Surviving Deflation

Last week’s CPI (-1.0%) and PPI (-2.8%) confirmed what many economists feared - the financial market crash and economic slowdown was triggering a period of deflation (falling prices).  Deflation is bad because it can cause an economy to come to a grinding halt.  It works through a number of insidious pathways.  Consumers defer purchases because goods will be cheaper in the future.  Businesses watch profit evaporate as inventories fall in value.  It also becomes difficult for businesses to undertake profitable investment projects since deflation causes the real (i.e., inflation adjusted) interest rate to rise - with a -2.8% deflation rate and a 6% nominal interest rate on loans, the real rate is 6.8% which may (particularly in recessionary times) be more than the business can earn on a new project.  As businesses cut back, unemployment rises, people consume even less, and deflation accelerates further, sinking the economy in a downward spiral.

What can you do to protect yourself?

  1. Pay off debt.  This is extremely important.  One of the particularly nasty effects of deflation is that it increases your real debt burden - you are paying the loan back with dollars worth more than when you took the loan out.  Try to eliminate debt as quickly as possible.
  2. Defer big purchases.  While this may be bad for the overall system, it is smart for the individual.
  3. Don’t invest any new money in risky investments.  Cash is king during a deflationary period.  Keep your money in liquid, FDIC-insure accounts.
  4. If you have money invested in stocks in a retirement account, and you have >10 years until retirement, leave it alone.  The market has fallen substantially in recent months and unless you need the money soon, pulling it out now is probably a mistake.  Do not add to it though, see #3 above.
  5. Avoid precious metals.  Gold is an inflation hedge.  It will perform poorly in a deflationary environment.
  6. Secure your job to the extent possible.  If your job situation is inherently insecure, start looking (discretely) for a new position.
  7. Don’t panic!  All we have so far is one data point, and the situation can change quickly.  There is also always the risk that the government overreacts, and brings about inflation a couple of years down the road.
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One Comment

  1. LSUxBlake
    Posted December 8, 2008 at 11:01 pm | Permalink

    Nice work, Rich. Just saw the link and defintely some good reads. Keep it up.

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