Fire or Ice? Inflation or Deflation?

Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.

Fire and Ice, Robert Frost, 1920

One would think with all the attention on the world's economic problems that people could agree on the ultimate bad outcome. But wouldn't you know it, that is not the case. Some experts are warning of massive inflation--an economic world consumed by the fire of money printing and overspending. Other experts are predicting deflation--an economic world frozen in ever-declining employment and prices.

Inflation and deflation each call for different financial strategies. What's an investor to do? Why does all this have to be so complicated? I'll try to address these questions in this post.

From a natural standpoint, the world is in a deflationary economic period--the result of too much government and personal debt, hyper-speculation, and aging baby boomers moving past their peak spending years. There are just too many obstacles and too little potential for spending to naturally push the world into an inflationary growth period. In short, the economies of the world want to contract. That means deflation. But governments don't like deflation and are willing to use their ability to create money out of thin air to try to shake the world out of its deflationary mood.

Deflation scares governments to death because, as I discussed in an earlier post, they like the appearance of growth (even though nobody is really getting ahead), inflation reduces debt (and unless you've been living on Jupiter for the last twenty years you know that most governments are hopelessly in debt), and inflation is effectively a tax (a way to transfer wealth from citizens who have assets to governments which have debt).

So the governments of the world are going to do everything they can to prevent the deflation that is naturally occurring. By doing so they risk making things worse in the long run. By printing so much money the government is risking hyperinflation.

What would hyperinflation mean? Well, on the positive side everyone's debt would vaporize because they would have more cash than they knew what to do with. The problem is savings would vaporize, too, along with the ability to buy anything, because all that cash would be worthless. Nobody would be able to afford anything. Hyperinflation is more common than people think. It just rarely happens in large countries. It's usually the ultimate result of a government taking the path of least resistance. Sound familiar?

What if on the other hand we moved into real deflation? Well, those in debt would suffer, because everything would become cheaper, including salaries, but debts would remain the same. On the other hand, savers would prosper, because their savings would buy more. Deflation is what happened when the housing bubble popped. People with big mortgages suffered. People with no mortgages but a lot of money in the bank gained, because their dollars could buy more. But deflation also means that jobs are scarcer. The big problem with deflation is that the economy can become a victim of too much frugality. Remember your parents staying in the same job for thirty years because of their memories of the Great Depression?

That said, it's my opinion that all the hand-wringing about deflation is mostly governments justifying their spendthrift ways. Deflation is the natural result of over-speculation. 

Regardless, whether we have inflation or deflation depends on just how much governments are willing to do to prevent deflation. They want to think they are simply lighting a fire to keep us from freezing. The problem is they may end up burning the house down--particularly if they don't honestly address underlying problems, like too many promises paid for with too much borrowing.

Severe inflation and deflation are both bad, but what is most important is knowing how to protect yourself in each. I'll try to keep this as simple as possible:

If severe inflation threatens, you want to be out of cash and invested in commodities like gold and oil. These will go up when there is inflation. Also, you can invest in foreign currencies that are resisting inflation because these will go up relative to the dollar. Some debt is not a problem in inflation. 

If severe deflation threatens, you want to be out of debt and in cash--U.S. dollars. You can also be in short-term bonds and other cash-like equivalents.

The stock market is not a good place to be in either extreme. Severe inflation or deflation are not good for the business environment, to put it mildly.

Note: This article is for informational purposes only and is not a recommendation to invest in any financial instruments.