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Knocking on Deflation's Door

There has been a lot of talk lately about inflation, the rising cost of goods and services. Historically, inflation has grown at 3 percent annually. The Federal Government (the Fed) controls inflation by increasing or decreasing the money supply by lowering or raising interest rates. The basic idea being that raising and lowering rates controls how much money is available to borrow or spend in the U.S. economy.

One issue that has been spoken about quietly among professional investors is the risk of deflation. Why would lowering the cost of goods and services be bad? Doesn't everyone like bargain prices?

In small doses, deflation isn't bad and usually is self correcting as consumers run out to buy discounted products. (Imagine if you could get an iPhone for half the price.) However, massive deflation is much harder to correct -- either by the Fed or by market forces.

A recent example of how deflation can ravish an economy is Japan's Lost Decade. The Japanese economy of the 1990s has been called the Lost Decade due to the complete lack of growth in their economy.

After the explosive economic growth of the 1980s, the Japanese economy was in the middle of a “growth bubble”. Realizing that this bubble was unsustainable and would lead to massive inflation, the Japanese government decided to pop it. This lead to a massive crash in their stock market and a debt crisis. The banks and government tried to prop up many firms that were believed to be too big to fail. (Sound familiar?) Instead of saving these firms, they delayed the inevitable failure of some firms, and the Japanese government took on massive amounts of debt.

Many Japanese firms were left holding debt from the growth years and added more trying to stay afloat. Even with interest rates at 0 percent, firms couldn't borrow more and instead used their profits to pay down debt instead of expand. (In the U.S., we are seeing a similar story play out. Banks have reduced lending to levels not seen since 1942, making business expansion and new home loan acquisitions nearly impossible.)

In addition, Japanese housing prices fell to a TENTH of what they were at the peak. The Japanese stock market lost three quarters of its value and has never returned to its former highs. The Nikkei peaked at 38,000 in 1990. Today it trades just above 10,000.

Consumers were afraid to make big ticket purchases as prices continued to drop. Why buy a new home, car, or even a new TV, if the prices will be less in the near future?

Does this mean the U.S. economy is about to face a similar situation? While the U.S. has taken many of the same steps that Japan did, three big differences will likely keep us from suffering the same fate:

    * The U.S., hopefully, has learned from the mistakes the Japanese government made during their crisis. Mistakes which included raising taxes too early to pay down their debt, trying to keep corporations afloat when they should have been allowed to fail, and creating “Zombie banks” (banks with no assets, only bad debt)  instead of letting the government take over failing banks. (Yes, the U.S. has rescued some corporations, but not nearly to the extent that the Japanese did.)

    * Culturally we are a lot different from the Japanese. The Japanese have always been a nation of savers, not spenders or investors. On average, Japanese families will keep 55 percent of their money in the bank. I would venture that the average U.S. family has the majority of their savings invested in a 401K plan.

    * Lastly, Japan does not have the same level of entrepreneurial drive and financing that exists in the U.S. According to the SBA, 44 percent of jobs in the U.S. belong to small business, and 64 percent of job creation has been due to small business growth over the past 15 years.

Even though some are already calling the 2000s the Lost Decade for U.S. investors (the S&P 500 index returned a -.95 percent total rate of return for those 10 years), these small, but key differences may keep the U.S. from experiencing the same fate as the Japanese economy.

Disclosure: No Positions Mentioned