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Deflation aids consumers but hurts those in debt

Updated: May 3, 2013 12:14PM

Originally published: May 22, 2003

Deflation? Who are they kidding? Like many Americans, you’re probably noticing that inflation continues to chip away at your lifestyle and buying power. Just ask any parent who is facing rising college tuition. Or any senior citizen facing medical bills or prescription costs. Or anyone who pays property taxes or homeowner’s insurance. There are plenty of instances of rising prices.

We might actually welcome some inflation. For example, no one complains or considers it inflation when the value of our homes keeps rising. That’s just a “smart investment.” And we wouldn’t mind at all if the stock market soared. In those cases, rising asset values are seen as a real benefit.

But what about deflation ? How does it feel, and should we worry about it?

Deflation, or falling prices, results from overcapacity built up in the boom times. Now, this excess of supply over demand pushes prices down--a phenomenon most Americans have never lived through. And while we don’t see a general decline in prices just yet, the inflation rate has hit a 37-year low. Year over year, the consumer price index has increased a slight 1.5 percent. And the CPI actually fell 0.3 percent between March and April. The Federal Reserve is now officially worried about deflation.

Deflation: a closer look

What’s wrong with a little deflation?

The view all depends on where you stand. Consumers of products like cars, computers, and telecom services are benefitting from deflationary price cuts, which tend to occur in goods where there is global competition to produce at the cheapest cost. Prices of new cars sold in the United States have fallen about 1.7 percent in the last year. You can get a lot more minutes for a lot less money on your cell phone account.

With deflation, the money you have goes a lot further. But the money you borrowed in the past becomes much more difficult to repay.

If you’re standing on the debtors’ side of the street, deflation will be very painful. Rising unemployment is part of the deflationary trend, as manufacturers, confronted with overcapacity, cut back production. That means workers lose jobs and can’t repay their loans. With consumer debt at record levels, business debt growing, and federal debt about to explode, a deflationary economy could exact a huge toll.

Economist A. Gary Shilling, author of Deflation: How to Survive and Thrive in Deflationary Times (McGraw-Hill), reminded me this week: “Deflation is lethal even at low interest rates, as incomes drop but debt must be repaid. Just because Americans haven’t seen deflation since the 1930’s doesn’t mean it can’t happen again.”

His advice: “Get out of debt, right now!”

While in Dallas earlier this week, I visited with an old friend, David Tice, who runs the Prudent Bear Fund (888-778-BEAR). [Full disclosure: I’ve been an investor in this fund for years.] Not surprisingly, the fund was among the top performers last year, gaining nearly 63 percent in a declining market, after substantial gains the two previous years. But in the bull market of 1998-’99, the fund posted losses.

On the subject of deflation, Tice notes that the Fed is aggressively inflating the money supply to prop up asset prices, even while they say they’re worrying about deflation. So the fund owns gold shares as a hedge against inflation.

Tice, whose fund can sell stocks short and buy put options, is still bearish in spite of the current stock market rally. He warns, “These seductive bear market rallies just tease investors to get back in to set you up for greater declines. A lot of people will still get hurt badly from here.”

Dow at 3,000?

Tice’s forecast is based on history. The average bear market decline, he notes, gives back 51/4 years of prior gains. That would put the Dow industrials at 5,000. But because this is a “once in a century bear market,” Tice is forecasting Dow 3,000 within 18 months. Just thought I’d get that into the record, while keeping my fingers crossed that he’s wrong!

It’s hard to decide what to worry about these days: deflation or inflation. Either or both may be in our future.

Since no one knows for sure, it’s wise to hedge your bets. And that’s the Savage Truth.

Terry Savage is a registered investment adviser and is on the board of directors of the Chicago Mercantile Exchange and McDonald’s Corp. She appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast.

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