👨🎓 Deflation - when prices go down
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Dear all,
In our journey through inflation and its extremes, we’ve touched on how rising prices can impact your finances.
Now, let’s talk about the flip side - deflation - and why, contrary to what you might think, falling prices can also pose significant challenges.
Deflation is the decrease in the general price level of goods and services. While it might sound appealing at first - who doesn’t like lower prices? - deflation can lead to a vicious cycle that harms the economy.
Here’s how it works:
Consumer Spending Declines
When people expect prices to keep falling, they may delay purchases, hoping to get a better deal in the future.
This decrease in spending can reduce demand for goods and services, leading to lower economic activity.
Business Profits Shrink
With less consumer spending, businesses see their revenues decline.
To cut costs, they may lower wages, lay off workers, or reduce investment in new projects.
This further reduces demand, as unemployed or underpaid workers have less money to spend.
Debt Becomes More Burdensome
In a deflationary environment, the real value of debt increases because the money you owe today is worth more than when you borrowed it.
This makes it harder for individuals and businesses to repay loans, leading to higher default rates and financial stress.
Economic Growth Stalls
As businesses cut back and consumers spend less, the economy can enter a period of stagnation or even contraction.
This was a significant issue during the Great Depression of the 1930s, where deflation exacerbated economic woes and prolonged the downturn.
For example, during the Great Depression, U.S. prices fell by nearly 25% from 1929 to 1933. While this might seem like a boon for consumers, the economy suffered immensely as businesses collapsed, unemployment soared, and wages plummeted.
Deflation can be particularly challenging for investors.
Traditional assets like stocks and real estate may perform poorly in deflationary environments, as declining prices and lower economic activity reduce profitability.
On the other hand, cash and high-quality government bonds can gain value in real terms, as the purchasing power of money increases.
So, how can you prepare for deflation? Here are a few strategies:
Hold Cash or Cash Equivalents: In deflationary periods, cash gains value as prices fall. Keeping a portion of your portfolio in cash or cash equivalents like money market funds can provide stability.
Invest in High-Quality Bonds: Government bonds, particularly those from stable economies, tend to perform well during deflation, as interest rates typically fall, driving up bond prices.
Diversify Globally: Deflation might affect some economies more than others. By diversifying your investments across different regions, you can reduce the impact of deflation in any one country.
In our next email, we’ll discuss a situation where both inflation and stagnation occur simultaneously - stagflation - and why it’s one of the most challenging economic environments.
Alessandro
Founder of Macro Mornings
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Thank you as well for answering and putting up with my questions. I found it very helpful to understand your work.
Ok. One last question. Prices declined disastrous from 1929 to 1933. This was a depression that pushed prices down not the other way around. This extreme of 25% decline is not deflation. It's depression. What would happen if prices declined by 2% each year for 4 years? Wouldn't this be a boon to spending while wages remained static?