As financial news watchers have probably already noticed, the word deflation has been coming up more frequently in news stories and discussions about the current national and global economic situation. Fiscal trend watchers worry about the potential effects that deflation could have on the global economy, such as prolonging the world-wide economic slowdown or even pushing the entire world into economic depression. While deflation certainly does have its dangers, it is possible to position oneself financially so as to reduce the potentially negative affects such a fiscal trend could have on your personal finances.

A recent USA Today article noted that “the prices of oil, food, cars, clothing and electronics have all plunged. Home prices continue to swoon and so do stock prices.”  Falling prices may, at first glance, seem like a good thing to the average consumer. However, a deeper look can offer a different view. The important thing to take note of is the reason for the decreasing prices. If the cause of lower prices is a systemic response to decreased demand due to turmoil and trouble in the economic system, then those lower prices may be an indicator of entering a period of deflation. 

The United States hasn’t seen significant deflation since the Great Depression, as was pointed out in an Associated Press article published on November 19, 2008. According to the article, “the U.S. Labor Department reported that consumer prices fell 1 percent in October from the previous month, the biggest fall since records began in 1947.” An article published at the Citizen-Times.com on November 28, 2008, stated that “November’s numbers seem to be following suit.”

The deflation of the Great Depression is often referred to as a “deflationary spiral” because it was a prolonged period of deflation, lasting from 1930 to 1933, that fed upon itself, making the overall economic situation worse. Basically, low demand for goods, due to economic worries and a lack of income – discretionary or otherwise – pushed prices down. That cut into business profits, and resulted in lay-offs and business failures, increasing unemployment, as well as fear and worry about money and the future, creating the classic vicious cycle.

Debt is another aspect of deflation that is dangerous, and very clearly a risk in our current multi-level indebted state. With personal, big business, and governmental debt reaching record levels, the affects of a deflationary cycle could be very painful indeed. That is because, as Mike Summey explained in his Citizen-Times.com article, “inflation rewards debt by allowing debtors to repay loans with cheaper dollars. It acts much like a tax on savings because it erodes the purchasing power of the dollar. Deflation works in just the opposite way: It rewards savings and forces debtors to repay loans with dollars that are harder to earn and have greater buying power than the dollars that were borrowed.”

Furthermore, being burdened with debt and less access to credit as struggling lenders reduce the amount of money they are loaning, many consumers will focus on paying debts and have little left over for spending beyond the essentials. This feeds right into the pattern of deflation. As Summey so aptly stated, “the most frightening thing about deflation, is that reducing debt and increasing savings only exacerbates the problem. Falling consumption coupled with the hoarding of cash only hastens the kind of deflationary spiral that led to the Great Depression.” 

Recent reports state that Federal Reserve officials say there is little chance of the US entering into a deflationary spiral and that there is no need to worry about the potential of a Great Depression type cycle of deflation occurring. Of course, this is the same group that was shocked, simply shocked, by the results of the housing bubble, the sub-prime mortgage meltdown, and the other major economic problems we face today.

We may be better off to take out a financial terms dictionary and make a little deflation checklist. Tightening of credit? Check. Deflating asset prices? Hmmm… housing, stocks, oil, commodities… better make that a check. OK, how about a significant decrease in consumer spending and demand? Check. Falling 401ks and other widespread incidents of negative risk adjusted rates of return? Check. Well, looking at the checklist, and what we see happening in the news on all of the basic economic fronts, even though the Fed officials say there is no real call for deflationary concern, it may be a good idea to take some steps to position yourself to be better able to financially withstand a deflationary period.

In any case, the best things that you can do to protect yourself against the negative potentials of a deflationary cycle are good for you anyway. So, even if the Federal Reserve officials are right, you’ll still be better off in the end if you concern yourself right now with working to reduce debt and increase savings. Granted, these things – in some economic viewpoints – may not be ‘good’ for the economy as a whole, or at least not the credit dependant, non-producing, consumption based, service industry economy we have sacrificed our manufacturing base and old-school thrift values for. They are, however, good for the individual and, as those who find our current system wrong-headed and unsustainable believe, better in the long-term for the overall economy.

At this point, the trouble in the economy is so deep rooted that there is little that can be done other than to watch it all unwind and self-correct. Thus, the individual needs to focus on what is best for his or her household economy and work towards making sure that they are positioned as well as possible. Paying down debt will make for more financial freedom of movement and even allow one to take some benefit from deflating prices, such as stocking up on non-perishable goods or buying assets at deflated prices. Increasing savings will offer a valuable cushion against the economic uncertainties on the horizon.