by Will Hepburn

Deflation: a Primer

Econ 101 says inflation is when too may dollars chase too few goods and prices go up. Deflation, on the other hand, is when too many goods chase too few dollars and prices go down. Right now the world has excess factories producing the “too many goods” and this is the beginning of deflation. Since we haven’t had deflation since the 1930’s it will catch many investors unaware. We, here at Hepburn Capital Management, manage money to protect our investors from deflation, but there are also many other facets of your life that could be affected by deflation, so it behooves each of us to learn about this problem.

We are all consumers, so deflating prices feel good. But our good feelings are very costly to the economy as a whole. The folks who have lost jobs recently as factories move overseas know this. And we can’t really blame the companies. The cost to a company for lower prices comes out of profits first and then out of payroll. It’s either move the plant or shut it down when the company is bleeding to death from lack of profit (losses). Jobs get lost either way if a company can’t earn enough to survive. This is bad for everyone, workers, holders of stocks or bonds or mutual funds of those companies. Even the real estate markets get hurt as laid off workers sell their homes Deflation is bad for everyone.

Internet shopping is another factor in deflation. On the “web”, pricing something at many different stores takes just a minute. Gone is the advantage a store has from a good location. On the internet, location and service barely matter. Only price matters. This highly efficient price shopping instantly cuts out all but the one middleman willing to work for the lowest amount. All the other middlemen lose their jobs, too.

This is the stuff we are hearing about in Presidential politics, but don’t expect it to change. Bush is not in control of it, and neither will be Kerry or Nader or Al Sharpton. You and I and consumers the world over, continually vote with our dollars for lower prices and more deflation. And I don’t see anything coming that will change that.

The government wants to keep price deflation from becoming asset or debt deflation, and is lowering interest rates to get more money circulating. Remember, deflation is too many goods and too few dollars. But just having more dollars available does no good if people don’t spend it. However, no one, not even Alan Greenspan, knows how this battle will play out. The government is risking inflation to whip deflation. Whichever way the economy goes will profoundly effect your life. Stay tuned.

Paul Pilzer, a visionary economist, refers to inflation as a tax caused by inefficiency. It appears that deflation may be a tax caused by efficiency. The irony is deep, indeed.

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What Me Worry? - About Inflation?

A New Retirement Plan:

At my Yavapai College class, I like to ask the trick question, “When was the period of highest inflation during our lifetime?” Almost everyone says the late 1970’s or early 1980’s, but the correct answer is 30 years earlier, 1947 and 1948, as the inflationary effects of the World War II spending were being worked off. The reason the question is a trick is that I was born in 1948, so I can just barely get away with it.

According to Robert Sahr of Oregon State University, the 1917-1920 period was even worse with four straight years of inflation in the high teens. This again was war related, as we paid off the costs of World War I by halving the value of everyone’s money.

Inflation, at its core, is a tax. The government can take part of your money without ever having to touch your wallet. They just print more money, making your existing money worth-less. These days they can even save the cost of ink and paper, by creating electronic lines of credit instead of actually printing dollars. Who pays the tax? Those of us holding dollars, or obligations denominated in dollars. IOU’s such as bonds, savings accounts and annuities buy less and less each year in an inflationary environment as this “tax” saps buying power.. The saddest example is pensioners who can no longer afford the price of food, because the cost of food has risen and their pension has not.

Right now some segments of the economy are inflating and some are deflating. Electronics prices are coming down and Walmart is also a huge deflator of prices. Home prices and medicine come to mind when looking for inflation. But the government is having to work to protect those prices from deflationary forces. The government prohibition regarding importing cheaper drugs from Canada into Maine is an example of price propping

Why am I telling you this? As you have just read, we have had successive cycles of high inflation approximately 30 years apart, 1917, 1947, and 1977. 30 more years would bring us to 2007. Will we have another round of high inflation by then? I don’t really know. And 30 years is certainly not a magic number. The point is that inflation clearly cycles up and down. Because we are currently in the low part of the cycle, astute investors must begin to look ahead for what is coming and prepare for it.

Obviously the government is fighting the specter of deflation with inflationary tactics. How much deflation we will see first, is unclear, but the foundation for the next round of inflation is being laid. I also remember that George Santayana said that “those who do not learn from history are doomed to repeat it.”

March 2004

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Now, On the Web!

HCM’s Prescott Center for Adaptive Market Strategies’ new web site is now up and running! We designed it to tell the story of our unique methods of Adapting to Changing Markets. You can check it out at

www.AdaptiveMarketStrategies.com, and please tell your friends.

I’d also like to ask a favor. While you are on the site, please spend a few minutes looking around, and give us some feedback. It is designed to clearly tell our story and we want to make it work as well as it can.

We’d like to hear from you. Please phone 717-0007 or email me at Will@HepburnCapital.com with comments.

Clients from years past were able to see us and their account balances on the web through the Hepburn & Associates web site which is www.Invest.Hepburn.com.

Now Hepburn Capital Management, through it’s Prescott Center for Adaptive Market Strategies can offer you access to current account balances, transaction histories and more through our new web site. If you would like to be able to see all of your accounts on one page, any time of the day or night, call us for instructions and a password.

WillHepburnbio

Will Hepburn is a private investment manager who specializes in active investment strategies. He owns the Prescott Center for Adaptive Market Strategies, and is President of Hepburn Capital Management, LLC, a Registered Investment Advisor. He may be reached at 2069 Willow Creek Road in Prescott, AZ, or by calling (928) 778-4000 or emailing Will@HepburnCapital.com.

Copyright 2004. Permission to copy granted given the above attribution is included. The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes a solicitation for purchase or sale or any security.