Deflation: Avoiding That Sinking Feeling

Are we entering a period of declining prices? Smart business owners should hope for the best and prepare for the worst

By David E. Gumpert

Surviving deflation requires planning and preparation of a sort foreign to most entrepreneurs. After all, it's been about 70 years since the Great Depression, our last bout of deflation, when the ravages of unemployment and financial misery forced down prices and asset values across the board. Governments hate deflation even more than they detest inflation, which explains why Fed Chairman Alan Greenspan recently told Congress of his concerns about "further disinflation" rather than use the dreaded "de" word.

Where inflation is often summarized as too much demand for too few goods (leading to rising prices), deflation is a matter of too little demand for too many goods (leading to falling prices). Deflation scares central bankers for two reasons: First, it is invariably accompanied by a slowdown in economic activity and, second, it puts huge pressures on borrowers as debt becomes more difficult to repay.


  If you want a preview of what happens during deflationary periods, just look at the current cost of borrowing money: Interest rates are approaching zero, and banks still can't seem to give the stuff away. Television ads by furniture stores and auto dealers are beginning to quarrel over whose zero-percent interest rates are truly zero, and for how long and under what conditions. In certain areas of manufacturing, deflation is already a reality -- computer prices are down nearly 18%, television sets by more than 12%, and new cars 1.5% over the last year. Those figures don't begin to capture the challenges facing small businesses supplying auto manufacturers and megaretailers like Wal-Mart, which are under huge ongoing pressure to continually reduce their prices.

While the chance of large-scale ongoing deflation actually occurring is thought by most economists to be small, the odds are definitely rising -- witness recent warnings by the Fed as well as by investors in the form of soaring prices (and declining rates) of U.S. Treasury bonds. Owners of small businesses concerned about deflation can take a number of steps to reduce its ravages. In essence, the steps are the opposite of those that are most effective for dealing with inflation. Among them:

Avoid long-term borrowing, lighten up on debt. While a favored tactic during inflationary periods is to lock in fixed-rate, long-term loans with a view to repaying today's debts with less-valuable future money, during deflation, cash is king. Debt becomes an ever-more weighty burden as prices decline and margins erode. Imagine what would happen if homeowners couldn't return to the well for mortgage refinancing every time rates fell. Rates that once looked like great bargains would suddenly become onerous. Bankers aren't nearly as ready to refinance loans for owners of small businesses as they are homeowners, especially if the business' revenues and/or margins are declining. (And if home prices ever begin to show signs of decline, homeowners will run into trouble refinancing as well.)

Reduce fixed costs as much as possible. For most companies, the largest fixed costs are for employees along with office, retail, or warehouse space. One way to change labor costs from fixed to variable is to explore transforming workers from employees into contract workers. This can be tricky for existing employees because of Internal Revenue Service regulations that require certain criteria to be met before someone can be considered a contract worker, but employees whose hours are reduced from full-time to part-time can sometimes simultaneously be made contract workers who bill you for their time or projects and don't receive benefits. If you have a service business, explore ways to reduce the amount of office space you require, such as by having part-timers or contract workers share desks and offices.

Avoid long-term financial commitments. These would primarily be for rental leases and supply purchase agreements. If you have a lease expiring shortly, try to negotiate a shorter term, or even a month-to-month rental arrangement, especially if you're in an area like many right now where commercial real estate is weak. What looks like a great deal now in exchange for a two or three year price commitment might be a much better deal in six months and then require no long-term commitment. Once again, do the exact opposite of what you'd do during an inflationary period, when you try to lock in today's prices for as long a period as possible.

Find ways to reduce prices while maintaining margins. Business management 101 instructs us to continually be seeking ways to add value, and justify price increases. Under this logic, reducing prices is the path to commoditization. But during deflation, pricing logic gets turned on its head, and those companies that successfully find ways to reduce prices will survive, and possibly thrive. Prices of many manufactured goods have come down because companies of all types and sizes have shifted manufacturing to China, Mexico, and other low-cost areas, enabling price reductions with stable or even increasing margins. We've even seen price pressure on such items as prescription drugs via ordering from Canadian sources on the Internet and dental services as consumers seek out Eastern European alternatives.

The key to surviving deflation is to be as liquid as possible, because the pressures on cash flow become enormous as everyone tries to conserve cash and spend less. It's a trick, too, because deflation demands that business owners reject everything we've been taught, namely that debt provides leverage and inflation is inevitable.

David E. Gumpert is the author of Burn Your Business Plan: What Investors Really Want from Entrepreneurs and How to Really Start Your Own Business. Readers can e-mail him at

Before it's here, it's on the Bloomberg Terminal. LEARN MORE