First let’s define “deflation.” Wikipedia says it is a general decrease in the general price of goods and services. Webster says deflation is a decrease in the amount of money or credit in an economy that causes prices of goods and services to go down. Disinflation is a decrease in the rate of inflation. The Austrian school of economics (supply side) argues that excessive growth of debt causes bad and disoriented investment choices. Not surprising when interest rates are rock bottom. Theory holds that this is caused by central bank policy and fractional bank reserves or leveraged bank loans. Keynesian theory deals mostly with the period after the peak at the end of the credit bubble and the contraction of debt leading to a fall in aggregate demand. Surprisingly they are actually pretty compatible.

As related by a note from Mauldin Economics, there was a recent meeting of the Bank of International Settlements (which is often referred to as a central bank for central bankers). Meetings are secret (no minutes recorded) and attendance and the participants are secret. President Jaime Caruna in private speech a few months ago warned of a global crisis in the future perhaps bigger than the last in 2008. He was referring to possible effects of deflation.

There are basically two schools of thought on what to do about deflation. Keynesian’s say that government action to forgive debt, such as bailing out financial institutions, will re-ignite inflation. They advocate such tactics as “Quantitative Easing” (bond purchases or money printing) and government directed spending (shovel ready projects) which will hopefully help inflation to begin again. The Austrian model of economists Mises and Hayek argue that government intervention does not solve the problem and in fact often postpones the recovery or aggravates the problem. Malinvestment should stop (bridges to nowhere) while the system naturally corrects itself through defaults and bankruptcies. Once this happens new growth begins just as a forest returns after the fire. Again as related in Wikipedia, central banks worldwide have printed the approximate equivalent of 13 trillion in the last 5 years. U.S. federal debt has doubled in the same short period. This is the Keynesian solution to begin inflation and to prevent deflation. The idea is to inflate asset prices to make the debt seem smaller. It’s only real success has been to inflate stock prices. Most other categories such as commodities and real estate have gone in the opposite direction. The consumer price index has averaged around 2.5% since 1998 in the U.S. and is actually negative in a number of foreign countries. Despite the feeling of illusory wealth based on higher stock prices, consumer spending has not responded accordingly, after all not everyone has a stock portfolio. This is not really a surprise, as 70 percent of the C.P.I. is consumer spending oriented. The resumption of government guaranteed mortgages with minimal or no down payment to persons with poor credit is the most recently revived attempt to reignite home prices. You would think this lesson had already been learned. I guess the reason might be that bureaucrats don’t loan their own money. The say insanity is doing the same thing over again and expecting different results.

Each stock market correction is met with more central bank money printing. Helping short circuit the October decline was action or promises of action by central banks of Japan, Europe, China and a member of the FED. Each episode appears to have a diminishing effect. Such actions have been unsuccessful in creating inflation or creating economic growth. Japan has printed money at about twice the rate of the U.S. relative to GDP. It is now again in a recession and the economy has been dead in the water for 20 years. Their central bank has even resorted to buying stocks, without much success by the way. Eight European countries are in or very near deflation right now.

In a deflation the value of money rises as the quantity of money and credit are exceeded by the supply of goods and services. Therefore, the value of money increases while prices of goods and services decline on average.

Why is this important? It’s because shrinking credit (as in credit crunch) and insufficient money supply comes first. Ummm … How can we have shrinking money and credit when the FED is printing money and buying bonds?” The biggest factor is contracting money velocity or the speed of money circulation. The slower the velocity the more scarce seems the supply or at least the effect of money on economic activity. According to the St. Louis Federal Reserve, velocity recently is lower than its lowest point following “The Great Depression” occurring in 1940. Credit contracts due to lack of confidence on the part of lenders regarding the borrower’s likelihood of repaying. Borrowers may actually share this concern or have no good economic purposes to assume the risk of borrowing. They will likely demand less credit. Investments and eventually production might be cut resulting in an increase in defaults.

The recently plunging oil price is certainly due in part to a reduction in demand. Companies whose business is oil related could be the first category of increased bond defaults. About 17 percent of junk bonds are oil related. (W.S.J.)

What does this mean for investing? In my opinion there are always opportunities especially during major economic changes. If you can identify the changes then make an assessment of their effects on economic activity, that is step one. Identify the investment product to capitalize on the affected areas. Remember there will be lots of things moving down. It is not un-American to position parts of a portfolio to make money when things decline. This is part of the process of hedging. Sorry but I cannot give details or make specific recommendations in print due to regulatory restrictions.

Best wishes for a great holiday Season.

Donald Hutchinson lives in Milford. Safe Harbor Financial Management. Questions may be answered by calling 203-301-0133. Securities offered through LPL Financial, Member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor before investing.