In simple terms, price inflation decreases the value of the money in my bank account. Why in the world, then, would I be doing a rain dance hoping to bring back inflation?
First, I think we need to put the issue in perspective. We are currently mired in an economic pickle brought on by the over-leveraging of pretty much everyone from consumers, to corporations, to the government.
This overhang of debt is something that needs to be addressed before we can hope to have a fully functioning economy -- let alone a healthy stock market -- again. Unfortunately, we don't have too many choices when it comes to addressing this debt overhang, and those choices look about as appetizing as choosing between fricassee of roadkill squirrel and curried moldy liver at a remedial cooking expo.
The choices are clear
Although there are myriad ways to talk around the debt issue and the potential solutions, when we boil it all down, we get to two basic solutions: inflation and deflation.
With inflation, nominal prices rise, and the value of every dollar declines. Assuming that new debt growth doesn't mirror the rate of inflation, the debt burden becomes worth less. Just like magic, the big debt problem suddenly becomes a much more manageable debt problem.
I've obviously simplified that scenario for fear of turning this into some sort of quasi-economic exploration that leaves you begging for your bed, but full-baked or not, the end result is the same -- the currency is devalued, and therefore, the value of debt shrinks.
The second potential solution to our problem is deflation. In this scenario, we simply step back and allow consumers, businesses, and the government to become more financially responsible so that they can pay down their debts and start saving.
While this may sound great to the financially responsible (like me), this sudden jolt of financial sobriety would lead to deflation as money created through the banking system would disappear from the system and drag prices down. Combine deflation with recessionary conditions and poor consumer and business sentiment, and you have a recipe for economic disaster as consumers stop spending and businesses find ever more reasons to hand out pink slips.
But isn't deflation a red herring?
A recent commentary from Bloomberg columnist Matthew Lynn, titled "Deflation Theory Is Lemon We Have All Been Sold," argues exactly this. While I think the author raises some interesting issues with the fears about deflation, I think he also misses some salient points.
For instance, here he lays out his thoughts on the benefits of deflation:
On the other hand, deflation is good news for savers, who get richer just by hanging on to their cash. And it is beneficial for consumers, who get cheaper prices. It is usually good for workers as well, as they can generally hold the value of their wages, even while prices fall.
The benefit to savers is certainly true, but this ignores the trouble created for the rest of the economy. As savers benefit by hanging onto their money, they also are avoiding spending, and likewise avoiding investing -- after all, why invest in companies that are facing tight wallets and falling prices?
Plus, even if workers are able to hang on to their same salaries, companies facing deflationary pressures may have to look toward becoming increasingly "efficient." And as we all know, becoming more efficient typically means laying off workers. Those savers we visited above may feel smug when deflation first sets in, but if a rocky economy costs them their jobs, the "benefits" of deflation may not seem so clear.
Investing for any outcome
Whether you like it or not, the outcome of your equity investments is going to be impacted by the direction the recovery takes.
If the world's central banks pull off the ultimate coup and are able to create just the right amount of inflation, most stocks should do well. The much-maligned banks like Bank of America (NYSE: BAC ) , Citigroup (NYSE: C ) , and JPMorgan Chase (NYSE: JPM ) should all get their footing back and start raking it in again. Consumer spending will kick back up above today's levels, and companies like Target and Nordstrom will no longer be on "avoid" lists.
If the inflationary actions push prices too far and we end up with uncomfortably high inflation, then companies that can increase prices in step with inflation will succeed. This means consumer staples like Coca-Cola (NYSE: KO ) , health-care companies such as Merck (NYSE: MRK ) , and commodity players (yes, folks, that includes gold) like ExxonMobil (NYSE: XOM ) .
In the unlucky event that we end up with stubborn deflation, it's going to be a similar pricing-power crew that will do the best -- so we're talking companies like Coke and Altria (NYSE: MO ) . Commodities are less likely to fare well in this scenario, though.
Holla back now
Now it's your turn to weigh in. Think I've hit the inflation nail on the head? Think I'm absolutely nuts? Chime in with your thoughts in the comments section below.
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