For the past several years, the greatest fear of policy-makers, investors, and bankers has been inflation. With the Federal Reserve’s unprecedented QE programs, and its massive printing of money to purchase debt, many worried whether this excess of dollars would spark a similarly unprecedented inflationary cycle. This, however, has not come to pass. Rather, there is now fear of a more pronounced, and more prolonged, deflationary cycle in the American and global economy.

The pedantic definition of deflation is: A reduction in the general level of prices in an economy. This means, for example, that a gallon of milk or gas will cost less next week than this week. A humorous indicator of deflation is: When an economy sells more adult diapers than baby diapers. That is, when an economy’s population is weighted more toward the elderly than the young, deflationary pressure will exist.

I believe we are soon entering a deflationary period. As Baby Boomers retire and downsize their lives, our economy will lose the single-greatest productive demographic it has ever seen. There will be less demand for homes, cars, furniture, and electronics, and there will be a marked shift in demand away from tangible goods and toward services. With decreasing demand, the general price level will fall.

One negative effect of a falling price level is that the real value of debt increases. Borrowers will owe more in real terms for any debt taken out when their loan comes due. This makes borrowers less likely to acquire debt, which, in turn, means fewer loans, less investment, and slower business growth. The worst-case, and not-uncommon, scenario is a deflationary spiral. The negative effects of a decrease in the utilization of debt cannot be overstated.

Japan, for example, has been in a deflationary spiral for nearly 25 years. After tremendous growth through the 1970s and 1980s, their economy went into recession in the early 1990s. They had acquired massive levels of debt, particularly in global real estate, but were unable to service this debt. Changes in demographics—namely, they weren’t having children and their population was rapidly aging—created an absence of inflationary pressure. Domestic demand was falling along with the general price level. To keep their exports competitive, Japan pursued one stimulus program after another throughout the 1990s and 2000s to keep their currency low. Their debt, while increasing in real terms, was being serviced with yen that were falling in nominal terms.

Japan’s error—which, unfortunately, is the prescription every advanced economy pursues during every recession—was to attempt to fight the natural business cycle. After a spectacular rise throughout the 1970s and 1980s, Japan was destined for a spectacular correction. The Bank of Japan’s actions in the subsequent 25 years attempted to soften this correction, but ultimately prevented organic market corrections from materializing. They essentially condemned themselves to this period of deflation rather than risk a quick but acute period of economic hardship.

With the latest financial crisis, I fear the US has pursued a similarly faulty course. We have embarked on a series of programs, from the stimulus to several rounds of quantitative easing, that were meant to keep the market from naturally correcting itself. But as history shows time and again, you cannot alter the business cycle; you can only prolong it. We have condemned ourselves to a prolonged period of low growth and high unemployment rather than endure a quicker, but more severe, course.

To prepare for this deflationary period, I advise people to do three things. First, if you’re planning to buy a new home or downsize to a smaller one, do so this year. This will be the last year that interest rates are this low, and as interest rates and deflationary pressure both increase, the value of a home’s debt will increase astronomically in both real and nominal terms. Second, diversify your portfolio. Speak with an investment firm on where to invest and what kinds of assets to hold to hedge against deflation. And finally, educate yourself on the topic. Strive to understand the mechanics of inflation and deflation, and what both can mean for your financial security both, present and future.

As always, I will discuss these topics in more detail in the coming weeks. If you haven’t yet, I encourage you to listen to this week’s show in the archives, as I went into more detail than this post allows. And stay tuned over the next few weeks as I explain how today’s news and current events are affecting, and will be affected by, the demographic changes we’re seeing today.

2-15-14 What in the World is Deflation

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