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A look at inflation vs. deflation

As more U.S. paper money is printed its value is diminished. Even fear inflatican trigger rush from currency inhard assets

As more U.S. paper money is printed, its value is diminished. Even the fear of inflation can trigger a rush from currency into hard assets such as minerals, oil and natural gas -- which is happening now.

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Updated: May 3, 2013 12:15PM



Inflation or deflation? Which direction will the economy -- and the value of the American dollar -- take in the future? This is not a theoretical economic debate. It will impact the value of your retirement savings, the prospects for your career, your children's education -- and your daily lifestyle.

The American economy is on a seesaw these days -- tilting between the possibilities of inflation and deflation, and balancing delicately in between. Some days, the markets worry about inflation, so energy and gold prices move higher, and the dollar falls. Other days, the world markets worry about deflation, so the dollar strengthens as global money rushes to the perceived strength and safety of the United States, pushing interest rates lower.

If you knew for sure which way the balance would definitively tilt, you would want to adjust your investments and spending plans. Since there's no way to know, the very least you can do is understand the symptoms -- and consequences -- of each of these possibilities.

Deflation

Declining asset values are the major symptom of deflation. And a quick look around tells you that the values of stocks, houses, commercial real estate and many other assets have fallen sharply. What happens to that "value" that is lost when a credit card debt is written off, or a foreclosed home is sold for a lower price? That money or value simply disappears into a void, leaving price levels lower and everyone feeling slightly less rich.

What would be the most valuable asset in a deflationary period? Cash. Liquidity is king in a deflation because it means you can buy assets -- if you choose -- at a far lower price than they used to command. But the key word here is choice. If you have cash, you might simply be sitting on the sidelines waiting for prices to go even lower, creating even bigger bargains. That hesitancy to spend, and that decision to keep saving, slow the economy even further -- debilitating business profits, causing more layoffs, more worry and lower prices. It is a depressing downward spiral.

Where have we seen economic deflation? The most obvious example came during the Great Depression in the 1930s. But a deflationary period can happen even in modern times with modern mechanisms for government responses. Basically, Japan has been in a period of deflation for more than a decade -- living proof that it is difficult to "cure" a deflationary psychology once it gets started.

Inflation

Inflation at its most simple definition is the creation of too much money. Because of excess money creation, the value of every existing dollar is diminished. Eventually, people start to notice! It's like diluting milk by adding water. At some point, it doesn't taste good -- and you want to get rid of it.

In a period of inflation, people want to trade their paper dollars for assets that will retain their value. Hard assets such as gold, oil, farmland, most real estate, and even stocks, will rise in price because of the demand for real "things" as opposed to paper currency that can be created at will by the government.

During an inflationary period, it may appear that you're getting "rich" as you watch the prices of things you own skyrocket. But in reality, you're getting poorer -- because inflation destroys the "buying power" of the dollars you have saved for the future.

Interest rates react immediately to fears of inflation, even before the inflation actually arrives. After all, if you're going to lend someone money for 30 years, perhaps in a mortgage loan, you want to make sure the money you get back down the road still has some buying power. If you suspect that the money will lose value, then you'll want to charge a higher interest rate on that loan.

Today's uneasy balance

Which way will the economy tilt now? That's the huge question. Bankruptcies continue to rise, credit card charge-offs and commercial real estate loan defaults give evidence that deflation is still something to fear.

On the other hand, the U.S. government continues to spend money it doesn't have to do everything from handing out money for people to buy cars to rescuing failing banks. Remember, even the fear of future inflation can start the mad rush out of paper dollars.

Last week, Warren Buffett stated the case clearly in a public editorial. In it, he noted that our current spending binge now has government expenditures at 185 percent of revenues. That continued overspending has pushed our budget deficit to 13 percent of our gross domestic production, more than double the highest level of non-wartime years.

We borrow that money from global central banks, especially China, which has a stockpile of dollars we've sent over there to buy their products. But they'll certainly demand higher rates of return as they see signs of inflation. Or they'll switch out of dollars -- and into other assets, such as minerals and oil and natural gas -- a process that's now happening around the world.

Americans are in the midst of learning a tough lesson about overspending and overborrowing. Now it's time for Congress to learn that lesson, too. And that's The Savage Truth.



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