Investment Insider: Gary Shilling on the dangers of deflation

June 20, 2003

A long spell of declining prices could mean financial disaster--unless you're prepared, this noted economist says.

 

INVESTMENT INSIDER

Gary Shilling on the dangers of deflation

A long spell of declining prices could mean financial disaster—unless you're prepared, this noted economist says.

Gary Shilling is convinced that deflation—a time of falling prices—looms in our near future.

Shilling has made his reputation forecasting economic events. In 1969, he was among the few who correctly predicted the recession that would start late that year. In 1973, he stood almost alone in forecasting the first major worldwide recession since the 1930s. Subsequent forecasts have solidified his reputation.

A regular columnist for Forbes magazine and author of five books on the economy, Shilling's most recent book is Deflation: How to Survive and Thrive in the Coming Wave of Deflation (McGraw-Hill, 1999). Before establishing his own firm in 1978, Shilling served as Merrill Lynch's first chief economist. He has appeared on MoneyWatch Radio Network, CNBC, the MacNeill/Lehrer NewsHour, and many other business radio and television shows. He is president of A. Gary Shilling & Co. in Springfield, NJ, a consulting firm that provides economic analysis and money management.

Shilling's prediction of deflation runs counter to that of many investment gurus, who say the recession will end, the economy will pick up, and inflation will return.

Shilling talked recently with Medical Economics' Senior Editor Leslie Kane.

What's a good working definition of deflation?

Deflation means that prices are declining. They may not go down every month, but on average the major price gauges, like the Consumer Price Index or Producer Price Index, drop. In a mild deflation, prices decline by about 1 to 2 percent a year.

Why is deflation so dangerous?

It has a major effect on debt. During inflationary periods, having a mortgage or other debt is good because your payments get relatively smaller compared to rising prices and salaries.

Deflation creates the opposite situation. Comparatively, your debt increases because prices and incomes don't rise to offset it. Corporate and business debts also go up in comparison to revenues, which fall due to declining prices. The debt payment becomes more and more onerous. Company profits are not likely to be very strong in current dollars.

Why do you think we're headed for deflation?

There are big similarities between conditions now and those that led to past deflation. During those periods, tremendous waves of new technology created a huge increase in productivity, leading to excess supply and declines in prices.

During the late 1800s, the industrial revolution and the growth of the railroads were the driving technologies. In 1866, a dozen handmade pressed glass goblets cost $3.50. By 1888, the goblets were made by machine, and cost 40 cents a dozen. These machines created excess supply and dramatically lowered cost. The second period of deflation occurred during the 1920s, with the electrification of homes and factories, and the mass production of cars.

I think technology-produced deflation lies ahead. Semiconductors, computers, biotechnology, the Internet, and telecommunications have now had time to gain critical mass and become dominant in the economy.

I've heard that you differentiate between "good deflation" and "bad deflation."

Yes. Deflation occurs when supply exceeds demand. Supply could exceed demand either if supply goes up or demand goes down.

Collapsing demand is symptomatic of poor business conditions. Those who anticipate bad deflation see it occurring because of people losing their jobs, and a continuation of the recession that we've been having. It occurs when the economy is in deep trouble.

However, I'm anticipating good deflation, which stems from excess supply. It's not "good" per se, but when it's based on more efficient production, it's not symptomatic of an economy that's in bad shape.

But you're saying that even "good" deflation is bad.

Right. It can cause a major problem initially if people are not prepared for it. And most people aren't. We've had more than 60 years of inflation. It has made many people feel that inflation is the way God made the world.

People who are unprepared for deflation have a huge amount of debt, which is wonderful in periods of inflation, but terrible in periods of deflation. Take mortgage debt as an example. Let's say that in the high-inflation 1970s, you put down 20 percent on a house and borrowed 80 percent. If you got a 10 percent mortgage rate, and the house appreciated 15 percent in the first year—not unusual back then—you made 35 percent on your money that year.

By contrast, let's assume prices are falling 2 percent a year in deflation. Real estate prices typically track inflation. If you put down 20 percent, and borrow 80 percent at 4 percent interest, but the house price declines 2 percent in the first year, you lose 26 percent on your money.

What are the odds of deflation occurring? When might it happen?

I'd say the chances are about 80/20. And I think we're pretty close to it happening very soon. Inflation is already very low. The real road test will occur after this recession ends. Inflation often declines during recession anyway, but revives afterward. The key is, after a recession is over, does inflation continue to decline and trip over into deflation?

Few other economists are forecasting deflation. Why is that?

This business exerts tremendous pressure to say that tomorrow is basically like today, only a little bit better. Very few people are willing to stick their necks out and forecast anything that they have not experienced. Also, very few of us ever forecast negative events like deflation or recession, because it does nothing for job security! There's a huge bias toward always being positive.

If deflation does occur, what can consumers do to protect their money?

First, reduce or pay off your debt. Whether it's your mortgage, stocks bought on margin, or credit card debt.

Also, lock in CDs or fixed income at the best rate you can get now, because rates are likely to decline. I recommend long-term Treasury bonds. They don't issue 30-year maturity Treasuries anymore, but you can still get 27-year bonds. If we enter deflation and yields fall from 5 percent to 3 percent, you will earn about 50 percent appreciation from Treasuries over the following two years. I also suggest buying 30-year zero coupon Treasuries, which sell at a discount. You don't get paid interest explicitly, but you get the interest in effect because you receive face value at maturity, yet you bought the Treasury at a discount. If you bought them today, and deflation occurred, you'd probably make about 80 percent appreciation. Junk bonds and high-grade corporate bonds have done well so far this year, but may be treacherous in deflation.

If deflation's coming, what should investors do with their stocks?

We had this unprecedented stock market for almost 18 years, and it lasted so long that people said, that's how it is. Well, it's unrealistic to expect a return to that sort of bull market. Most people's portfolios contain from 60 to 80 percent stocks and 20 to 40 percent bonds. Based on our forecast for deflation, I would suggest almost the exact opposite.

If you're going to buy stock, be cautious. Look for stocks that pay meaningful dividends. Dividends provide current income, and a company that can pay dividends is more likely to be operating well.

What about investing in real estate?

I think the real estate market has peaked, both at the upper end and the lower end. Many people with low incomes have been able to buy houses or are planning to buy houses because they can get mortgages for minimal down payments. But if they lose their jobs, they're in trouble. That ripples up the real estate market.

During deflation, real estate is often a poor investment because of the debt incurred. That means fewer people will be as eager to buy houses, which will bring down house prices. This will be a big shock for people who have shifted their money into real estate. Whether people realize it or not, they've been betting on inflation to keep their house values appreciating.

How long could deflation last?

If it were just a couple of years, we wouldn't have to pay much attention to it. But it could last decades, or at least long enough to affect everybody's business and investment time horizon. I think it will last long enough to be significant.

So to sum up, your basic message would be, pay down debts, lock in CDs, buy Treasuries, save as much as possible, and choose dividend-paying stocks.

To help you save, try to enjoy the benefit of small luxuries. Maybe you won't be able to afford a new car, but you can get a new watch or stereo.

 

Leslie Kane. Investment Insider: Gary Shilling on the dangers of deflation. Medical Economics Jun. 20, 2003;80:28.