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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.
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