Gold and Deflation
Well-known market analyst Robert Prechter has, for many years, been forecasting an imminent deflationary collapse in the US. There's a good chance that he will eventually be proven right if he continues to make the same forecast, but we think there's little chance of him being proven right over the coming three years. Before we reiterate our reasoning -- "reiterate" because this is a topic we've covered ad nauseam since we first began posting articles on the internet way back in 1997 -- we will, however, note that if we were to begin with Mr Prechter's premise that deflation was about to occur then we would be in agreement with his market forecasts. In particular, we would be very bearish on gold.
As discussed in our September-2002 article, the reason that gold would probably NOT perform well if genuine deflation(1) occurred over the next few years is a corollary of the reason it DID perform well during previous periods of deflation over the past few hundred years (the last period of genuine deflation was, by the way, the early-1930s). Specifically, during deflationary episodes of the past gold was the official money of the land -- gold coins either circulated as currency or the world's senior currency was convertible into gold at a fixed rate -- and, as a result, it represented liquidity. All taxes could be paid in gold, all debts could be repaid in gold, and almost all purchases could be made in gold. Under such a monetary system, when the purchasing power of the national currency rose as a result of deflation there was a concomitant rise in the purchasing power of gold.
As an aside, when the national currency was convertible into gold at a fixed rate a reduction in the purchasing power of cash would result in a reduction in the purchasing power of gold. That is, when gold and the national currency were officially tied together gold would be a poor investment during periods of inflation. Of course, when the national currency was convertible into gold the amount of inflation was generally very small compared to what we've become accustomed to under the current system.
Under the current monetary system gold is not the official form of money and therefore does not represent liquidity. In particular, taxes cannot be paid with gold, debts cannot be repaid with gold unless a special agreement to do so is made between the borrower and the lender, and more than 99% of purchases cannot be made with gold. Therefore, in a situation where dollar-denominated obligations were huge and the supply of dollars was contracting many private investors would probably be forced to sell their gold in order to obtain the dollars needed to meet their financial obligations. Also, under such circumstances those who were sitting on a large amount of cash and were therefore under no pressure to sell anything would be far more likely to invest their cash in US Treasury bonds than invest it in gold. This is because T-Bonds would be one of the few places where a guaranteed income stream could be obtained. In fact, if we thought a deflationary outcome was likely over the coming few years we'd now be advocating the buying of T-Bonds during every significant dip in their price because the scene would be set for bonds to provide substantial real returns.
The last remaining official link between gold and the dollar was severed in 1971 and, not coincidentally, deflation hasn't occurred since that time. Unfortunately, this means there aren't any historical examples of how gold performs during deflation when the metal is not the official form of money. However, we can get an idea of what to expect from gold if deflation were to occur now by a) looking at how silver performed during the 1930s, and b) looking at how gold performed in Yen terms during the first half of the 1990s (the period following the bursting of Japan's credit bubble). These examples aren't ideal, but they are all we have and they are appropriate because silver was in a similar position during the early-1930s to the one in which gold finds itself today (during the 1930s silver was not the official money of day but the bulk of silver's large aboveground supply was held for monetary purposes), and although post-bubble Japan did not experience genuine deflation it came a lot closer to deflation than has any other country during the floating exchange-rate era.
Cutting to the chase, the average price of silver during 1932 (the peak of the 1930s deflation) was about 50% lower than its average price during 1929 (just prior to the start of the deflation) while the below chart shows that the gold price, in Yen terms, embarked on a powerful downward trend shortly after Japan's credit bubble burst (the bubble burst at the beginning of 1990). Japan did not experience genuine deflation during the 1990s, but between the final quarter of 1989 and the final quarter of 1990 Japan's M2 growth slowed from a double-digit rate to around 2% and remained at low levels for several years thereafter. Had Japan experienced genuine deflation it is very likely that the Yen gold price would have fallen by an even greater amount.
To summarise the above, when gold was the official form of money it was a hedge against deflation whereas under the current monetary system it is a hedge against inflation(2). We think additional inflation is by far the most likely outcome over the coming 1-5 years so it follows that we are long-term bulls on gold.
Before we re-visit our opinion that a bigger inflation problem is what the next few years hold in store we will quickly address the idea that gold, at the present time, is an effective hedge against both deflation and inflation. This idea violates the laws of logic because something can't be itself and simultaneously be something else. Or, to put it more aptly, it is not possible for something to be a hedge against one financial outcome and to simultaneously be a hedge against the opposite outcome. What this means is that if you are an investor in gold you cannot avoid taking a position on the inflation/deflation issue. It certainly makes no sense to just buy gold and assume that you are going to be fine regardless of whether we get inflation or deflation.
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