Deflation: What is it and why should I care?

Very few of us alive today have lived through a period of deflation. The last time the

U.S. experienced deflation was during the Great Depression in the 1930’s. Many of us

recall periods of inflation, since we’ve experienced inflation in varying degrees steadily

since World War II but deflation and its effects are strangers to our thinking.

The textbook definition of deflation is “a decrease in the general price level of goods and

services (including wages).” Deflation can also be described as the opposite of inflation

or a negative inflation rate.

In periods of inflation dollars become worth less and consumers tend to buy more goods

and services because they will be more expensive tomorrow. It’s also a better time to

be a borrower rather that a lender since debts are paid back in cheaper dollars. The

real interest rate is lower than the nominal or stated interest rate (i.e. if your nominal

rate to borrow is 5 percent and inflation is 2 percent, your real interest rate is 3 percent).

Inflation generally encourages consumption (spending) and borrowing.

The effects of deflation are the opposite. Since people’s expectations during a

deflationary period are that prices will be cheaper tomorrow, they tend to defer

purchases. They will also have to repay borrowings with dollars that are worth more.

It’s better to be a lender not a borrower during deflationary periods. The effects on

interest paid to borrow is also the reverse of inflation since loan principle and interest

must be repaid in harder not cheaper dollars. If your nominal (stated) rate to borrow is 5

percent and deflation is 2 percent your real interest rate is 7 percent!

A related term of interest is “debt deflation” originated by economist Irving Fisher. The

phrase refers to a period of extensive over indebtedness that leads to deflation.

If deflation persists, a “deflationary spiral” can occur. As prices decline consumers

hoard their cash or pay down debt waiting for prices to drop further. As a result,

production slows since less goods and services are needed. As demand drops

businesses stop hiring and begin to lay off employees. Significant deflation has always

caused unemployment to rise and output to fall. This process tends to feed on itself

further perpetuating the deflationary spiral.

Why should all of this concern the average American? After the extreme buildup of debt

in the 1920’s, persistent deflation lasted until World War ll during which the

unemployment rate reached 25 %. This was also the case after the massive buildup of

canal, turnpike, and steamship debt in the 1820’s and early 1830’s and the large

accumulation of railroad debt in the 1860’s and early 1870’s.

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The Federal Reserve and the Government through Congress and the Treasury have

taken and continue to take measures to stimulate demand. Low interest rates, tax

credits, cash for clunkers etc. etc are examples of their actions. Will they be

successful? Too early to tell. It may be that the best we can hope for is a long period of

zero or slow economic growth bouncing between modest deflation and low inflation as

the economy works through the excesses of the past few years. Time will tell. A long

period of negative growth isn’t in our domestic or the global communities’ best interest.

Ben Bernanke, Federal Reserve Chairman, pointed out in a 2002 speech on deflation

that “deflation is always reversible in a fiat (paper) money system”

Let’s hope we don’t have to test his claim.

October 2009

John D. Ritchie, Managing Principal

Great Northern Asset Management

(360)-567-3300

Great Northern Asset Management provides investment advisory services to individuals

and families.