AdSlot1

Economics: deflation alert

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.

Practices will come under severe financial pressure and some will fail or be
forced to merge. Yet those engaged in insolvency work will prosper with the rise
in administrations and liquidations.

Retired accountants on a pension will gain as the purchasing power of their
pension will increase, even more so if they have a pension with an annual fixed
increase.

Accountants who are employed should endeavour to make sure their jobs are
relatively safe. Easier said than done, when one looks at the job losses of the
last few months.

You should recognise early on that deflation requires a different strategy
from inflation and should look to convince clients to opt for a low margin, high
value strategy, plus the higher value of investment necessary. This strategy
would recognise increasing price awareness by consumers.

Firms that do not recognise the changed business environment will perish.
Accountants will have to build deflation into their budgets and business plans,
and adjust selling prices accordingly. You must take into account that interest
rates will be low and prices for plant, machinery, vehicles etc. are unlikely to
rise and could even fall.

Accountants will have to recognise that in a deflationary era, the rate of
return on capital investment does not need to be as high as that in an
inflationary environment.

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 (including accountants) 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.

Related reading

/IMG/102/330102/handshake-generic-2015-1
/IMG/433/165433/p16-cash
cta-polynotes-higgins
/IMG/757/318757/tescor32r3