Managing in Deflationary Cycles

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  • Those who are heavily leveraged will pay the penalty in a deflationary cycle
  • In deflation, assets can be purchased for only a portion of the original dollar amount

 

The business newscasts are split between the possibility of inflation and deflation. In recent weeks the Federal Reserve has used a second round of quantitative easing (QE2) in an attempt to reduce the likelihood of deflation. Only time will tell how this strategy will work. Let’s take the low road of economics and discuss managing in an era of deflation.

If the U.S. economy and global economy move into a deflationary cycle, those who are heavily leveraged, whether it is the household, consumer or business, would pay the penalty. In essence, debt service becomes more expensive in a deflationary cycle because a fixed commitment will be repaid by lower business income, earnings, etc., as employment and the economy constrict.

People with a large amount of cash will find that in deflation, assets can be purchased for only a portion of the original dollar amount. For example, in the 1930s, farmland values declined by 30-60% of their purchase values three years earlier. Those who had cash or liquid assets – i.e. assets that can be turned to cash quickly – benefitted by being able to purchase capital assets at bargain prices.

In a deflationary environment, those on fixed incomes, such as senior citizens and others living on pensions, will find that their income will go further and will allow them to purchase a greater basket of goods and services.

In a deflationary environment, assets will generally spiral down below a reasonable value as the psychology of the marketplace creates a herd mentality on the downside. As a case in point, one of my basketball friends just purchased a Florida farm for 47¢ on the dollar. His comment was that he overpaid for the asset, realizing that its value could go lower if he delayed making the investment.

Rules for a deflationary environment:

  • Keep four to nine months of household expenditures in cash on hand.
  • Businesses should keep 60-90 days worth of cash in the bank. It is about return of the investment, not return on the investment.
  • Seek a strategy to deleverage to a point where your debt-to-asset ratio does not exceed 40%.
  • Fine-tune your budgeting strategies.

P.S. Investors worldwide are following two strategies:

  • Buying gold in case of inflation and risk.
  • Buying cash bonds and treasuries in case of a deflationary cycle.

 

Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at sullylab@vt.edu.

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