The Case for Deflation

One concern that I have is that many of the people that called the crashes in housing, the stock market, and the credit markets cannot agree on the next stage of the economy. Many believe that we are in for a period of high inflation as the value of the dollar declines. However, others believe we are in for a period of deflation. Text in bold is my emphasis. From the WSJ:

While most investors fear deflation, Gary Shilling is looking forward to it.

The idiosyncratic economist manages about $100 million for clients from a small office here. For many, many years, he has predicted an era of falling prices that never arrived. Now, finally, it just might.

He has a batch of advice for investors on how to weather deflation: Don't expect your house's worth to rebound. Stash your money in apartment real-estate trusts and conventional Treasurys. Don't invest in companies that carry a lot of debt or in inflation-protected Treasurys.

The last time deflation appeared was in the Depression. U.S. prices slid 32% from 1929 to 1933. Suddenly, many observers these days fear that the popping of the housing bubble, along with the financial crisis, could be pushing the U.S. toward a new deflationary era. The consumer-price index including food and energy dropped 0.8% for December, year over year, and was flat for January. When the February CPI is reported on Wednesday, many expect it to be flat or negative again.

Mr. Shilling believes price drops of 2% to 3% yearly will persist long after this recession because of huge efficiencies driven by globalization and technology, plus retirement-panicked baby boomers curbing their spendthrift ways and pumping up their puny savings. That would echo similar deflationary spells during prosperous, high-growth times like the late 1800s and the 1920s.

Increasingly, Mr. Shilling is getting company from economists who think deflation may be on the way, notably New York University's Nouriel Roubini and Merrill Lynch's David Rosenberg. Of course, others such as Northern Trust's Paul Kasriel, argue that heavy federal spending by the Obama administration to jump-start the economy risks just the opposite, a vexing inflation.

Yet few go as far in seeing persisting deflation as Mr. Shilling, 71 years old, a Stanford Ph.D. in economics who once was Merrill's chief economist.

Deflation in the Depression was truly baleful because it fostered a falloff in demand, since consumers were leery to buy what would be cheaper in the future. And it punished debt holders, who had to pay fixed amounts even as the value of the underlying asset sunk. The same condition bedeviled Japan in the 1990s.

A frequent talking head on CNBC, Mr. Shilling sometimes comes across as an oddball with his chronic bearishness. "People say I'm always negative, and when I'm right, it's like the stopped clock being right twice a day," Mr. Shilling says. Indeed, in January 2004, he predicted a housing crash within the year. "I was early," he says.

Even Mr. Shilling's hobby is on the eccentric side: He keeps bees. At his Short Hills, N.J., home and a nearby property, he tends 80 hives. Mr. Shilling gives the honey away to friends in plastic bear containers with labels saying things like: "Our bountiful bees need no bailout."
Over the years, Mr. Shilling has devised a virtual deflationary handbook for investors.

Good ideas: Longer-term Treasurys and certificates of deposit, which will continue to pay interest in the low single-digits. If the CPI is down 2% and 30-year Treasurys yield 3.6%, as they do now, then you get an effective 5.6%.

The housing bust is showing Americans that a place to live is no longer a can't-lose investment, Mr. Shilling says. Hence, he forecasts a surge into rental apartments, which should boost now-flagging apartment REITs. In health care, Mr. Shilling thinks winners will be companies dedicated to cost containment, like pharmacy-benefit managers.

His expected victims of deflation? Auto makers (savings-minded consumers will hold onto their old cars longer) and sellers of other big-ticket goods like refrigerators. He also is down on mortgage-backed securities, linked to the plummeting housing sector.