Is Deflation Exactly What Every U.S. Household Needs?

by: Alexander Smith

There has been a never-ending fear surrounding deflation and the damaging financial and social impacts it would have on society. There are very clear and understandable reasons for this. To help investors better understand the long-term flaws of inflation and why periods of deflation are needed, I've chosen the average family household to use as an example.

The average household spends roughly 30% on housing expenditures, including insurance (whether you rent or own). The cost to maintain a house is obviously more when you own. In a period of deflation, 70% of your disposable income is now benefiting from a lower cost of living. Items such as utilities, food, transportation costs (including car parts and repairs), clothing, and entertainment are becoming cheaper.

Click to enlarge image.

Click to enlarge

Source: U.S. inflation calculator.

What stops most individuals, investors, and economists in their tracks when it comes to deflation vs. inflation is the value of one's home -- yes, that beautiful place you come home to every night, the sacred building that holds your family and protects you from the elements. Individuals cannot imagine a happy world where the value of their home, which some consider an asset, declines in value. I do not consider a primary residence to be an asset because of how much money it costs to maintain. It is, nevertheless, where the majority of individuals hold their net worth.

What most people fail to appreciate due to a misguided fear of losing money is that all other assets fall in value: properties, cars, bicycles -- even food and energy. The real cost of living becomes less. If deflation takes over at 5% annually for four years and you lose 20% on your house, chances are so did the guy across the street. The chances are even greater that an overpriced condo or a house on a nicer street lost just as much, if not more, than your home. In respect to purchasing power, you haven't lost anything; it just appears that way because your net worth has declined. In the meantime, your ability to save has increased because your cost of living has decreased. This is beneficial for your long-term net worth. Don't worry -- when inflation takes over again your house and assets will rise accordingly, along with your living expenses.

You now have the ability to save and spend accordingly to either increase your net worth by purchasing assets, or by saving for items you value or need. Healthcare and retirement come to mind. How would it feel to know these types of necessary expenditures might actually decrease in value in the future? Deflationary periods bring on an increased savings rate, allowing people to save for the future and thus stimulate the economy.

Still Not Seeing The Light?

The misinterpretation and misplaced fear toward deflation is very understandable. The public, like all living things, remembers only what can hurt it and what to avoid. The financial crises and deflationary episodes of 1890, 1893, 1910, and the 1930s all saw massive panics and reduced productivity and prosperity. During these panics the money supply was reduced as investors and individuals hoarded what cash they had, thus putting the brakes on the economy.

The generation that lived through the Great Depression, god bless them, have almost all left us. Every one of us had a father or grandfather who saved every dime and paid cash for everything. These crises shape people's perceptions and form habits, just as the current multidecade credit binge has been shaping our minds. In a cheap money/high inflation environment it becomes harder and harder to get ahead because prices keep rising. Employers are always a year or two behind in raises because they are fighting the same forces you are. A company's bottom line is getting beaten down by inflated prices, or the cost of doing business, which ultimately leaves less to pay out in raises. The household economies of America need a break, and it will come with a period of deflation -- not inflation.

Some of the most prosperous periods of growth over the past 100 years came during periods of disinflation. Disinflation is a decrease in inflation. It occurs when inflation falls or, in other words, increases at a slower rate, thus allowing the worker to save more and spend more productively. If the price of milk was rising at 5% for three years and then declined to rise by only 4% inflation and then 2% inflation, it was in a period of disinflation -- or lower prices. This benefits the economy and is what we need.

Let's quickly look back even further to a more prosperous time in the U.S. Between 1876 and 1879, the price of goods and services fell 5% year after year while growth exceeded 7.6%. How can this be, you ask? This is good deflation.

Good Deflation

Good deflation occurs when technological improvements or access to cheap labor reduce production costs. This lowers prices and allows investors to save more cash, increasing the purchasing power of individuals. The early 1990s saw very low inflation rates with the creation of the Internet, as millions of jobs were able to be done more efficiently and at less cost.

The old saying goes that a crisis of great magnitude comes every generation, just infrequently enough for the great mistakes of the past to be forgotten. The Federal Reserve -- or current global central bank, as I like to think of it -- has more control now than ever before. It has become the lender of last resort to the world, along with the IMF, and is fighting off deflation because it thinks it has to. In my opinion, it is prolonging the greatest debt bubble in the history of the world.

Unfortunately, at this stage, deflation is an unrealistic route for the Federal Reserve or U.S. government to pursue. The massive public and private debt bubble is just too big. The U.S. owes too much money, both to foreign bond holders and its own people in the form of unfunded entitlements. Just as it was after WWI and WWII, a period of high inflation is waiting for us on our doorstep. By devaluing our currency, we can pay off our debt with cheaper dollars. It is not rocket science. The period of deflation will come, but not for five or 10 years. I believe during this period we will see the most growth as our economy finally becomes less like a credit bubble, dependent on service sector jobs, and more like the U.S. I used to know.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.