The first thing one must understand about deflation is, for all the fear of falling prices, it raises buying power. Obviously, lower gas prices are a good thing for consumers. But if prices fall too far too fast companies can go out of business and debt defaults could become commonplace, and this could cause stress in the financial sector and systemic damage, increased unemployment, and a recession.

Deflation used to be a normal adjustment of the price index given a free market. Prices go up and prices go down. For a hundred years during the 19th century, prices generally moved up and down by about 2%. The move was so gradual it was never an issue. During the gold standard of America there was no term “inflation” or “deflation” as we know them today.

 

 

It was only when the government established the Federal Reserve System in 1913, that the American public was introduced to the inflation of the roaring 20s and the deflation of the 30s. They were reintroduced to roaring inflation in the 70s as it soared to 14% rates, and it has been fighting deflation, more than inflation along with the rest of the world today.

 

One form of protection against both, is to own gold and silver. In the last gold bull market as gold went to 1900 dollars an ounce, and while everything was crashing around us, you could buy a house in terms of gold at century-low prices. Home prices in some cases fell by half in dollar terms. But in gold terms they fell far more. Today gold is substantially lower but the gold-oil ratio is higher and allows us to buy gas in terms of gold at historic lows. So gold is something everyone should own in a deflationary period in order to preserve purchasing power.

 

Cash is another. While gold may fall during a period of deflation, it is likely not to lose value in exchange for most other goods and services. If gold falls by 40% over a decade and goods and services fall by the same amount, purchasing power is preserved.  Cash however if protected, and like a gallon of gas today, will definitely buy more than gold if all prices fall. So gold and cash are good diversified hedges against deflation and provide a preservation of purchasing power.

 

 

Another strategy to hedge deflation is to pay off debt. As interest rates have fallen to zero for savers, and even turned negative in Europe and Japan, the interest paid on debt by consumers is substantial. Every dollar of debt paid off is a dollar "earned". 

 

Other hedges are to buy rental property or government bonds. Here the principle invested is illiquid, but you will get a return. If you buy a rental when home prices are falling, you will eventually reap the rewards in a period of inflation. And while you wait, if there is a generalized deflation, if the price of your investment falls along with your rent, your rent will continue to buy what it did before the deflation; once again, a preservation of purchasing power. And with bonds, as long as they are secure, your return will buy more as prices fall.

 

But the most important point to understand about deflation is that deflations are at times associated with deleveraging and crashes, such as the deflation of the 1930s, and the crash of 2008. If a deflation is the result of fear, it can result in stock market crashes, bank runs, real estate crashes, and wealth destruction; and it can lead a nation, indeed a world, into chaos, recession or even depression. Add to that the geopolitical threat of terrorist attacks and the threat of rogue and government cyberattacks, and a diversified portfolio is essential in today's world.