Personal Finance 101: Deflation and You

Addressing Questions You May Have About Deflation

Michael writes:

I’ve read several articles recently that claim the United States is headed into a period of deflation, but they made it sound like that was bad news. The way I understand it, deflation means lower prices for everyone. How can that be bad?

pf101Several commentaries from various writers and radio broadcasters are circulating at the moment predicting a “deflationary spiral” for 2009 and beyond. I read about this first in the November 13 issue of The Economist in an article entitled Depressing Times. On the surface, that might seem like a good thing, but when you dig deep, it’s not a good thing at all.

What is deflation?

Deflation is the direct opposite of inflation. Deflation occurs when, over time, prices on goods and services go down instead of up. Deflation can occur in just some specific sectors – like cars, for example – or it can strike everything and cause all prices to fall.

Deflation is rather unusual, actually. In developed countries, a constant but relatively low level of inflation is actually the normal state of affairs. That’s why, normally, year after year, we see prices of the ordinary things we buy inch upwards – it’s inflation at work.

Isn’t deflation a good thing for consumers?

Over the very short term, it is a good thing. If deflation occurred over a very short time, ended, and prices started to climb again, that’d be great – it’d be like a global 5% off sale everywhere, and that would undoubtedly be a good thing for people who are just worried about putting food on the table and buying Christmas presents for their kids.

Things get problematic, though, if deflation happens over a long period and comes to be viewed as the norm. When that happens, people stop spending money.

Why would deflation cause people to stop spending money?

Think about it. Let’s say you were thinking about buying a new car, for example. The current price tag on that model was $20,000. However, you knew that deflation was at work and all prices were falling. Wouldn’t you think to yourself, “You know, I could just wait a year and that car would only cost me $19,000.”

Compare that to a situation with inflation. You see a car there for $19,000, but you know prices are going up. You can reasonably expect that next year the price of that car will be $20,000, so there is some push to buy that car now rather than later.

And that’s the key difference. Inflation encourages people to spend money now – deflation encourages people to choose to spend money later.

If a lot of people choose to spend their money later and not spend their money now, products go unsold. Because there’s no demand, manufacturers slow down production. Factories slow down. People get laid off – and then can’t spend money anyway. Retailers cut costs to try to attract buyers. And the cycle continues.

What can I do to protect myself if deflation happens?

The best thing you can do is not to assume that deflation will continue forever. Don’t delay purchases with the idea that the price will continue to drop everywhere. Instead, do careful bargain hunting, but pull the trigger when you find the item for a suitably low price.

This is similar to the logic of why it’s a waste of time to obsess over timing the stock market. No one knows for certain when the stock market is at an absolute bottom, so you shouldn’t waste time trying to guess when that bottom is. Instead, take advantage of the fact that prices are down, period, and make smart purchases.

If you’re worried about your investments, the solution, as always, is to diversify. Don’t have all of your retirement money in domestic stocks. Spread it out to international stocks, bonds, cash, real estate, and so on. That way, no matter what happens, you have some stability.

For now, though, don’t worry about it. Keep making sound financial choices. Spend less than you earn and sock away the rest. Practicing good, sound financial behavior in your day-to-day life will provide the basis for weathering any storm.

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