Deflation - Do you need to worry?

Welcome back.

Yesterday, we discussed inflation and how it can affect your financial well-being. At the end of yesterday's article, I noted that inflation occurred in each an every one of the last 50 years in the United States. That's half the story.

Here's the other half. Let's spread our net a little wider and see what the historical chances of inflation are since, say 1914. Uh-oh. Now the story changes a little bit. Instead of looking at a 100% certainty that we lose value to inflation, we find an 11.4% chance that cash money sitting under the mattress will actually increase in value while it sits there doing nothing.

Deflation was strongest in the period of 1927 - 1933. In 1932, deflation rose above 10%, the worst deflationary year in our country's history. As any student of the Great Depression knows, 1932 was one of the most painful years of the period. Jobs were lost, companies went out of business and it seemed like no one was hiring or buying anything but the bare necessities. Why not? Because it made more sense not to. If you had a pile of cash and you knew that it would be worth more if you simply sat on it, why would you risk it on a business venture? And what business can afford to pay $1 for something that will only be worth $0.90 by the time they can sell it? If you owned that business, you would need to sell your goods extra-super-fast or else just shut the doors. And when all your customers are losing their jobs, too, chances are you'll choose to shut down and save your cash.

Fast forward to today

With all the economic uncertainty we face right now, there are many who argue that we run the risk of hitting another deflationary cycle. If they are correct, deflation could wreak havoc on our economy and virtually shut down commerce in this country. Their reasoning in rooted in the fact that many of the current political policies from the White House mirror those of Franklin Delano Roosevelt, who was President during the Great Depression. In short, these experts believe that similar policies will create the same results. But there is one very big difference.

At the start of the Great Depression, the United States currency was on the Gold Standard. That means that every dollar was worth a certain amount of gold. When the economy began to contract, people decided they would rather own the the gold instead. The effect of trading in paper money for gold was to make paper money more scarce. The supply of paper money fell at an even faster rate than the general economy. With less dollars chasing more goods, the value of the paper money increased. Thus, we had deflation.

My point to investors is that the money supply today is actually growing, not shrinking like it did at the start of the Great Depression. But our economy is shrinking. This means more dollars will be chasing fewer and fewer goods. And that, my friends, is the dictionary definition of inflation.

A detailed analysis of deflation can be found here and here.