Inflation or deflation? Which direction will the economy -- and the value of the American dollar -- take in the future? This is not a theoretical economic debate. It will impact the value of your retirement savings, the prospects for your career, your children's education -- and your daily lifestyle.
The American economy is on a seesaw these days -- tilting between the possibilities of inflation and deflation, and balancing delicately in between. Some days, the markets worry about inflation, so energy and gold prices move higher and the dollar falls. Other days, the world markets worry about deflation, so the dollar strengthens as global money rushes to the perceived strength and safety of the United States, pushing interest rates lower.
As more U.S. paper money is printed, its value is diminished. Even the fear of inflation can trigger a rush from currency into hard assets such as minerals, oil and natural gas -- which is happening now.
If you knew for sure which way the balance would definitively tilt, you would want to adjust your investments and spending plans. Since there's no way to know, the very least you can do is understand the symptoms -- and consequences -- of each of these possibilities.
Deflation
Declining asset values are the major symptom of deflation. And a quick look around tells you that the values of stocks, houses, commercial real estate and many other assets have fallen sharply. What happens to that "value" that is lost when a credit card debt is written off or a foreclosed home is sold for a lower price? That money or value simply disappears into a void, leaving price levels lower and everyone feeling slightly less rich.
What would be the most valuable asset in a deflationary period? Cash. Liquidity is king in a deflation because it means you can buy assets -- if you choose -- at a far lower price than they used to command.
But the key word here is choice. If you have cash, you might simply be sitting on the sidelines waiting for prices to go even lower, creating even bigger bargains. That hesitancy to spend, and that decision to keep saving, slow the economy even further -- debilitating business profits, causing more layoffs, more worry and lower prices. It is a depressing downward spiral.
Where have we seen economic deflation? The most obvious example came during the Great Depression in the 1930s. But a deflationary period can happen even in modern times with modern mechanisms for government responses. Basically, Japan has been in a period of deflation for more than a decade -- living proof that it is difficult to "cure" a deflationary psychology once it gets started.
Inflation