Devil’s advocate: If deflation is allowed to take hold what would it mean for investors?


This is the first in a series of articles entitled Devil’s advocate which examines alternative scenarios and opinions. One such scenario is that the global debt crisis will be resolved by a powerful wave of deflation – just as occurred during the Great Depression of the 1930’s – and that this event has already begun.

Despite the fact that I don’t agree with this scenario, and rather see deflation occurring after a prolonged period of high inflation, this article examines what would happen if deflation were allowed to take hold immediately.


When discussing either deflation or inflation it is important to begin with the definition of both words. Deflation is defined as a contraction in the supply of money and credit, while inflation is an expansion in the supply of money and credit.

This is important because it’s a commonly held belief, even among many economists, that inflation is defined as rising prices and that deflation is falling prices. This is misleading however, since rising and falling prices describe the symptoms of inflation and deflation rather than their cause. The root cause of both inflation and deflation is an increase in the supply of money and credit.

Why prolonged deflation is unlikely

It is certainly true that the world is currently experiencing a bout of deflation. The real M1 money supply – that is cash and overnight deposits – in China, the Eurozone, Britain and the US has been contracting since early spring. It is my opinion however, that before this deflationary force can gather downward momentum it will be countered by massive, coordinated money printing from around the globe.

Here are just some of the reasons I hold this view:

1.      While inflation decreases the value of money and credit, deflation actually increases the value of money and credit. Deflation therefore makes the repayment and servicing of debt more difficult, and given the colossal levels of debt throughout the world’s largest developed economies a prolonged period of deflation would likely send many of these nations into default.

2.      The dominant economic philosophy within the G20 (particularly amongst economists and finance ministers) is that of Keynesianism, or rather a modern interpretation of Keynesianism. As a result they see the ongoing of debt crisis as a liquidity crisis and have therefore slashed interest rates to near-zero and continue to pump newly created money into the system in an attempt to stimulate demand, i.e. spending. The problem however, is that they are not fighting a liquidity crisis, they are fighting a solvency crisis and no amount of money printing can fix that. In fact, it only makes it worse.

3.      Rather than have the value of their debt burdens increase, indebted nations would far rather have it reduced through high inflation. Indeed, if a government can maintain an average inflation rate of 4% for a period of 7 years, it will have eroded nearly 25% of its debt. I believe this is why we are seeing the widespread adoption of financial repression.

4.      When choosing between the pain associated with a deep recession, or even depression, or the risk of high inflation that could result from further quantitative easing (QE), it seems clear that politicians will choose the latter. Indeed, it is this pain that QE is designed to prevent. Under today’s system of fractional-reserve banking, where banks hold only a fraction (often less than 10%) of their customer’s deposits as reserves, deflation causes a sharp contraction of credit. Deflation also makes debt much harder to repay, and can, as it did following the 1929 crash on Wall Street, lead to bank failures, which leads to further deflation. QE aims to stop deflation causing the real value of outstanding debt from spiking, and therefore prevents the deflationary spiral from gathering momentum. Thus far, thanks to falling money velocity, and low inflation expectations, QE has caused only moderate inflation, and therefore the majority of policymakers deem it a success.

We papered over the cracks in 2008 and 2010, and I believe that we will paper over the cracks in 2012. Eventually however, perhaps five years from now, these reflationary efforts will fail, at which point we will see a period of deflation during which asset prices will fall, mal-investment will be cleansed and savings will gradually be rebuilt. I further believe that during this period the global monetary system will be reconfigured, and it is my expectation that a new gold backed global reserve currency will emerge. 

What deflation would mean for investors

If deflation were allowed to take hold, in other words, if G20 government’s simultaneously agreed to stop intervening in the financial markets and rather let free market forces bring about a rebalancing, then we would likely see a harsh depression lasting 2-4 years.

The “Second Great Depression”, as it would likely be known, would cause a great many businesses to declare bankruptcy. Banks too would suffer as bad loans had to be written off, with many failing to find sufficient capital to stay afloat.

A prolonged period of deflation would almost certainly bring about the bursting of the bond bubble. Issuers of bonds, i.e. the borrowers, that were in bad shape financially would likely struggle to pay interest or principal, and the realisation among investors that default is a very real possibility would send prices tumbling and yields soaring.

As I’ve argued before however, not all the effects of deflation are negative. Indeed, as deflation gained momentum the shrinking supply of money and credit would cause the price of goods and services to fall, something which would help provide a safety net to squeezed consumers.

Savers, provided they are in cash and their money was not in one of the collapsed banks, would be one of the main beneficiaries of deflation, since they would see the value of their savings appreciate.

Market historian and author of the long-running Dow Theory Letters, Richard Russell, a man who actually lived through the Great Depression, once remarked that “in a deflationary environment, the winner is he who loses the least”. With that in mind, investors should consider holding a portion of their wealth in physical gold and gold equities.

The last great period of deflation was during the 1930’s, however back then gold was pegged to the US dollar at US$35 per ounce. It’s therefore impossible to know how gold would have performed were it under free market conditions. However, it is possible to look at Homestake Mining, which was one of the largest gold mining businesses in the United States, and use that as a proxy for gold. Homestake’s share price actually rose from US$65 in November 1929 to US$528 in February of 1936 with no significant pullbacks. This evidence suggests that both gold and gold stocks would make a good investment during a period of deflation.

Investment strategy

Whether you believe that governments and central bankers will sit back and allow the world to enter a deflationary spiral, or that they will do everything in their power to prevent deflation through the use of the printing press, a conservative portfolio ought to contain the same three assets, i.e. cash, physical gold and a selection of quality gold stocks.

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