Very few of us have experienced deflation. The lessons we learned about finance and economics, in classroom theory and in daily practice, dating back to our formative years, have featured inflation. Although not necessarily hyperinflation, we have always assumed some inflation rate to exist – typically in the low-single digits – and this has (implicitly or explicitly) driven business planning, corporate finance models, the assessment of investments, and a host of other financial thought that, since the dawn of our time, has been ingrained in our psyche. Of late, and with evidence mounting, it seems that we may have to adjust our perspective. Deflation no longer a remote possibility, but increasingly real and already manifest in major economic segments, we might begin to incorporate this concept into decisions and calculations with the same ease of manner with which we have heretofore observed its counterpart. This will be no easy task, because lifetimes of habit and cultural reinforcement cannot be blown away in stride. But as the implications are not trivial, it isn’t too soon to try.
For example – and only to pick one aspect to illustrate – let’s take the treatment of liquidity and illiquidity. We have been taught and are well practiced in the concept of a liquidity premium when dealing with public versus private securities, and have learned to differentiate between assets that cannot be liquified at will and those that can. The idea being this: Independent of the underlying profile of a business, collateral, or other security or holding, there is a risk to illiquidity – which is to say, an owner’s inability to readily convert the asset to its cash equivalent – which risk is reflected in a discount priced into such an asset. It may not naturally come to mind, however, that as a very different point from illiquidity risk and its discount, the opposite of illiquidity – pure cash – has inherent value that should be priced at a premium. In a deflationary environment, in which the purchasing power of cash increases over time, a “cash premium,” if you will, is something to which we might begin to pay homage.
(Much has been discussed recently about the hoarding of cash by major corporations; and much has been observed in regard to a supposed Treasury bubble. In a deflationary environment, even an interest rate of 0% is not as low as advertised, and accumulating cash is not a lost opportunity when real assets are devalued and equities fall flat. Referring to the bond environment as a bubble, and to cash savings as hoarding, may be evidence that old habits and established perspectives are difficult to break. Should evidence of deflation continue to mount, such perspectives will undoubtedly change.)
In another article I touched on the positive effect on equities, venture capital, and entrepreneurship, of a high-inflation environment. In a reverse scenario, of deflation rather than high inflation, the opposite will be true for all involved, unless underlying models and underlying thought processes are modified. While structurally difficult for private equity to change objectives, an emphasis on immediate cash such as through dividend distributions may be indicated, for example. And entrepreneurs may be well served to think along similar lines: to build businesses that don’t require ongoing capital infusions, and to invent technologies around cash-generating models rather than the other way around.
In this brief and simplified discussion I’ve only selected a couple of examples from many, and these probably hit closer to home with some than with others. Much more extensive analysis is obviously necessary, and some has already been formulated by economists like David Rosenberg. We are nowhere close, however, to the idea becoming mainstream just yet, and maybe this is a good thing for good reason. But as was previously noted, evidence is starting to build, and changing perspectives can take time and a little bit of effort. It is never too soon, or a wasted effort, to consider possibilities.
