Deflation, then inflation

Every day I read something about the worry of deflation followed by inflation. Looks to me like there isn't much that can be done to get off of this path, especially since people are horribly in over their heads in debt - there is no way that these indebted people can just start spending again no matter how much money the government prints up.

Here is such an article by Jim Kingsdale on deflation/inflation:

http://www.dailymarkets.com/economy/2008/12/23/on-the-road-to-deflation/

. . . When people defer purchases because they expect lower prices later the economy slows further and thereby causes the lower prices people expect. That reality convinces more people that prices are falling and induces more deferral of purchases, etc. This virulent feedback loop cannot be reversed by standard Fed policy tools of lower interest rates and added liquidity. The only hope is to reflate via massive government expenditures. Unfortunately, the Bush administration has left the U.S. with gargantuan debts and deficits piled on during good times, so adding massively to them now is dangerous. That’s why deflation has put fear in the heart of the Fed and the Treasury.

What is the rational investment position to take during a deflation? Cash makes sense as do bonds because deflation, by definition, means that debts must be paid off in more valuable dollars. But there are two problems with owning bonds during a deflation. One is a heightened risk of bankruptcy for all entities, corporate and governmental, which could endanger the value of the bonds. Secondly there is some risk that the enormous expected efforts by the U.S. and other governments to re-inflate the economy could push us into inflationary times again. These two risks argue for cash. In a deflation your cash is worth more in terms of purchasing power as time goes on so there is some inherent return to cash even if there is little or no interest income.

Inflation, the opposite problem and the one with which we have more experience, is favored by governments because it allows them to pay back their debts in less valuable dollars. It is also favored by investors and has been the primary condition of the economy during nearly all of the period since 1982 during which stocks have experienced superior returns. A mild inflation makes it cheaper for corporations to borrow to fund their operations because they pay back the debts in cheaper dollars. Inflation also helps them show growth. Both conditions increase earnings more rapidly. So as a general rule, it makes sense to own stocks during a period of gentle inflation but not during a period of deflation.