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Deflation - The "Tar Baby" of Economic Forces By Stephen J. Butler

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I hate to offend anyone who lives by their horoscope, but my former professor, John Kenneth Galbraith, once said, "astrology was invented to make economics look good." In his obtuse world of the "dark science," Galbraith would describe deflation as the darkest possible side of the Force.

In recent weeks, responsible economists have been voicing concerns about the growing possibility that prices of goods and assets may actually fall in value. Deflation prompts us to stop consuming goods because we assume that we can buy them for fewer dollars if we wait. This mentality triggers a downward spiral as companies further reduce prices in an effort to generate at least some sales. Collectively, we generate a self-fulfilling prophecy that becomes very difficult to reverse with the usual economic controls. How do you lower interest rates to stimulate an economy, for instance, when they are already at 0% as they are in Japan?

Elsewhere in a deflationary economy, those with outstanding loans are struggling to pay them back with dollars that become increasingly more expensive and more difficult to earn. A hard asset, like a home, becomes worth less, but the original mortgage remains in place with the same high number of dollars that need to be paid back. To understand deflation and its pernicious effects, it is best to compare it with inflation. When we borrow money in inflationary times, we pay it back over many years with dollars that get easier and easier to earn as they become worth less. A loaf of bread costing a dollar today will cost $2 in ten years because the currency has dropped in value. Meanwhile, we have hopefully received at least "cost-of-living" increases in our incomes. Our government, when borrowing heavily, will deliberately allow inflation to set in so that the loans can be paid back in the future with "cheap" dollars whose value has been reduced by inflation.

With deflation, the opposite happens. The currency becomes worth more, so the earlier dollars we borrowed will have to be paid back with new, more expensive ones. When it becomes harder to pay back what we owe, we don't have as much money to spend on more consumer goods. Consumer spending is what keeps our economy sputtering along today, so any threat to the economy's primary feeding trough is not a good thing.

A magazine, "The Economist," pointed out recently that Inflation and deflation are not always tied to growing or slowing economies. An economy can actually be growing slightly and still experience deflation. Or, the economy can be experiencing "stagflation" which means a recession AND rampant inflation. This was the case during the Jerry Ford presidency when he was passing out his "WIN" buttons that stood for "Whip Inflation Now."

Since we are so close to zero inflation today, it may be anyone's guess as to what will happen over the next few years. Some of the more hysterical investment newsletters are predicting that money markets will beat common stocks for the next twenty years. This prediction is based upon an interpretation of where we happen to be on the Kondratiev Wave. Kondratiev, the Russian economist of the Stalinist era, showed that the world's free market economy cratered about once every 54 years. Next year, 2003, is exactly 54 years after 1929.

Deflation, by some measurements, has been taking place in a small way over the past eleven months, but it shows no signs of evolving into a downward spiral that can leave us with economic havoc. Economic bubbles can often lead to deflation-prone economies, but most of today's policymakers are too young to have ever had first-hand experience at combating the problem. Economic historians, however, are quick to point out that a deflationary spiral is easy to get stuck in and difficult to escape.

What does this mean for the average retirement investor? If you still have ten or more years until retirement, common stocks continue to make the best sense.

Any further implosion of the market will be unsettling as it happens, but it will offer further opportunities to buy stocks and mutual funds at the best prices since the mid nineties. For those of us who feel the itch to do something, anything, in the light of these realities, a shift to some value-oriented, dividend-paying stocks or mutual funds can offer more immediate gratification than the average growth fund. Small company funds tend to be the first out of the blocks when recessions end. High- yield bond funds with low expense ratios perform more like stock funds but with the advantage of high dividend yields in the neighborhood of 10% right now. A partial hedging of bets to protect against the doomsday scenario of a deflationary spiral may be worth considering for some with weak stomachs, but a wholesale sell-off into cash would definitely be a mistake for anyone with a long-term view.