which may get banned under socialized medicine (real sudafed, motrin, etc)
3. Canned goods with long shelf life that are good barter (canned meats, canned cheese, stuff people want but might have trouble affording with inflation)
4. Little super useful stuff that may get banned for environmental reasons. Lead solder, for example, or good batteries with lead.

Just a few thoughts. May have more later.

[NVDave]

I’m not one to give out specific investment advice. I don’t know all your particulars, and there’s lots of factors that go into decisions made at this time, not the least of which are how old the investor is, what their future plans are, etc.

Deflations are where cash becomes king, because credit becomes tight - very tight. Banks are unwilling to lend usually because (just like now) borrowers are defaulting on loans already, asset prices (ie, the value of assets used for collateral) are declining, etc.

So the businesses and people who have little to no debt, some savings put away, are sitting fat and relatively happy. They’re not super-happy, because almost all interest-bearing investments of any sound nature are paying nothing or next to nothing. The Fed has slashed interest rates in a deliberate move to spur people to put money to work, but it doesn’t work because deflations happen so rarely that people are not sure what their risk is.

The people who are in the worst possible position are those deeply in debt. As the deflation progresses, cash goes up in effective value as prices compress. This means that the loan is being repaid with stronger currency than it was made at - which raises the effective or “real” interest rate. This is one of the classic signs of a deflation - the publicized interest rate isn’t what you’re really paying.

Let’s back up for an example during normal times: Let’s say you take out a mortgage at 5%. Let’s also say that home prices are inflating by 3% per year.

So what are you really paying on the house? 5% - 3% = 2%. That’s a pretty sweet deal, yea?

Now let’s look at a deflation: Let’s say you still have the same contracted interest rate (5%) and now housing prices are *deflating* at 5%/year (which is far lower than they’re deflating now in many areas, but go with me on this...)

5% - (-5%) = 10% “real” interest rate. Yowsa! And you get to deduct only the bank’s 5%! Now you see how holding a mortgage in a deflationary market is really not a good prospect.

At the end of deflations, profit margins will have been crushed, and the price of real assets are cheap compared to historical trends. This is the time to turn cash back into assets, because the fact you have cash at this time allows you to do what few others can - buy, buy, buy.

Now, there’s a twist on the current situation: the US was already deeply in debt when we went into this. Unlike the 30’s, where the government was on a sound footing and the private sector took on too much debt, here we have the worst of all possible situations: the public treasury is in debt, has huge unfunded liabilities down the road (SS/Medicare), the private sector is deeply in debt, and what we’re doing is moving private sector debt onto the national balance sheet through the Treasury and Fed.

The outcome of this, many area arguing, will by hyperinflation. I am not so certain of this, because the US is the world’s reserve currency. The world will not sit idly by and allow the US to inflate its way out of this situation. The PRC just sent a warning shot across our bow that they want assurance that we’re not going to devalue the dollar and that they’d view such an action by the US in a very serious light. Translated, that’s a warning to Bernanke and Geithner that we’re not going to inflate our way out of this and still have the PRC fund our debt. At some point in the future, I expect higher interest rates, possibly much higher.

[paul51]

I just asked this of my 6th-grader, and he got it right.

Better go back and discuss further with the 6th grader. Wages will not be sustained in a true deflationary trend.

[Centurion2000]

Make no mistake. We're in deflation right now. In six months that will all be changed. 3.5 trillion dollars in the last what 6 months? Yeah .... no more deflation and must less confidence in our currency.

[Centurion2000]

I have rolled over into some gold, my debts are few, and my wife and myself make a decent living. Anything else??

Ammo ... seriously.

[Onelifetogive]

Why is deflation bad?

Unexpected inflation benefits debtors. Unexpected deflation benefits creditors. The government and most voters are debtors. Rich people are creditors.

[eyedigress]

I’ve started with #1 and have spent 1800 since November. I don’t take medicine much but you can never have too much aspirin.
I have some spam but surely not enough.
Lead solder I have but a new gun may be in the works.

Thanks for the advice. :^)

[freeone7]

Buy gold or bottled water? Some day when bottled water is in short supply, how much gold would you have to give to get a bottle of water?

[blam]

Bank May Start Printing Money To Reverse 'Deep' Downturn

Gary Duncan, Economics Editor and Grainne Gilmore
Feburary 12, 2009

The Bank of England’s Governor admitted yesterday that Britain is now in “deep recession” and signalled that it is ready to start “printing money” as soon as next month in aggressive, last-ditch moves to limit the slump.

Mervyn King indicated that the Bank is poised to move beyond relying on further interest rate cuts to combat recession. It will give a green light within weeks to a strategy of “quantitative easing”, the modern equivalent of printing money, he made clear.

The Governor’s strong hints that the Bank will shortly embark on this radical action to breathe life into the stalled economy came as he unveiled its bleakest assessment yet of Britain’s prospects.

[snip]

[NVDave]

Everyone appears to be ready to go into “QE” - it is the new-fangled buzzword of central banking. Japan did it in the 90’s, we’ve been doing it with the Fed’s swap programs, the ECB has done target injections...

And still, there’s no inflation.

This is the power of deflations. They’re rare, but when they happen, the people who kept up the anti-inflation programs do what the Fed did in the 30’s — the wrong thing.

[afortiori]

Mankiw has been tracking data that he thinks show deflation fears subside.

http://gregmankiw.blogspot.com/2009/02/deflation-fears-subside.html

[Kozak]

If you continue to make the same wage,

Pretty big IF. Almost never the case.

[muawiyah]

Deflation could result in loss of property and casualty insurance companies. Then your 170 year old house would be at more risk than a newer home.

Plus, there might not even be materials on the market to rebuild it after it turns down, falls over in a hurricane, or flies off into the sky in a tornado.

You could be reduced to living in a rehabilitated FEMA trailer ~ IF you could find one without a family of 7 living in it.

Deflation is much more dangerous than you imagine ~ it's not just a repricing of assets.

[webschooner]

Correct! Inflation is coming, and possibly runaway inflation. I know not when, but it is coming. It is a mathematical certainty, with the Fed printing money madcap.

[muawiyah]

As part of his effort to combat a deflationary spiral Franklin Roosevelt CUT federal government employee pay.

I still have the pen around here where he signed the only pay raise he ever authorized.