Published 1/16/05.
Additional comments on deflation are presented in 
Stock and House Prices Might Not Fall Off a Cliff.
Over the last few years, the Federal Reserve Board (FED) and many noted market observers have issued serious warnings about the continuing danger of deflation throughout the U.S. economy. They correctly point out that a repeat of the 1930's style of deflation would be a disaster in the framework of a debt based economy. The Optimist, however, sees little risk of serious deflation in the USA.
Consider the characteristics of deflation, and who the losers and winners would be in a major deflation. First, what is deflation? There can be several abstract definitions, but the Optimist prefers to focus on the change in purchasing power of the dollar. A deflationary period like the 1930's would result in the dollar gaining a substantial increase in purchasing power, so that houses, cars, energy, food, and just about everything else would cost much less than they would without deflation. As the purchasing power of the dollar increased with deflation, anyone who owed money would be a clear loser because of the need to pay back that debt with more expensive money which gained in purchasing power. The list of those who would bear the lion's share of deflationary pain includes not only the individuals who borrowed to buy cars or houses, but also businesses, banks, and all levels of governments from local to federal. Governments would be doubly hard hit by not only needing to pay back loans with expensive money that has a higher purchasing power, but also by a sharp reduction in the tax revenues the governments would receive.
Although many people, businesses, and governments would be seriously harmed by a deflationary crash, there would be some significant winners. The obvious candidates for the winner's wreath would include retirees who receive fixed income, and all labor with contracts that prevent the reduction in wages. The biggest winners from deflation, however, might not be so obvious. For example, the surprise in the winner's column is all the foreign nations which hold trillions in US paper debt. By simply doing nothing with that debt, those nations would become substantially richer in a deflationary environment where their accumulated wealth would buy an even greater percentage of America.
For deflation to occur, dollars must become relatively scarce so that the purchasing power of each dollar increases. The FED clearly stated that they have the ability to print as many dollars as may be needed to prevent deflation that could be caused by the dollar becoming scarce. Although the FED's abilities may be limited in some areas (to support the dollar exchange rate, for example, or to hold down the rise in long term bond yields), the Optimist firmly believes that the FED can print money!
In the final analysis, each investor must make his or her own decision about whether to invest by betting for or against deflation. As part of that analysis, investors might consider whether they want to bet with the winners from deflation (i.e., Social Security recipients and foreign nations holding U.S. debt), or to bet with the losers from deflation (all the voters who have debts and owe money, almost all businesses and banks, and all levels of government). Those advisors who strongly support the deflation scenario should be prepared to answer a simple subscriber question: Would it be a good investment strategy to simply convert assets into crisp and freshly printed U.S. hundred dollar bills and stack them in a safe deposit box as an easy way to bet that the USA will experience deflation? In the 1930's, many people hid paper money in a mattress, and gained purchasing power by doing so. Obviously, there are more rewarding ways to bet for deflation (like keeping funds in a savings account earning less than 1% per year), but the question that deflation advocates must answer is if they believe that stashing cash in the safe deposit box equivalent of a mattress will be a good investment plan. Those same advisors might also want to volunteer how long they have been advocating investment strategies that are comparable to stashing paper in a safe deposit box.
The Optimist has a very positive attitude and an upbeat view that he does not need to worry about allocating his investment funds to protect against deflation. The cheerful view is that the FED can print money to prevent scarcity of dollars, and that all voters with debts and businesses and banks and levels of governments will successfully encourage the FED to do so to avoid the pain of a repeat of the deflation in the 1930's. The paper money printed by the FED won't prevent the continued loss of productive jobs, or the depression that will lead to, but the Optimist is confident that those who are out of work in the depression will not also need to contend with the additional burden that deflation would impose. That positive and optimistic attitude enables the Optimist to fully allocate his investments to protect against Inflation instead, and to focus his investments into the Gold and Silver arena.
4/08/05 Update with reader input by Truth Seeker:
Just read your piece on deflation. A friend pointed out to me that the dollar is not really the medium of exchange used either in the USA or around the world. The real medium (present company excepted, of course) is credit. If this is true, deflation means less credit chasing goods and services. I've been thinking about this for months. In the familiar Ponzi scheme, we put x dollars in the bank which instantly regards it as 7x dollars it can lend. (I may have the wrong multiplier, I'm a babe in the woods at this). Credit is another name for faith. We have a faith-based economy. I used to hear "The dollar is backed by the full faith and credit of the U.S.Government-"
Now it may not be politically correct to say it, but the faith and credit of the United States around the world have suffered some serious compromise in the last 5 or so years. A reputation for honesty is not an easy thing to re-establish once one has shown oneself to be a pathological liar with a penchant for serial murder. Credit, or the general belief that one will act responsibly, keep one's agreements, and not infringe unjustly on the persons or property of others, not to mention bombing friendly countries back to the stone age, or promoting dictatorships, torture, and the blatant theft of ancient ancestral lands, such credit cannot be printed on government printing presses. Yes, the offices of disinformation can churn out propaganda and their media minions can broadcast the increasingly bazaar spins, but who, outside the United States I mean, will believe it?
