A Lesson from the Great Depression
July 3rd, 2009
By David Goldman
<!– –>The present deflation is worth putting in context. Below is the annual rate of CPI change since 1913:
We are in the first deflation since the Great Depression, albeit a mild one. In fact, raw materials prices have fallen just as far, but our consumption basket has shifted to items whose prices are slower to deflate.
Note that the great deflation of 1929-1933 is followed by a brief increase in inflation (to a 5% year on year CPI gain) before falling back into negative numbers. This was the result of FDR’s devaluation of the dollar against gold, from $20.67 to $35 an ounce (a level that held until August 1971 when Richard Nixon again devalued the dollar). That the effects of the dollar devaluation were quite temporary is evident from the chart.
It seems quite plausible that the dollar will fall sharply against some other currencies, notably the Asians, and against gold and other commodities. That may not, however, interrupt the deflationary tendencies which predominate, for to have actual inflation, someone has to take cash and buy goods rather than (for example) securities. If everyone hypothetically wanted to buy securities rather than goods, prices of goods would crash.
Something like this is happening, of course. An aging population increases its purchases of securities and decreases its purchases of goods as it saves for retirement. Americans have saved nothing for the past ten years, and the capital gains that they considered savings-substitutes have vanished. That means that an enormous savings deficit accumulated over more than a decade has been exposed, and that Americans must attempt to correct it quickly and under the worst of circumstances.
That creates a deflationary shock that a few trillion dollars’ worth of stimulus cannot begin to mitigate. America may have the worst of both worlds: currency devaluation AND price deflation, as in the 1930s. That is why TIPS and other nominal inflation hedges do not convince me. Gold, oil, commodities, and Chinese blue-chips are my preferred hedges against a dollar crash. Most of my portfolio remains in high-quality fixed income. I have sold lower-rated credit and taken profits in anticipation of further market weakening.