"The challenge of investing (in times of low or negative real returns) isn't deciding where to put your money, but resisting the temptation to put it somewhere else."

- Andrew Tobias

NEWS that the US Federal Reserve was likely to cut interest rates this week, down as low as one per cent, confirms the growing fear that we might be about to enter an extended period of deflation.

Although a consensus is growing that deflation will be the likeliest outcome of current economic policy, there is as yet no consensus on how long the damaging era of deflation might last. Those who have expressed an opinion suggest anywhere from a year or two up to ten years.

George Bush is almost certain to win a second term in office, particularly with the Democrats completely rudderless. Bush has amply demonstrated that he shares his father's almost total inability to comprehend how the domestic economy operates. As a result, the American economy is about to follow the Japanese and German economies into deflation.

Deflation, as you would expect, is the reverse of inflation. Deflation is a gradual reduction in prices occasioned by a lack of demand for products from people either recently made unemployed or scared that they are about to lose their jobs.

People generally will spend only when they have a reasonable expectation of earning more to replace the spent money. Those out of work, or convinced that they might be soon, do not make great consumers - as you would expect.

The lowering of prices, which sounds theoretically welcome, is accompanied in a deflationary environment, by fewer jobs and lower wages (or at least no increases) for the employed. The problem is that the capitalist economic model relies on two main features: growth and confidence. A lack of growth is what starts deflation and a lack of confidence is what sustains it.

No one under the age of 60 who has spent their life in Bermuda will have much experience of deflation. The Second World War and its immediate aftermath were the last time the major economies of the West experienced such conditions. The 1930s were the last time deflation was felt in the West with any real teeth.

In deflationary times, the key question for the investor changes somewhat, from how to I go about making money, to (firstly) how do I go about not losing money? Today, with inflation still prevalent, banks pay one per cent or less in interest to the saver, but inflation proceeds at two to three per cent a year.

ONE hundred dollars saved is worth $101 after a year, but the goods and services that would have cost $100 at the start of the year now cost, let's say, $103, if inflation is at three per cent. (All these comments are for those not paying income tax, such as Bermuda residents.)

The saver is thus caned for not spending his money. Where he could buy $100 worth of goods with a year's savings, a year ago, now he can only buy $98 worth. He is punished, effectively, for not spending his money and thereby encouraging the economy.

Punishing savers, in the long run, would lead to the collapse of society. Banks do not have a great deal of their own money; they lend other people's. If no one saves, the banks would have no money to lend, and eventually anarchy and chaos would ensue. Deflation is, therefore, painful in the early stages and can be deadly later.

If that makes you wonder why Alan Greenspan believes in punishing savers, you would be forced to the conclusion that either the US economy is in dire straits, or Greenspan is a fool. Both, as it happens, are more true than false.

Given the determination of Bush and Greenspan to get it as wrong as they possibly can, how should you or I adjust our financial techniques to weather the deflationary storm?

The answer depends, to an extent, on how long deflation is going to be around. If it comes and goes within a few weeks, it can be ignored. If, however, the aforementioned boneheads conclude that punishing savers is a worthwhile practice, we could indeed be in for ten years of unparalleled economic destruction.

Either way, oddly enough, savers would not want to change their financial habits much. You have to keep saving. Increasing the monthly savings bite might solve all one's deflationary problems of in one go, but if you can't do that, just keep on keeping on, is my advice.

There are those who argue that saving in deflationary times is a wasted effort. Your money is only going to become less valuable, so why bother? Here's why.

Let's assume ten years of deflation are about to occur, with rates essentially where they are today: the banks pay one per cent and inflation steals three. (That's exactly the same at the end of the day as any number of other scenarios: the bank pays zero interest and inflation is two per cent a year, or the bank charges savers two per cent and inflation is zero.)

Ten years of that, and the $100 you save in the first year would only be worth about three-quarters of its buying power at the time it was saved. Since the value has fallen, some argue, why invest at all?

THE answer, of course, is that $75 saved out $100 isn't good, but nothing saved is almost infinitely worse. While the buying power of your money may be eroding, at least at the end the ten years, if you've saved $100 a year, you'd have $750 (or a bit more) saved up. The non-saver would have zero.

The $750 is better than nothing. Anything is better than nothing. And therein lies the secret of saving. The game is not to make a zillion dollars by saving a few bucks; that isn't going to happen. The aim is to produce a cushion against life's vicissitudes, a comfort zone. The size of your comfort zone is not entirely up to you, as the foregoing proves, but whether you have a comfort zone or not is entirely your own choice, unless you are unemployed, or working in the most menial of jobs.

In sum then: if you're saving, save more. If you're not saving, start saving. Either way, let others worry about deflation. My guess is that this present era will end within 18 months. Greenspan (pictured) is due to retire and Bush has a re-election campaign to run.

You'd be amazed how much brighter things are going to start looking next year, whether such behaviour is justified by economic fundamentals or not.