We hear a lot about inflation from the financial media, but less well discussed – and understood – is deflation. What is deflation and how could it affect you?
What is Deflation?
The net effect of deflation is a general decline in price levels. That includes not only a drop in prices for goods and services, but also for wages and other types of compensation.
Most of us are well acquainted with inflation, which is rising prices. Even in today’s era of relatively low inflation, certain prices are rising at more dramatic levels. These include healthcare, housing, higher education, and often taxes.
Technically speaking, deflation is an inflation rate that falls below 0%. Basically, the money supply shrinks due to various factors. Since there is less money in circulation, price levels tend to drop. The average person, business or even government agency simply lacks the financial resources to pay higher prices.
The best example of a general deflation was the Great Depression of the 1930s. During that crisis, general price levels fell in response to major declines in industrial production, employment, and foreign trade.
What Causes Deflation
Much like inflation, deflation is a spiral. It generally starts with a decline in the economy. For example, during the Great Depression, there was a major stock market crash, followed by a large wave of bank failures. The banks themselves failed due to an explosion in defaulted loans. The circumstances combined to remove a substantial amount of money from circulation.
As the money supply quickly fell, demand for goods and services collapsed. The fall in demand resulted in a dramatic decline in production, which translated into chronic unemployment that reached as high as 25% of the labor force.
With both unemployment and loan defaults rising, credit disappeared. Without it, sales of big-ticket items, like autos and houses, collapsed. All contributed to the downward spiral.
As more people became unemployed, demand fell further. Much like inflation, deflation tends to feed on itself. And while the rate of deflation ebbed and flowed throughout the 1930s, it didn’t come to an end until the beginning of World War II, which created demand for war materials. That got the factories running again, which increased employment, putting money in the hands of consumers.
How Deflation Could Affect You
The 1930s was a classic example of general deflation, but a highly destructive one. A more moderate time of deflation could have mixed results.
The upside of deflation is the general decline in price levels. It means most goods and services become less expensive. If you’re able to maintain your income, you’ll find that it will go farther.
For example, if you earn $50,000, but general price levels fall by 5%, it will be the equivalent of a 5% increase in pay. You didn’t get a raise, but the income you have simply goes farther.
In a more serious deflation, your job could disappear. In other situations, either your pay or your hours may be cut. The same as possible with benefits. In a general deflation, employers may decide it’s no longer worth providing health insurance and other benefits.
It’s even possible work will become more sporadic. If your employer is busy, you may be working only part-time. But during times of a slowdown in business, you may be unemployed.
If your income doesn’t remain stable, the benefit of lower prices for goods and services will largely be lost. Even though they’re declining in price, the lack of income means you can’t afford them even at lower prices.
Another potential outcome is a reduction or elimination of credit. That would make it difficult or even impossible to borrow money to make major purchases, or even to cover short-term living expenses.
Is there Any Way to Prepare for Deflation?
Federal Reserve policy makes it difficult for deflation to take hold. Based on the experience of the 1930s, the Fed actively works to prevent deflation from happening in the first place.
But if you’re not confident in the ability of the central bank to prevent a deflation, there are certain steps you can take to prepare for that outcome:
Build a strong savings base. If income becomes a doubt, the best antidote will be a large savings account. You can live on your savings during times of unemployment or underemployment.
Avoid risky investments. Since deflation lowers demand for goods and services and hurts company profits, equity investments like stocks can be major casualties. Bonds may also be an issue if companies lack the cash flow to service their debts. Holding safer investments, like U.S. Treasury securities will likely be a better option. Since they’re guaranteed by the US government, they’re much less likely to default or stop making interest payments.
Payoff debt. If inflation favors debtors, deflation is their worst nightmare. As money becomes less available, it becomes more difficult to service debt. And if you’re unemployed, there’s a very high likelihood you’ll be forced to default on your obligations. By paying off your debt, you’ll avoid the drain on your limited income, as well as the potential for default.
Favor certain careers. These would include jobs in healthcare, municipal services (police, firefighters, etc.), and education. Those are career fields that involve providing services that are necessary at a very basic level.
Final Thoughts on What is Deflation and How Could it Affect You
Since the early 1980s, the Federal Reserve has done an outstanding job of managing a tightly balanced, low-inflation economy. Since it’s unlikely that will change anytime soon, or to any major degree, we shouldn’t be too concerned.
Building up savings, getting out of debt, and advancing your career are good strategies for any type of economic environment, whether it’s inflationary, deflationary, or somewhere in between, as we are now.