What is Deflation?
Deflation is a general slowdown of economic activity during the course of the economic business cycle. It is considered a recession when it lasts between six to eighteen months or longer. Effects that are characteristic of deflation include but are not limited to:
- Declining prices
- Decreasing consumer demand
- Low interest rates
- Less government spending
- Declining business investment spending
- Fewer investment assets
More than one economic situation causes deflation such as:
- A shrinking supply of money
- An oversupply of goods and services
- A decreasing demand for goods
- An increasing demand for money
The Effect on Businesses
How deflation affects a business just boils down to simple supply and demand. A business slowdown will occur If a company can’t sell their goods or services and are unable to
raise cash for daily operations; measures must be taken to compensate for this as much as possible. This is usually manifested as cutting costs wherever it can be done.
Some of the most familiar cost-cutting measures are reducing production, laying off employees, and cutting unnecessary non-production related expenses. Usually, the process consists of cutting out the fat to become lean and efficient as possible; sometimes it’s worse than that.
Are There Any Business Advantages?
Despite all of the financial woes that deflation brings to businesses, there does seem to be a somewhat bittersweet upside to it. Idle cash in cash accounts increases in value and prices for goods and services generally decrease.
Businesses can find ways to take advantage of these conditions while they last. They are:
- Start buying production related new technologies that can help increase productivity.
- Buy materials for production in small lots and more often to take advantage of decreasing prices. Using a JIT. (Just in Time) inventory strategy or adopting some of its methods can help to accomplish this.
- Try to add higher value/higher profit niche products to your production mix.
- A company experiencing declining prices for their goods might find a market in other countries with stronger economies. This sounds good on paper, but governments can adopt protective economic policies concerning cheaper foreign imports competing with their own domestically produced goods.
Keeping cash idle in a cash account offers a margin of safety during periods of deflation. If it’s large enough, it might help the company cover the expenses of daily operations for the duration of the deflationary period.
Even with the account’s cash increasing in value it is still experiencing a dollar depletion as it’s being utilized. It just makes sense that anyone would want to
at least slow the process as much as possible especially if there is little or no source of replenishment like revenues from sales.
A repositioning of cash in the cash account might help. This could be done by purchasing some very liquid, short-term, low-risk or no-risk investments that would serve as cash generators for a small contribution to the cash account when the funds become available to replenish it.
Money market accounts would be a likely place to be investing funds for this purpose. These are where investment banks put their money between deals and are also used by hedge funds if a market downturn seems imminent.
An investor can invest in money market instruments, which include certificates of deposit, commercial paper, US Treasuries, banker’s acceptances, and repurchase agreements. The income is small but the risk is low and dollars with increasing value will be added to a cash account to slow its depletion. Anyone contemplating this should definitely look before they leap to make sure they choose investments that are suitable for them. No one would like to need cash quickly and have no money market investments coming due soon enough.
Deflation of economic activity is a situation that every business dreads no matter what their product or service might be. Trying to find how deflation is advantageous and how to get through it smoothly, business as usual, seems like trying to find the Holy Grail but there are some lighter areas in its dark cloud cover. It could be considered a good time to do some shopping around while the values and low-interest rates last.
Taking advantage of lower prices while available cash is increasing in value is of some significance and keeping a comfortable cash margin that will likely last through the duration of a deflationary period is basic. Trying to keep it invested in highly liquid, low risk investments until it is needed could enhance its value while being used to cover necessary expenses or buy new lower priced assets to help improve productivity in the future.
jscreationzs / FreeDigitalPhotos.net, Umbrella With Dollar, http://www.freedigitalphotos.net/images/view_photog.php?photogid=1152
renjith krishnan / FreeDigitalPhotos.net, Economy, http://www.freedigitalphotos.net/images/view_photog.php?photogid=721
Schmidt, Michael, CFA, “Upside OF Inflation,” http://www.investopedia.com/articles/economics/09/upside-or-deflation.asp#axzz1Swdjqd8y
Pologeorgis, Nicolas, “Deflationary Shocks: Helping Or Hurting The Economy,” http://www.investopedia.com/articles/economics/09/deflationary-shocks-economy.asp#axzz1Swdjqd8y