Comments by the Optimist:
The Optimist is shocked to learn there is gambling here! Oops, wrong movie, but it is shocking to consider that the reputation of the USA is in question. The Optimist agrees that the effects from a diminished reputation, both within the US and around the world, will be substantial. Those effects will extend beyond a mere reduction of credit (which must happen anyway due to the rapidly rising risk of defaults) to also impact the political climate and the social fabric of our nation. In the same way that rising real interest rates act as a drag on the economy, a compression of credit will also act to slow business activity. Both will have a negative effect on employment, and will cool the overheated housing market. The hangover after a wild party is never a happy time!
The Optimist, however, maintains a positive viewpoint about the peril of deflation. Even though unemployment will surely get worse and housing prices may suffer a nasty correction, the Optimist is convinced that the prices of everything else will continue to escalate to the upside in a manner similar to the 1970's. The FED has openly stated that they will not permit the economy to implode through system wide price reductions in the form of deflation, and the Optimist is pleased to report that the FED is not lying about that. Even if unemployment continues to increase toward levels last seen in the 1930's, and even if shell shocked citizens are too busy with their bankruptcy process to borrow any money, the FED will retain tools to force feed money into the economy. Although the Optimist is skeptical about any serious plans to drop hundred dollar bills from a fleet of helicopters, he has read rumors that the PPT sometimes uses funds from the FED to purchase token amounts of stocks and bonds. If that process works well on a small scale, the Optimist has no doubts that our talented central planners can find a way to increase the efficiency of the process by hiring lots of unemployed people to work in many different PPT's, so they can buy lots more stocks, bonds, houses, shopping centers, Brooklyn Bridges, ranch land south of Key West, etc! If they buy too much stuff to handle, the FED can simply donate it to charity or sell it at a much cheaper price, and deduct the loss on their income tax! The Optimist cautions the reader to not underestimate the power of being able to print money at little cost.
Fortunately, the FED has not yet developed the right technique for printing precious metals. That small inadequacy on the part of the FED helps the Optimist to sleep soundly at night when his investments are secure in silver and gold!
A reader expects deflation first, and then inflation (7/24/05)
I see the world economy as an expansion of the world comprised of family, friends, and neighborhood. Debt is rampant without any ability in real terms to repay it. I foresee this fall , with housing prices flat, delinquency rates spiking along with a first wave of bankruptcies and foreclosures. Deflation, (where Cash is King) - 2006 -2007
This process will domino until foreign investors no longer feel the US dollar is worth the risk and begins the devaluation. With this process underway, the fed will take advantage and allow a free fall devaluation of the US dollar, watering down all debt public, private and government by 50 % or more. Hyperinflation : Balancing to the true inflated costs of land commodities and energy.
DEBT PROBLEMS SOLVED !! The trick is to do this before your trading partners do.
the Optimist thinks delation and inflation may coexist for a brief time:
Some readers may think that the Optimist wears blinders which limit his vision to seeing only increasing inflation ahead. They may be surprised to learn that he actually guesses that deflation and inflation will coexist and partially offset each other over the next few years. The surprise candidates for deflation are the luxuries which have been acquired in great abundance by the accumulation of high levels of consumer debt. The biggest single category of over priced luxury items is residential real estate. Although having a roof over one's head is a necessity, it is not essential for every person in the nation to immerse himself in debt to purchase the house attached to that roof. Many people in previous generations found that they could live within their means by renting, and that they could build up savings instead of compounding debts in the process. The Optimist guesses that many of the current buyers of overpriced real estate will rediscover the joys of renting as unemployment cascades higher, and that house prices in the most over priced areas will suffer as a result. Similarly, the Optimist guesses that big ticket items of conspicuous consumption will also have less buying pressure during the coming rise in unemployment. Examples of items which would feel deflationary forces could include 48 inch plasma TVs and extra large SUVs (which are also extra heavy and get comparably terrible fuel mileage). In an atmosphere saturated with excessive consumer debt and depressed by increasing unemployment, purchases of expensive luxuries will be reduced and the resulting decline in prices of luxury items will look like a taste of deflation for a few years ahead.
The Optimist is confident, however, that the prices of necessities will move incessantly higher. First on the list of necessary purchases is fuel. Escalating world wide demand for crude oil and liquid natural gas will continue to push those prices higher without respite. Since all of the other necessities of modern urban life require energy to produce and transport, the prices of those necessities can only increase even as consumers with excessive debt try to cut down on purchasing luxuries. Two other areas of persistently rising prices of necessities will also become evident in the months ahead. First, even as excessively high house prices revert to the mean, the costs of rent will push ever higher. Secondly, consumers will increase the time between trading up to a new car, and the prices of used cars will begin to firm. The Optimist expects rising profit margins for used car parts and repair businesses. As highly indebted consumers are squeezed into a lower standard of living, there will be a brief transition time in which we could see mild deflation in luxury items (including over priced real estate) and simultaneous rising inflation in the full spectrum of necessities. After that transition, the Optimist expects only inflation to be seen everywhere, and to be rising at an ever more rapid pace. If that view is correct, then the next few short years may be the final opportunity for consumers to escape the jaws of the vise by paying down debt and simplifying their lifestyle so they can save funds which they can use to purchase precious metals while they are still relatively affordable. After that window slams shut, the twin jaws of inflation on one side and high interest rates on the other will mercilessly squeeze anyone with debts in the vise of rising unemployment.