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Inflation and Deflation

September 15, 2011 Leave a comment Go to comments

Gerald Klassen and I co-authored a Real Estate Center white paper answering eight common questions regarding inflation and deflation. Here’s some of what we said. To read the complete white paper, go to http://recenter.tamu.edu/pdf/1946.pdf

What is the difference between debt deflation and deflation?

These are two different things, but they are related. Debt deflation is a theory developed by economist Irving Fisher during the Great Depression. It asserts that recessions and depressions are caused by the overall level of debt shrinking in an economy.

Debt deflation is the reduction in total debt in an economy. Today we have an unprecedented reduction in consumer credit and mortgage debt in the U.S. economy. People are either paying down debt using their savings or defaulting on the debt. And that is a problem.

From an accounting balance sheet perspective, if the market value of debt (right side of the balance sheet) in an economy shrinks, then the market value of the assets (left side of the balance sheet) in the economy must shrink by the same amount if new equity (right side of the balance) is not added. Assets must be sold to reduce the debt. When many assets are sold all at once, values fall.

Deflation is a little different. Consumer price deflation is what the media most commonly means when it mentions deflation. The principle behind consumer price deflation is that consumer prices fall because people are consuming less, and businesses are forced to reduce prices to sell their products.

Anticipating lower prices in the future, people continue to consume less, and falling demand causes businesses to continue to cut prices. It becomes a self-reinforcing cycle of delayed consumption and price cutting. This is very damaging because businesses have to cut jobs and production to stay profitable, while people consume less because they lose their jobs. When business profits and employment income fall, it becomes difficult to repay loans.

So which is worse, inflation or deflation?

Deflation is much worse because it leads to falling profits and asset values. When profits and asset values fall, people go bankrupt. However, deflation is beneficial for those on fixed incomes with no debt, because their money buys more. Deflation results in lower interest rates.

With inflation, wages rise and debt becomes easier to pay off. If businesses can adjust to rising costs, their profits grow because they are getting higher prices for their products. But inflation is bad for those on fixed incomes because their money does not buy as much. Inflation results in higher interest rates.

Is real estate a good investment during deflation?

The answer depends on how much equity you have. During deflation, commercial rents will fall, and some tenants will go out of business because of falling profits. The most important thing when buying real estate during deflation is to avoid the need to go back to the bank to get relief on the mortgage payment.

If buyers pay all cash and have cash to make tenant improvements, foreclosure is not a threat if the property gets into trouble. There will be plenty of time in the years ahead when credit is expanding to leverage up the property, extract equity and increase returns. Deflation is a time for caution and reduced return requirements to protect investment principal.

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