The key to survival in a period of deflation is to have as little debt as possible. Over the years, economists who have warned of the consequences of credit expansion, such as Austrians Ludwig von Mises and Friedrich Hayek, have mostly been ignored. However, debt becomes even more of a burden for businesses in a deflationary economy.
Think about a scenario in which Company A has bought Company B for $100 million and funded the transaction by issuing $75 million in debt. A deflationary environment might reduce the value of Company B’s business to, say, $50 million. At the time of the acquisition, Company A took on debt worth 75 percent of the value of the asset it funded. Now, the same debt is worth 150 percent of the asset’s value. Even self-liquidating credit becomes burdensome in deflation. Suppose Company C borrows money to invest in a new widget-making machine. Under normal economic conditions, the expected return on selling extra widgets would compensate for the added debt, making the whole transaction viable. In a deflationary economy, however, the pessimistic social mood leads to stagnant or negative economic growth and demand for widgets declines. The debt-funded investment in new machinery cannot pay for itself.
Turnover is vanity and profit is sanity, but cash is king. Corporate treasurers and financial risk managers should inherently understand the wisdom in this age-old saying. Cash is not only the ultimate hedge, but also the only investment that rises in value during deflation. As stocks, bonds, real estate, and commodities are all losing value, the amount of cash required to purchase these assets is falling, by definition. In other words, the relative value of cash is going up.
Most people tend to gauge the value of cash according to the interest rate it can earn. Short-term interest rates in the major currencies will probably remain close to zero for the foreseeable future. Don’t be fooled into thinking that this means a large cash holding is a wasted asset. On the contrary, as the vice-like grip of deflation takes hold, a company with significant cash reserves will be able to take advantage of the increasing numbers of opportunities that will present themselves.
Tightening credit and falling prices are natural byproducts of a normal business cycle. They are also indicative of an environment in which cash-rich companies will be able to buy some businesses and productive resources at bargain-basement prices. For companies with a substantial debt burden, deflation may mean a struggle to survive. But those that have made cash king can leverage the situation to gain even stronger competitive positioning when the cycle turns again and the economic recovery starts.