Inflation, Deflation, a Crystal Ball and Adaptability

Inflation and deflation of the money supply affects all of us. It affects how and when we save, buy and invest and how we feel about the world and the future.

Inflation and Deflation

I will keep the definitions for this article simple, including definitions for inflation, deflation and money. Inflation is more dollars chasing the same amount of goods and deflation is fewer dollars chasing the same amount of goods. As a result, deflation means lower prices and inflation means higher prices for goods, services and assets.

Money is created for the most part through credit and debt creation, by the banking fractional reserve system whereby banks only need to hold a portion of reserves (say 10%) for deposits and then loan out the rest, thus increasing the money supply. Dollars are destroyed when debt is paid off, however, because interest is charged on debt, money will need to come from somewhere to pay off this interest. As an individual or as a business, one may be able to settle their accounts but after the transfer of money between buyer, seller, etc. the money to pay off interest has to come from somewhere in the system ultimately – it comes from the creation of more debt.

Central banks can also increase the money supply by purchasing assets, also known as printing money, and then loaning that money out to banks which allows banks to create more credit. Where does this money come from? Nowhere.

Velocity of Money

Inflation is also increased as the velocity of money is increased. If I go out to a restaurant with my family and spend $100, and the restaurant owner takes $20 of this for a taxi home, and the taxi driver spends this money on gas and so on, the ‘same dollar’ is being used multiple times, increasing the money supply in a sense. The velocity of money is decreased when we keep our money in our pockets, this pattern is deflationary.

Demographics, Geography and Generations

People spend different amounts of money depending on where they are in life, starting out, having or not having kids, saving for retirement, and being retired. When people spend money, particularly when taking on debt, this has an inflationary effect. When people pay off debt, this has a deflationary effect.

If each year, there were the same number of people born and demographics were even then there would be less inflationary/deflationary pressures. However, currently in many countries, because there was a boom of births after WW2, there is a boomer generation which has more people per year than the preceding and succeeding generations. Some nations such as Japan have had their boomer generation pass through earlier and this has led to deflationary pressures including real estate and stock markets busts and slow recoveries.

In the west, Boomers are retiring, scaling down and this is creating deflationary pressures. In China, the one child policy which only recently ended will create deflationary pressure in China in the years to come.

Technology

As technology advances, some prices for goods and services can be reduced as labour and production costs go down. An example is how each year we can buy a better TV for less money. The internet has created opportunities and decreased costs that hardly anyone could imagine 30 years ago. I would argue that block chain technologies, robots and AI may also have a similar effect.

Purchasing Power and Day to Day Spending

Who cares if there is inflation if we are going to continue to make more money in the future? Workers may not, people on a fixed income people certainly do, so do people with minimal increases of pay. Boomers will soon be retiring and as they are a larger population (and with more wealth), they will have political and economic influence, likely influencing the inflationary or deflationary environment.

Generally everyone is affected by the price of food and energy, if prices go up more than incomes then this causes stress, it affects our lives both physically and emotionally.

Today, saving money means we are losing money, real interest rates (nominal interest rate – inflation rate) is devaluing our savings.

Official inflation statistics just don’t seem to match our day to day experience. Websites such as ShadowStats.com would suggest that real inflation rates are higher.

Government Policies

Virtually all governments in most countries and on all levels are in debt, inflation means that tomorrow’s debt is cheaper and therefore their policies are based on having small inflation goals, say 2%, enough to help pay off debt but not enough to outrage voters.

Most governments have short term interests in mind and wish to get re-elected and it is seldom popular to suggest economic reform.

Deflation is often viewed as more disastrous than inflation and policies are in place to prevent deflation.

Asset Bubbles

In order to maintain our purchasing power in the future, we frequently invest our money with the hope of maintaining or increasing it.

In inflationary cycles, many asset classes will rise, this often gives us the false impression that this is a never ending trend. For some, we applaud ourselves on investment savviness when in reality, under the current cycle, we were simply born at the right time, invested at the right time, and bought houses at the right time. For others, we feel frustrated at so few opportunities to invest, house prices are too high and the future seems bleak.

Entitlements and Pensions

Most pensions are based on the price of stocks and bonds increasing overtime. The money within pensions is highly dependent on new money being entered within the pension and the appreciation of the underlying investments including stocks and bonds. The money put into a pension is not guaranteed, examples are showing up more and more in the media.

Entitlements such as health care in some countries, old age security etc. are dependent on the health of governments paying out these entitlements. With too much debt, governments will struggle to pay these entitlements.

A Crystal Ball

If we knew what the price of anything was going to be tomorrow, or next year, or 10 years from now what would we do differently from what we are doing now?

On a day to day basis, we need to buy many things anyway, such as food, gas, clothing, pay electricity, water bills, etc. We are going to buy many of these things anyway, we may shop around if we have time and energy but we will need these things.

From an investment point of view, what should we do? What asset allocation should we follow?

This is a personal question and depends on each of our experiences and where we are in life. If there is an economic downturn, how would we respond? Many view that we should simply ride it out, especially if we are young. Others believe that we should tailor a portfolio based on views on inflation and deflation. Those who view that the near future may involve a credit bust view deflationary hedges such as currencies (of nations least affected) and high quality bonds as hedges while those who see the future as having more inflationary pressures view real assets such as land, precious metals, and investible art as hedges. There is a spectrum of views here varying from corrections to much more dire economic conditions.

The view that cryptocurrencies are another inflationary hedge is also picking up ‘steem.’

Adaptability

Personally, I have seen strong arguments on what to do if deflationary or inflationary pressures increase as a result of economic downturn and I believe that these views need to be researched and respected.

The future is hard to predict and it also important to remind ourselves what is most important to all of us. For some, perhaps it is time for that dream vacation, as it is hard to take away the experience. Some may want to save, realign their portfolios based on seeking advice and doing one’s own research. For many of us, it is important to simply spend time with the ones we love and share within the communities around us.