Thank you for your most recent submission on Inflation/Deflation and Purchasing Power.

I have been a loyal reader of your site for about the past year, and while always interested in your commentaries on the markets in particular, was moved to make a comment for the first time.

I too have been sucked into too many expert opinions on whether we will experience I nflation/Deflation or some other esoteric academic iteration or combination of the two. If one looks one can find the concept hotly debated on the web ad nausem (not to imply criticism of the web as at least we can enter into the debate, unlike with mainstream media). Alternatively one can read the commentary of experts (economists and the like) and be swayed back an forth by one side or another.

For a time I became captivated and obsessed with learning the answer to the question. Your submission has clarified and simplified the problem for me. However I cannot help thinking that there are still practical realities and impacts to me as an individual investor – depending on whether we experience hyper inflation generally, or a general decline in the cost of housing, consumable products, etc. brought about by an oversupply and a lack of demand (essentially because the spending mania has or will soon end).

First and foremost you are essentially correct. What matters to me, as an individual, is what my unique experience will be in the face of what is known and or can be reasonably projected (for example rising food prices, lower big screen TV prices, higher gas prices, and stable or falling house prices). It is clear to me (more clear after reading your blog) that their will be both gains and losses in purchasing power. It’s the net effect in your circumstance that matters most. For those that planned well there may be significant gains in purchasing power. I for example,

sold my house 18 months ago, rented a condo, invested one half of the equity in safe interest bearing vehicles and the other half in Gold and Oil/Gas investments. I am also a Canadian and we are fortunate that our currency has done well relative to the rest of the world – at least of late. So far so good. For perhaps many more individuals – who perhaps have not planned ahead, I fear that there will be a significant and continual loss of purchasing power.

Am I worried that my equity investments are susceptible to a potential deflationary spiral? Yes. The reason is that less purchasing power in the population generally, means less aggregate spending. Less spending means less demand for goods. Less demand means overcapacity. Overcapacity means lower prices. Eventually less demand for goods and services in general (and agreed not for everything like healthcare, gas, food, etc.), will mean lower corporate profits.

Lower corporate profits means lower stock market prices, fewer jobs, etc. One could then make the argument for a downward spiral ala Japan. If that is the consequence then my purchasing power has been negatively impacted if I do not prepare accordingly (e.g. increase the cash component).

One often reads that Bernake, as any good Central Banker would, fears “deflation”, and will flood the “system” with money thereby forestalling deflation but as a necessary consequence, will cause prices to increase (agreed the incorrect definition of inflation). Nobody has properly defined what “flooding the system with money” actually means. At least not to me. How does this money get into the hands of the debt satiated consumer who apparently is a key ingredient of the economy (to the tune of about 70% of GDP)?

Is it simply as easy as offering 1 % interest rates to the masses? Of course the deflationists take up the argument and say that you can lead a horse to water but you can’t make him drink (in other words lower rates and more and easy credit will not induce more spending) when (1) banks are not willing participants, (2) credit is “maxed out”, and (3) people suddenly “get” that it makes sense to save.

But what if the hyper-inflationists are right, and one last time the masses are granted this easy money and they in turn drive up the price of all goods. Not just gas, food and healthcare (that are clearly going there anyway) but stocks, Chinese made electronics, and perhaps even Real Estate once again? While I am confident that the value of my gold and gold stocks will appreciate at an even greater rate than general prices, I still have to prepare in a different way for this consequence, do I not? (e.g. decrease my cash component).

There are no easy answers, but at least you are bringing the debate down (from the lofty academic level) to the practical and individual level. I hope that you will continue the debate this topic in light of my questions and confusion - which I am sure is shared by many.

Perhaps it can be boiled down to one simple question. While the impact of whatever happens (inflation or deflation) is a function of each individual’s circumstances, is it not true that what happens to the general population (ie either a mass loss of purchasing power, or an illusionary increase in purchasing power through dollar devaluation) will in turn impact the individual investor and how they should plan?