What’s So Bad About Deflation?

Last Updated: 25 May 2024

As was the case in 2002, we are confronted by a very scary bogeyman.

Our political leaders, bureaucrats and almost all commentators agree that it is best to avoid all contact with this creature, and in fact it is worth taking pretty much any measures – including mortgaging our children’s and grandchildren’s inheritances – to prevent us running into him.

The bogeyman’s name is, of course, deflation.

“Abandon all hope once you enter deflation”, Ambrose Evans-Pritchard of the Daily Telegraph in London tells us, echoing Dante’s “Inferno”.

But if we take a step back and think for a second about this terrible hell-hole that confronts us, some strange and rather heretical thoughts creep in.

Deflation – falling prices – has been with us for eighteen months, if you are an owner of equities, and three years, for US property owners.  It’s been painful, sure, for them.  On the other hand those waiting to buy, or those renting, have gained.  And if you were short…well you may have made out like John Paulson (who, incidentally, has reportedly started buying mortgage-backed securities, having made a fortune from shorting them during 2006/07).

Or look it at another way.  Imagine you go to a shop to buy a loaf of bread, or a TV, or a nice outfit, and you discover that the price is 20% lower than a year earlier.  Could you imagine anything more horrific?

I can go on, but it becomes clear that deflation is bad news for those who have overextended themselves (such as our governments, our banks, property developers and many individuals, particularly in the Anglo-Saxon economies).  For those that have saved up, been thrifty, or produced a lot and accumulated cash, deflation is very good news indeed.

It’s one of the mysteries of Western economic thinking that we are supposed to subsidise the first group at the expense of the second.  In fact an impartial observer might argue that a system that rewards the reckless and punishes the thrifty is going to collapse.

Nevertheless that is the current dogma, and we have to be aware of it and factor it in when making investment decisions.  There is even a helpful paragraph on the Federal Reserve website to answer the question I posed in the headline.  “Deflation raises the real burden of making a stream of payments whose nominal value is fixed….it can lead to significant declines in the value of collateral owned by households and firms, making it more difficult to borrow.”  In other words deflation hurts borrowers and we mustn’t do anything to affect them.

Whether we actually get prolonged deflation is another question.  There’s certainly a full-scale war going on between the custodians of our currencies (the inflationists) and the natural deleveraging process that is the result of too much debt in the system in the first place.  It’s early to tell who will win.

But it’s also worth reminding ourselves that a pretty lengthy period of deflation has already been priced in by markets.  The current breakeven inflation rates for both UK and US inflation-linked bonds tell us that we will experience negative inflation for a few years  – a couple of days ago the 5 year breakeven rate was -0.48% (US) and -0.33% (UK).  Beyond that point the breakeven rate moves slowly back into positive territory, but not by much.  But, just to spell that out, to prefer five-year fixed-rate government bonds over their inflation-linked counterparts you have to believe that inflation will be lower than this (ie more negative) on average, over the next five years.  If it’s anything higher than that negative half a percent a year you should be switching out of fixed-rate bonds and into inflation-linked bonds.  And maybe out of bonds and into equities as well.

I’m still agnostic on this one.  For much of the year I’ve inclined towards the deflationists.  Now, I wonder whether those who have rushed into fixed-rate government debt to protect themselves during the equity bear market might not be preparing themselves for a scalping.

  • Luke Handt

    Luke Handt is a seasoned cryptocurrency investor and advisor with over 7 years of experience in the blockchain and digital asset space. His passion for crypto began while studying computer science and economics at Stanford University in the early 2010s.

    Since 2016, Luke has been an active cryptocurrency trader, strategically investing in major coins as well as up-and-coming altcoins. He is knowledgeable about advanced crypto trading strategies, market analysis, and the nuances of blockchain protocols.

    In addition to managing his own crypto portfolio, Luke shares his expertise with others as a crypto writer and analyst for leading finance publications. He enjoys educating retail traders about digital assets and is a sought-after voice at fintech conferences worldwide.

    When he's not glued to price charts or researching promising new projects, Luke enjoys surfing, travel, and fine wine. He currently resides in Newport Beach, California where he continues to follow crypto markets closely and connect with other industry leaders.

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