Deflation is the debtor's worst enemy just as inflation is the debtor's best friend. In inflationary times the value of the asset you borrowed money to buy goes up so quickly that you can always sell and come out ahead despite the interest you paid in the meantime. In deflationary time, the outstanding amount of the loan can easily become greater than the current value of the asset. Now you're underwater and can't sell without putting money in. If you're having trouble making the payments, you have big trouble.
Obviously we have deflation in the housing market today. But what's much scarier is that we may be going through a period of much more general deflation, perhaps triggered by housing, perhaps just overdue. Commodity prices have also come crashing down, also from lofty peaks of course. Deflation is what characterizes depressions (which I'm not predicting but deflation is serious stuff). Deflation also tempts governments into hyper-inflation as a cure; can you count to $850 billion?
Deflation of an asset is self-perpetuating. When houses could do nothing but go up, you offered more than the asking price before the realtor was through showing you the place to beat out the next guy. When house prices are going down, you think long and hard about making any offer at all. If you do offer, it's low. And you don't budge much in negotiation. When fuel prices were going up faster than the wheels could spin on gas pumps, we filled up when the tanks were half empty to avoid paying more tomorrow ; so did the guys with the huge storage tanks – and they borrowed money to do so. Now I drive to near empty because the gas I buy tomorrow'll probably be cheaper than what I'd pay today . The guys with the huge storage tanks have to sell to pay back their loans but the stuff now cost less than when they bought it (if you were concerned about hoarders, deflation is your revenge). Now the pendulum is swinging towards deflation even though neither houses nor commodities have yet gotten cheaper than they would have been had they only tracked the general rate of inflation for the past five years.
In times of inflation, any Wall Streeter'll tell you "cash is trash". In times of deflation, "cash is king". Everyone all of a sudden wants to see and feel his or her cash; banks are debtors; depositors are creditors. Deflation is the debtor's worst enemy; but deflation is only the creditor's friend if he or she can get paid back. More in the next post.