Economists make a business of predicting the future, usually with about as much success as what Paul Samuelson, himself an economist, said about Wall Street: “Wall Street indexes predicted nine out of the last five recessions.”
When the economy turns sour, some economists will predict severe inflation. They'll say that tax revenues are down even as the economy contracts, but government keeps spending more money. What choice will it have but to make up the shortfall by printing the dollars it doesn’t collect in taxes – and to borrow what it doesn’t print?
Lo, the scourge of inflation – more and more money chasing fewer and fewer goods.
Other economists will argue that it’s not inflation that threatens us. It’s a shrinking economy and falling prices.
Lo, the scourge of deflation – less and less money chasing more and more goods.
If these economists are right, investors face very tough times, because deflation can have a far heavier impact on a stock portfolio than inflation.
To see why, think about the difference between IR and deflation. If you bought a house in 1990, you saw inflation at work first hand as the value of your home shot up. If you still owned that house in 2008 and 2009, you saw its value plunge as the housing bubble burst. The economy as a whole slowed during that time, and prices for many items fell, at breakneck speed – oil, commodities, durable goods, consumer items of all kinds, and pretty much anything else you can name except, of course, the cost of government, which goes up so long as we keep electing people to Congress.
An economist would tell you that deflation is a contraction in money and credit relative to available goods. In plain English, this means two things: Prices decline in a deflationary economy, and people stop buying because they earn less and they have less access to credit. In any case they hold on to whatever money they have in the expectation that they will have to part with less of it in the future to satisfy their needs.
The impact of deflation on stocks should be clear. If people don’t have money to buy Company XYZ’s widgets, or in the alternative think they’ll be better off waiting to buy those widgets tomorrow, Company XYZ’s sales and profits decline, and its stock goes in the tank. In a worst-case scenario, if the company fails to cut costs as sales decline, the company itself ends up in the tank. (Think Detroit and you’ll see how this works.)
This makes things dicey for the investor. You want to avoid the stocks of companies likely to go into the tank, and you want instead to load up on the stocks of companies likely to do well. But which is which?
Things don’t get much clearer even if you think the answer has to do with needs and wants – even if, in other words, you can 1) figure out what things people must buy in hard times or good and what things they can do without, and 2) limit yourself to buying the stocks of companies serving needs, not wants. People need food, clothing, and shelter no matter what, but in hard times they cut back on every expense, with the result that the stocks of many big grocery chains and clothing retailers are way down.
Look at the problem from another perspective. Say you’re in the market for a car in an era of falling prices. Last year the car you want cost $30,000, but since then the economy has shrunk 5 percent, and the price of that car has come down 5 percent, too, to $28,500.
You’d be better off buying that car now than you would have been a year ago, to be sure. But should you buy now or wait a while to see if prices come down more? Put another way, would you spend good money now for something that will probably cost less soon? Worse, would you borrow now to make such a purchase?
Most people would wait for a better price. As for borrowing, say you had to borrow $25,000 to buy that car today. But if it declines in price another 5 percent over the next year, you’d have to borrow that much less to buy it then. It makes sense to wait to borrow, too, right?
Economists say that the burden of debt is lighter in inflationary times and heavier in deflationary times. What they mean is that, if you borrow money in inflationary times, you pay it back with cheaper dollars, since inflation eats away at the value of money. Conversely, if you borrow in deflationary times, you pay it back with more expensive dollars, since deflation makes money dearer.
Put another way, it makes sense to borrow money to buy that car if you think we’re headed for inflationary times – because inflation will make it easier to come by the money to repay debt. It makes no sense to borrow if you think deflation is our problem – because deflation makes it harder to come by the money to repay debt.
This crystallizes the problem for the investor. Deflation is a vicious cycle. Companies see a decline in sales, so they cut costs, starting with their labor costs. People earn less, so they buy less. That makes sales fall even more, leading to more layoffs, leading to less money in consumers’ pockets, leading – well, leading down the tubes.
What this boils down to is that, if deflation comes, it will have a huge impact on investors holding the stocks of companies whose revenues depend on discretionary spending, and even on the stocks of companies selling necessities such as food, clothing, and shelter. Indeed, in deflationary times, for investors as a whole, all bets are off, because investing is all about hope, and deflation eats away at hope.