Personal Business

Coping with deflation

Prices would fall, but so would incomes. The lack of demand would trigger mass layoffs.

Ross Laver December 1 1997
Personal Business

Coping with deflation

Prices would fall, but so would incomes. The lack of demand would trigger mass layoffs.

Ross Laver December 1 1997

Coping with deflation

Prices would fall, but so would incomes. The lack of demand would trigger mass layoffs.

Ross Laver

Personal Business

When they fall asleep at night, investors and central bankers have nightmares about rampant inflation. Recently, however, a small band of economists has argued that deflation is a more serious threat to our economy. Are they right, and if so what can investors do now to protect their savings?

As conditioned as Canadians are to rising prices, it would be foolhardy to ignore the risk of a sustained decline in prices and wages. Roger Bootle, a respected British analyst of financial markets, points out that the chronic inflation that has afflicted Western economies in recent decades is an aberration, and that for centuries prices tended to fall as often as they rose. In fact, Bootle’s own research suggests that 97 per cent of all price inflation dating back to the 13th century has occurred since 1940.

Today, however, inflation has almost disappeared, thanks in large measure to globalization and changes in technology that have sapped the power of unions and made markets more competitive. For millions of consumers, the resulting drop in interest rates has rendered mortgages, car loans and other major expenses more affordable. Investors have benefited as well, because lower corporate borrowing costs and increased consumer demand have contributed to big profits and generous returns for shareholders. Unable to raise prices at will, companies have endeavored to improve productivity, which ultimately leads to a higher standard of living for all.

But while the gradual decline of inflation over the past decade has had many positive spinoffs, too much of a good thing—deflation—could prove dangerous. Yes, prices would fall, but so would personal incomes. Consumers would learn to postpone discretionary purchases as long as possible in the expectation that prices would continue to drop—as happens now, for example, in the computer business. Falling demand would lead to reduced corporate profits and mass layoffs as companies ratcheted down

production or were forced into bankruptcy.

like inflation, deflation can easily become self-perpetuating. One reason is that interest rates cannot drop below zero. As prices and incomes fall, therefore, the effective rate of interest increases. Borrowers would still have to pay back their loans, but they would have less money in their pockets to do so. By magnifying the burden of debt for consumers, companies and governments alike, deflation raises the spectre of widespread default And with most individuals and businesses earning less, government tax revenues would fall, causing the deficit to soar. The $600-billion federal debt which has only recently begun to shrink as a percentage of gross domestic product, would loom ever larger.

Could any of this happen? The chances may appear slim, but the current economic crisis in Asia proves that it is not impossible. In Japan, prices in many industries have been falling for most of the 1990s. The entire region is now suffering its worst deflationary spiral since the 1930s. Already, the crisis is beginning to spill over into North America in the form of lower-priced imports and reduced Asian demand for Canadian and U.S. products.

For now, deflation is only a theoretical threat. But if you worry it could happen here, there are several relatively painless investment strategies. First, make sure some of your savings are in the form of long-term government bonds. The current yield on 30year treasuries is just under six per cent. If it drops to five per cent, as some economists believe is likely next year, you can sell the bonds at a profit or hang on to them for their richer yield. Second, pay close attention to credit risk. Companies that are loaded up with debt would be among the hardest hit in a period of deflation, since their real debt burdens would be even higher. Third, look for companies that sell unique products and are in a position to maintain or even raise prices when the overall economy is weak. Although deflation may never strike, investors will sleep better knowing they are in better shape to ride it out if it does.