A brief discussion of deflation and the Federal Reserve

Some people are concerned about the possibility of inflation caused by the federal government "printing money", but that's only one side of the coin. Any inflation caused by the Fed can easily be dwarfed by deflationary forces (see Chapter 13 of Conquer the Crash). This is exactly what happened during the steep selloff in the stock market in 2008. A lot of investors' wealth simply vanished.

In a deflationary environment, there is a way to prosper: hold onto your dollars. Deflation reduces the number of dollars and thereby distributes their value over existing dollars.

Think of it this way. A typical graph of a market shows dollars (value of shares) on the vertical axis and time on the horizontal axis. A rising graph over time reflects a bull market in the prices of shares. Now draw another graph where the vertical axis is instead the value of dollars in terms of numbers of shares; a bull market in stocks will yield a descending graph, meaning that shares buy more dollars over time.

To help understand this, think of what is being bought and sold.  On the typical graph one sells dollars to buy shares.  On the second graph, one sells shares to buy dollars.

In a bear market the reverse is true. The second graph will rise, indicating a bull market in dollars as share prices fall. This is what deflation does: it increases the value (purchasing power) of your dollars, both in stocks and in everyday goods and services.

The big question is if/when we will see deflation. CtC argues a strong case for it. So the best preparation one can make is to horde dollars in the safest forms, and that means short-term debt from the U.S Treasury.

Fortunately for us lil folk the Treasury makes it simple and easy to invest. They run a website called Treasury Direct. When you set up an account there you provide the feds with the number of an account at your bank. Once set up, you can go online and schedule purchases at the dates of auction. 90-day bills are auctioned every week, for example.

Here are the results of recent auctions. The current interest rate for 90-day bills is a mere 0.05%, but don't be fooled. Plus 0.05% is better than minus anything, and that's a risk we must avoid. Investing in other debt that pays a higher yield is pointless if the issuing agency defaults on it.

What is the risk of the Treasury defaulting? Minimal, and if that should happen our geese are cooked no matter what. To prepare for that possibility some portion of the portfolio should be invested in precious metals like gold and silver, which are presently very expensive. But deflation will counter that. When people are unloading their metals to stock up on dollars, prices will fall and the old buck will buy more metal than it does today.

And finally, when the going gets tough the feds can do some crazy things. Back in 1933 President Roosevelt issued Executive Order 6102, effectively extorting gold held by individuals and businesses in the private sector in return for dollars (the post-gold-standard dollars which are backed by nothing at all). This IMO is a gross abuse of executive power, and certainly not the only one committed by FDR.

One defense against that is to hold your gold offshore. International firms like GoldMoney provide a simple, easy, and secure way to do just that.

Bottom line: every investment carries risk. But there are ways to mitigate it and prepare for hard times.