Deflation FAQ (Version 1.1)

About this FAQ

This FAQ has been created to provide a view or perspective to those who fear that it is likely that we will enter a deflationary period, and to enhance the knowledge about the related cause and effects of deflation and how one can prepare against it.

The last deflationary period in U.S.A. took place about 70 years ago.

The latest version of this FAQ can be found on: http://www.mhessler.de/deflation/

Warning: The described measures and hints should neither be seen as complete nor as applicable to everyone. Everyone has to make up his own mind and act accordingly! The author cannot be held responsible for any of the information stated in this FAQ. Use it at your own risk.

What is a deflation?

Deflation = Imbalance on the market for goods (and services): the supply of goods and services is higher than the demand

Result: prices decrease

Note: the extent of price decreases may vary: dispensable or luxury goods (i.e. new car) may fall more than indispensable goods (i.e. food).

What causes a deflation?

Shift of mood from optimism to pessimism
People save; less credit given and less debit taken
Decrease of money 'willing to buy' goods
Demand decreases more quickly than supply/production can be reduced
Prices decrease = deflation!

Why is a deflation so dangerous (results)?

Once it has started, a deflation is self-reinforcing (everyone waits for cheaper prices and hoards money => production will come to a halt)
Everyone is affected: many companies become bankrupt, high unemployment, many debt defaults
It is very easy to ruin yourself financially: almost all investments will decrease in value
(stocks, bonds, real estate will decrease a lot in value, to possibly less than 10% from their peak value!)
Many banks and insurances will become bankrupt, many investors will lose their money
High Unemployment, especially in weak, or in 'dispensable' areas (e.g. social area)
Decreasing wages will lead to less disposable income
Government will incur large reduction of tax related income, this will lead to higher taxes, and reduced social benefits (such as reduction of unemployment benefits, pensions, social welfare and services)
Political unrest, increase in crime

Who is affected?

Everyone is affected:

Employers
Employees
Recipients of social benefits (pension, unemployment/social welfare)
Investors in stocks, bonds, funds
Investors in real estate and physical goods
Debtors (i.e. those with loans and mortgages)
Creditors (i.e. those with investments or who lent money)

What should I do (personally)?

The most important rule is to ensure your own liquidity and physical survival:

Consolidate and reduce your spending
Be prepared for the loss of you job and for unemployment
Do not rely on pensions or social benefit
Do not take any loan, pay back all your loans

The second line of defense is to conserve your own wealth:

Call in loans you have handed out
Sell your stock and bonds
Real estate: if you have not yet completely paid off the house you live in: sell it (the bank will take over and sell your house if its value decreases below the amount of the mortgage)
Convert physical goods into cash if you do not really need them (e.g. car)
Take cash out of your bank account before the bank goes bankrupt
Reduce insurance to a minimum; sell capital accumulating insurances (especially if investing in funds), as long as it is still possible and you can recover at least a part of your investment

Relocation to another country is unlikely to help since with the globalization of the economy an economical depression will be a worldwide affair.

Why is only a minority preparing for deflation?

Globally we have become acclimatized to many years of economical growth and boom; taking precautions and investment in cash is neither in favour nor familiar. The majority will try to ignore the problem until it is too late. However, this will not prevent the consequences; being an unfounded optimist can be life threatening during a deflation!

What, if I do not prepare for a deflation?

Being unprepared will be very uncomfortable during a deflation due to: the fight for survival mentality that will abound, and large losses/financial ruin

If there is no deflation despite preparation then the loss is small: safe investments such as cash do not yield as much profit

Could one prevent a deflation (in general)?

Since the cause of deflation is a correction of proceeding excess (optimism, excessive indebtedness especially consumer debt) it can only be prevented if humans are not influenced any more by their mood fluctuating between optimism and pessimism. Due to human nature we will probably have to live with these fluctuations.

More control over the factors which amplify the effects of a deflation (e.g. prohibition of indebtedness for households, companies, governments) would strongly reduce the extend and results of deflation; however, unfortunately, humans seem to have the tendency to ignore any rules made during a previous period of pessimism when they are in an optimistic mood.

According to historical experience, one thing can be said for sure: once a deflation has started, it can not be stopped until the market for goods is back in balance on a much lower level; in the past, all trials to stop a deflation in process have failed (see Japan: now in deflation for more than 10 years)

A central bank cannot stop a deflation since it cannot control against the pessimistic public mood. On the contrary, every precaution it might try to undertake can result in a panic, which accelerates speed and depth of the deflation.

How can I recognize the beginning of a deflation?

People save; saving is popular
Almost everything will become cheaper (large discounts will mark the beginning)
The weakest industry will first be in difficulty; initial bankruptcies lead to unemployed which spreads to the next weakest industry and so on, until all industries and individuals are affected
It will be more and more difficult to obtain a loan, until it is eventually impossible even if you are very credit worthy
Stocks prices are the first to fall massively in value
The spread for bonds will increase (good ones will hardly yield interest, bad ones will have to yield very high rates of interest)
Finally, real estate prices will plummet

What is the duration of a deflation?

The good news: a deflation is usually very painful, but also very brief (compared to the duration of the preceding boom).

Normally one could expect a few years (in the 30's: about 3-5 years). However, it could also be longer: Japan is in a deflation since 1990!

What happens afterwards?

Ideally: new start from a lower level

In a worse case: if the amount of money has been increased during deflation due to political pressures (e.g. printing of additional notes), then this will not prevent the course of the deflation as long as everyone saves during the pessimistic mood; however, after the end of deflation the increased amount of money will result in a hyper inflation which devalues everything denominated in monetary terms (savings, cash). To avoid high losses one has to switch completely from cash to physical goods. It will be very difficult to time the switching properly!

Where can I find additional information?

To read more about why a deflation is very likely and how to take precautions against it, read the book 'Conquer the Crash' (in German: 'Besiege den Crash') by Robert R Prechter. A good overview on the potential effects to society (in German): 'Was passiert, wenn der Crash kommt' by Eberhard and Eike Hamer.