With low interest rates and a prolonged low inflation rate environment, finance talk has recently turned to deflation. Why are people afraid of deflation when many do not understand what it means? Because in almost every family, there is still someone alive who experienced or knew someone's family from long ago who lived through the United States Great Depression of 1929-1933. Precipitated by the Great Wall Street Stock Market Crash of 1929, those were the years when prices on everything fell more than 25 percent, companies and banks went out of business by the thousands, the unemployment rate hit 25 percent, and thousands of US citizens lives were irrevocably changed.

In the course of researching sources for this article, to my surprise, there is very little current data available; perhaps because it has been so long since the US economy has had to deal with the concept, an entire generation of finance literature has ignored it altogether, as if it was a non-event. Yet, we know that Japan has struggled with deflationary pressures and a stagnant economy for more than a decade. There are some concerns that Germany is headed down the same path, having been in a stranglehold with labour unions for decades.

What is Deflation?

According to one economics textbook - the opposite of inflation. Not a paragraph, just a sentence. If deflation is the opposite of inflation, a very simple definition of inflation is a rise in the general level of prices in the economy, where your purchasing power (dollars) become less and less over time. The classic picture of rampant inflation is forever etched in our minds (those of us older enough to remember our History of the World) with the picture of the lady in war-torn Europe pushing a wheelbarrow full of money to buy one, count, one only loaf of bread.

Demand and prices drop

In a deflationary environment, prices of goods and services drop across the board, and demand drops. If your dollar loses purchasing power in an inflationary environment, during deflation, as prices go down, your dollar becomes more valuable, it can purchase more. Cash is king. What deflation then fosters is the expectation that prices will drop even further, demand continues to be driven down as consumers conserve cash and delay spending indefinitely waiting for more bargains. This holding back on spending puts downward pressure on businesses to lower wages (or institute redundancies) because profits are falling due to lack of demand and lowered prices; both companies and households then struggle to pay off debt with fewer dollars, which forces everyone to consume even less. And the spiral sinks even lower.

Debt becomes a real burden

Mortgage and consumer debt is a real drag on family income in deflation, because it is harder to pay off the same debt with lower earnings. Those who have stretched to the top of the debt to income ratio pyramid may struggle fiercely if they have not prepared for the contingency of lower real wages. Governments become strapped for cash and may raise property taxes, making the real cost of owning property even higher, adding insult to injury. In the Great Depression, mortgage defaults rose to over 40 percent due to a repressive short-term full repayment schedule of only five-ten years. With few job prospects, most people could not obtain refinancing; many became homeless, and began a US westbound migration to greener pastures (jobs).

Bonds look good.

If debt is bad, some investments, such as bonds, hold more than their value. As interest rates fall, bond prices rise, offering investors some protection against falling prices. In addition, as most people know, the coupon rate on the bond will be paid to you, no matter what the market interest rate dictates. Investors need to be very selective, however, about the type of bonds chosen. Those guaranteed by Uncle Sam, or the Government of the United Kingdom, for instance, are good bets, but corporate bonds are only as good as the financial strength of the company that issued them. Default on corporate debt may rise during deflation.

Stocks Idle

Stocks don't generally fare well because stock prices are driven by corporate profits, absent entirely if demand for goods and services disappear. Deflation is thought to be generally easy to control, print more money or place more money into circulation. Franklin Delano Roosevelt broke the back of the Great Depression with the New Deal. The US government hired millions of unemployed by putting them back to work, repairing the infrastructure of that great country. Slowly, the population had money in their pockets and hope for their financial futures.

So, what is the lesson here?

Heavy debt obligations are not good in any economic cycle.

Deflation remedies put more money into circulation. People earn and learn again. Gradually, a little mild inflation appears; interest rates start to rise, deposit holders and investors start to feel a little wealthy as accounts perk up and stock appreciates. Real wages rise. Consumerism is encouraged. Home renovations, vacation trips and cruises, major appliances, etc. are bought. The economic cycle moves into full swing. Life picks up and moves on. One week from the time this article was started, economic pundits are now concerned about 'mild inflation'.

Martha Harris Myron CPA CFP™ is a Bermudian, a Certified Financial Planner (US licence) practitioner and VP and Manager, Personal Financial Services, Bank of Bermuda. She holds a NASD Series 7 licence, is a former US tax practitioner, and is the winner 2001-The Bermudian Magazine - Best of Bermuda Gold Award for Investment Advice. Confidential Email can be directed to marthamyron@northrock.bm

The article expresses the opinion of the author alone, and not necessarily that of Bank of Bermuda.

Under no circumstances is this advice to be taken as a recommendation to buy or sell investment products or as a promotion for financial plans.