DEFLATION IS COMING. A view.NOT MINE

Some financial pundits have forecast that we are in danger of falling into an era of deflation, or falling prices.

Why should deflation come about? We have had 70 years of inflation and there is evidence, going back hundreds of years, that a prolonged period of inflation is normally followed by a period of deflation. Also this is the price we may well have to pay for the ending of the biggest asset and credit bubble in history.



In recent years we have seen prices fall in clothing and electrical goods due to cheap imports from the Far East, as well as falls in the price of electronic goods due to advances in technology, but we probably find it difficult to imagine a fall in the Retail Price Index.

However, in the UK between 1921 and 1932 prices fell by an average of 3% a year and deflation was last seen in 1938. More recently, following the Asian crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the fourth quarter of 2004. In Japan deflation started in the early 1990s and lasted until 2007.

Cause and effect

So what would be the effect of deflation?

We have already seen a fall in stock markets around the world that could develop into a full-blown crash. A stock market crash could be the event that sparks off deflation, or conversely the fear of deflation could set off a stock market crash itself.

The current recession could turn into a depression on the lines of 1930-40 (arguably shortened by the Second World War), which was not even the worst ever, the title of which goes to the Great Depression of 1873-1897.

What will happen to bonds in a deflationary situation? As at present there will be a flight to quality, i.e. triple A rated government bonds, particularly those of the US, Germany and the UK. These bonds will continue their increase in value and for the individual British investor any capital gains realised on UK Government bonds are, of course, tax free.

The yields, and perhaps the capital, of index-linked investments will fall during a deflationary period.

Deflation is far more difficult to control than inflation, unfolds at a faster rate and leaves more havoc in its wake. Along with deflation we get a contracting economy, and with that badly run businesses will fail along with others that use old methods and technology. Business activity will decline, resulting in lower sales and profits, and many companies will declare losses.

Commercial property will fall in price due to lack of demand and lack of credit. House prices will continue to fall and housing turnover will continue to remain low. This will be due to people seeing houses as a place to live, rather than an inflation hedge or investment. Rising unemployment and the possibility of lower pay levels will hit house prices.

Commodities will fall in price, particularly base metals, as the production of goods that contain them will drop.

The price of antiques and works of art could fall dramatically as the contraction in the economy and the difficulty in obtaining credit would make this market come to a virtual standstill.

So how will all this affect you and the rest of the profession? In a prolonged spell of deflation and depression many accountants will lose their jobs. Employers will seek cost reductions, including rates of pay; accountants will not be immune from this trend.

Those in the profession seeking to borrow money, to start a business for example, will find it very hard in a deflationary era as banks and other financial institutions will only want to lend where there is adequate security.

All bad things, as well as good, must come to an end. If the fall in share prices turns into a full scale bear market it will end sometime, giving a once in a generation chance to buy good quality shares at low prices but high yields offering strong prospects of substantial capital gains.

Deflation will bring opportunities for the prepared, particularly after the initial panic is over. New industries will spring up as they did in the 1930s, but this time in such areas such as via the internet, biotechnology and nanotechnology. Successful new businesses will start up and will be able to take advantage of low rents, reduced cost of goods and a plentiful supply of cheap labour, with no annual wage increases apart from merit and promotional increases. Annual wage round negotiations could disappear. Also a non-inflationary environment makes for easier business decisions without the distortion that inflation brings.

For those business owners and managers who get their deflation strategy right, the reward will be a prosperous future as many of their rivals struggle, get taken over or go out of business.