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Here’s what Nouriel Rubini says about deflation:

Deflation is dangerous as it leads to a liquidity trap: nominal policy rates cannot fall below zero, so monetary policy becomes ineffective. Falling prices mean that the real cost of capital is high and the real value of nominal debts rise, leading to further declines in consumption and investment - and thus setting in motion a vicious circle in which incomes and jobs are squeezed further, aggravating the fall in demand and prices.

The simple way I like to think of deflation is that falling prices keep people from spending money unless absolutely necessary because they become confident that they can get more for their money later. This leads to the perfectly rational notion that holding cash is good. The perception of the high value of cash leads to a vicious circle of lower revenues and lower prices. The same principle holds for investments; cash becomes a rational alternative to stocks and to any bonds that are perceived to entail risks.

Rubini was the most negative economist going into the current downturn, which makes him the most correct. A full commentary on his expectations going forward is here. In sum, he expects a horrible economy in 2009 with a risk of deflation but with the possibility that aggressive government actions taken around the world could save us from that.

I suppose the best indication of whether the world will fall into deflation or not will be the action of the stock market. If it tanks below its November 20th lows and keeps heading south then it probably is signaling a multi-year period of deflation during which one does want to be in cash.

If it can stay above those lows (which are about 15% below the current market levels) and perhaps work higher, and the longer it does that, then it is signaling that the worst has been seen. If that is the case then in general one would want to go back into the water. I suppose the best stocks to own will be those good companies that have been hurt the most. An example, and one that I own, is TBSI, a shipping company with a unique high-service-component profile that is less impacted by the Baltic Dry Index than are bulk carriers.

Obviously there are many other beaten down stocks, not least Citibank (NYSE:C) and other banks. I expect that reforms to the regulatory system and simple market damage will vastly erode the “shadow banking” alternatives to real, government- regulated and deposit-guaranteed banks. So the banking business should be pretty good in the next upturn.

Will oil stocks be among those that react best on the upside if the economy has bottomed? Perhaps so. But a substantial glut in spare oil capacity is building, particularly with the more optimistic outlook for Iraq. So I suspect the price of oil itself will not obtain $100 plus levels for some years after the economy bottoms. Thus oil stocks will begin to discount somewhat higher oil prices quickly. But I doubt the bounce in oil stocks will be quite as robust as the bounce in stocks of companies that are more sensitive to an economic recovery.

The question is whether the next upturn will come before a fall into deflation occurs. In addition to watching stock prices to get an early reading on that question, I will continue to scan the data environment in the hope of finding some signals that might be useful. Feel free to contribute your own observations on the deflation outlook, dear readers. And Happy New Year.

Source: Can Deflation Be Avoided?