Inflation vs Deflation

For a little less than a year now the stock market has been going sideways. That is, it has gone up and then down, but the net effect is sideways. The All Ords chart below from Yahoo! illustrates this. Since September 2009, the Australian stock market has been going up and down, bounching back and forth between a ceiling of 5000 and a floor of 4500.

However, recently we have seen the stock market start to plunge below the 4500 point floor, suggesting that a dreaded double-dip recession may be just around the corner. Chinese premier Wen Jiabao warned that a double-dip recession was likely, and billionaire investor George Soros claimed that the second phase of the GFC was imminent.

This may be it!

For the last few days of the 2009-10 financial year, stocks all over the world have been tumbling. On 1 July 2010, the price of gold collapsed from US$1250 per ounce to US$1200 per ounce, and at the same time long-term US Treasury bonds have gone up in price. All this points to investors expecting deflation in the future. That is, prices are going to fall. Some people who complain about high petrol and electricity prices may be happy with this, but deflation may result in falls in stock prices and real estate prices, and this will destroy wealth, especially since many people hold wealth in their houses and their retirement funds. Economic theory also states that falling prices encourage consumers to horde cash and delay purchases becuase they expect goods to be cheaper in the future. This hording of cash and lack of spending will reduce sales, reduce business profits, and in turn lead to higher unemployment or lower wages, which will reduce demand for goods even further as consumers who have their wages cut cannot afford to buy goods. This will lead to even more price cutting by businesses, which leads to a vicious cycle or a deflationary spiral. As people lose jobs and suffer from wage cuts, they cannot afford to buy houses and the many who already suffer from mortgage stress will default. This is a nightmare economic situation.

On the other hand, there are those who believe that deflation will not happen. They claim that because deflation is so nightmarish, the government will not allow it because the government wants to win votes. Rather, the government will continue to simulate the economy by giving away cash. Splashing cash into the economy will increase wages and increase stock prices and real estate prices. Inflation will especially increase gold prices. I have my doubts about this inflation story because splashing cash into the economy cannot last forever. Eventually the government will run out of money and will have to go into debt, which is what we are seeing in Greece. Voters surely will not support neverending increases in public debt, and lenders (i.e. bondholders) will not tolerate it. The demands of voters and lenders should force governments with high public debts to impliment austerity measures that cut spending and raise taxes. Tax increases will retard economy growth, which pushes down stock prices.

If you think inflation is likely, go into stocks and gold. If you think deflation is likely, go into cash and bonds. If you are unsure, equal amounts of all four is probably the best move.