I had a long conversation this weekend about what AI-driven deflation actually does to a portfolio. We kept coming back to the same uncomfortable question: if AI and robotics really compress prices the way we think they will, does the old fiat-era playbook still make sense?
In my March post on the AI abundance economy I argued that AI could break the standard “productivity goes up, stocks go up forever” story. But I didn’t spend enough time on what deflation itself actually is, and I didn’t really challenge one of the most important beliefs of almost every investor I know: that cash is trash.
After thinking this through, I don’t believe that this is automatically true anymore, because it depends on what kind of deflation you are in.
Two very different kinds of deflation
Most people, especially people trained in modern economics (like myself), think of deflation as one thing: a dangerous spiral where demand collapses, debts crush borrowers, and central banks have to rescue the system. I think that can happen, but it is only one type of deflation (‘bad deflation’), and it is the only one fiat economists are trained to worry about.
There is another kind, and that is the kind I think we are about to experience ourselves. When entrepreneurs produce more with less, and when AI and robots collapse unit costs, prices fall because production becomes genuinely cheaper. That could actually be a good thing, because in that case: Productivity goes up → lower per unit costs → falling prices → higher real purchasing power. I call this good deflation.
The 19th century industrial boom under the gold standard looked a lot like this. Real wages went up, the economy grew, and nominal prices fell. I feel we rarely talk about it because the post-1971 world (when the US abandoned the gold standard) has trained everyone to fear any price declines as if the world would come to an end.
AI deflation looks much more like the 19th century version than we have seen in the 1930s, and that means it will likely have a positive effect.
What happens to revenues and profits
For most production companies, nominal revenues will almost certainly decline. If a robot-powered factory produces 10x the output at a tenth of the labour cost, competition drags prices. This is great for consumers, but for most companies revenues will go down, unless volume explodes enough to compensate the lower price per unit.
The picture for profits is more interesting: A small minority of companies will redeploy capital into AI-based production faster than their competitors. Their unit costs collapse faster than their prices, so their margins increase and profits rise. These are the AI-first players, the early adopters.
The majority of companies won’t adapt in time, however. Legacy costs and processes will stop them from acting fast enough. I believe they are doomed to fail.
I think the total profits in the economy might go up, but they will get concentrated in very few companies. Profits for the average firm will fall. The slow movers get killed.
Index investing in times of deflation
Stock prices are discounted future cash flows. In good deflation, broad indices like the S&P 500 probably decline in nominal terms. Revenues go down for most companies, while multiples go down because investors price in lower growth.
At the same time, AI and robotics leaders could do extremely well in real terms. But watch out: because AI changes so extremely fast, even today’s winners can become tomorrow’s losers. If you don’t keep up and don’t keep investing in AI (=laying off most of your workers), others will pass you and it’s over and out. That is why I believe that all of a sudden we will see a huge increase in unemployment. Companies are forced to lay off most people in order to survive.
I keep coming back to the point I made in March: even the winners risk getting squeezed by taxes, once governments realise the labour tax base has evaporated and only the AI giants have cash flow left to bleed.
So broad market indices like the S&P 500 probably do not “moon”. Only ownership of the few winners will make you money, but you have to pick the right ones, and be willing to exchange them for better ones if you feel they are getting left behind. This is exactly why I am concentrated in AI and robotics stocks (both in the US and in China), rather than holding broad ETFs.
Holding cash
In a pure innovation-driven deflationary world, cash gains purchasing power. If prices across a broad basket of goods fall 10-20% per year, cash effectively earns a 10-20% real return without risk. That is the exact opposite of the world I have operated in for my entire investing career. In the fiat era, “cash is trash” has always been my slogan. Inflation ate your cash, so you had to be invested in the market.
But under good deflation, cash is no longer trash. It’s then an asset that becomes more valuable over time, when prices go down (with every dollar you can buy more next year than you can now). But investing in equity will still make you a lot more money. If you hold only cash, you preserve wealth but you miss the real wealth creation.
Cash will be is a reasonable short-term parking asset, but it is still suboptimal for the long run if you are an investor. Selective exposure to AI leaders beats cash, while broad index exposure probably does not. Stock indices might actually underperform cash in nominal terms. In our current economic world that is a strange sentence to write, but it is where my logic lands.
This is the opposite of the current fiat-era playbook. Under inflation, you have to be invested or you lose. Under good deflation, you can sit in cash without bleeding, but the best move is still to allocate capital to the narrow set of real winners. The “hold the whole market” advice from most financial advisors was written for an inflationary world that may be ending.
Bitcoin
And Bitcoin? Bitcoin has a fixed supply of 21 million. In a world where productivity gains are not diluted by money printing, a scarce, non-sovereign savings asset is exactly what you want. Purchasing power of BTC should rise with the deflation rate, on top of any adoption-driven appreciation. In Austrian economics terms, BTC is what honest money looks like in a world where the state has lost its monetary monopoly.
In a prosperity boom where people save more, demand for superior savings instruments will go up. Fiat cash will give you more purchasing power, but bitcoin will go up more, because it has the same monetary properties plus a fixed supply.
The nominal price of BTC measured in a deflating fiat might not “moon” the way people hope, because everything denominated in that fiat is falling. But the real value, what a Bitcoin can actually buy, will explode.
Still, there is a short-term risk: if broad markets crash, BTC often gets sold with everything else. But long term, it is the asset most aligned with a deflationary regime. That is why even though I don’t have a lot of Bitcoin exposure anymore, I still think it should be part of every balanced portfolio.
Open issues
There are still a couple of things I am not sure about. The first one is how much governments will distort this. If governments keep printing money the way they do right now, it may offset the deflationary effects. In that case scarce assets like Bitcoin would be very good to hold.
Taxation is another issue that is unclear. If everyone loses their jobs, someone has to pay for them to survive (I wrote about this in March as well). If the AI giants become the de facto tax base for a universal basic income, the after-tax returns on investing in these companies could be much lower.
Finally, it’s unclear who large the group of winners will be. If it is 10 companies globally, picking the right ones is extremely important and getting it wrong is catastrophic. If it is a hundred, diversification starts to work again. My guess is closer to ten, and they will all be AI or robot-related.
Closing thoughts
The fiat-era investor assumes three things: inflation is permanent, cash loses, and investing in an index always wins in the long run. If AI delivers the productivity revolution I think it will, all three of those will be wrong. Inflation won’t be permanent, and we will be heading into structural deflation in many categories.
Cash does not necessarily lose anymore, because in times of deflation it can earn a real return by doing nothing. Lasty, index investing may not be a smart strategy anymore. The index will be mostly a portfolio of slow movers, that get outcompeted or taxed into irrelevance.
The right portfolio in this world looks nothing like the 2000s or 2010s playbook. It is concentrated in hyper-winners, it holds Bitcoin as the non-sovereign savings asset, and it can hold cash more comfortably than before.
As always, this is not investment advice. It is just how I am thinking about it right now, and I am still figuring this out myself.