Deflation, which refers to a general and sustained decline of price levels in an economy, is a rare but highly undesirable phenomenon. Although lower prices sound like a good thing, deflation almost always results from highly unfavorable economic conditions. Investors must make very careful choices in such an environment to avoid financial ruin.
The term "inflation" means that the prices for goods and services in an economy are going up. Deflation, however, means that prices are going down. It is not unusual for price levels to decline for one or two months out of the year before resuming their advance. Such factors as a sudden drop in oil prices or sudden influx of cheap foreign goods can lower prices for a short while. An economy is said to be experiencing deflation if prices are consistently dropping. While there is no universally accepted definition of deflation, economists often talk of a deflationary environment if prices have gone down for several consecutive months and are expected to go down for many more months to come.
Deflation is almost always the result of shrinking economic activity. The laws of supply and demand dictate that if companies can sell all that they are able to manufacture, they will raise their prices. If people do not have the purchasing power to buy goods and services, suppliers will cut prices to attract buyers. If most manufacturers must cut prices, the result is a broad decline in prices. Under such conditions, companies lay off workers, lower corporate profits result in declining stock prices, and personal wealth declines. This often leads to even less purchasing power and can result in a deflationary spiral -- a true economic nightmare.
In a deflationary economy, prices of tangible assets such as real estate decline. Less wealth and lower economic activity mean fewer potential buyers for fixed assets and -- consequently -- lower prices. Fixed assets therefore are not good investments during times of deflation. Luxury items, such as expensive mansions in high-income areas, yachts and sports cars tend to be hit particularly hard. Since these are not necessities, people immediately -- and sometimes dramatically -- curb their spending on such items. The prices of big ticket fixed assets therefore tend to decline more than the prices of their more modest counterparts, such as smaller houses and economy cars.
Liquid assets -- including cash -- are advantageous during a deflationary period. Even if banks offered zero percent interest on your deposits, which is extremely unlikely even in a deflationary economy, merely having access to your money provides some measure of security. When prices are falling, having money readily at hand will enable you to purchase more goods and services. In addition to bank deposits, which are FDIC-insured, government-issued securities such as Treasury bills also make a great choice. The government can always print more money to pay its debt and will not default. Therefore, government securities offer not only capital protection but a little extra income in the form of annual interest payments.
- Burke/Triolo Productions/Brand X Pictures/Getty Images