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Gold and Deflation (Sept, 2002)Steve Saville When comparing the present financial market situation to the past there is a human tendency to focus on similarities and ignore differences. This often leads to mistakes in forecasting. For example, the similarities between the 1987 stock market crash and the 1929 stock market crash led many analysts to mistakenly forecast a 1930s-style depression in the aftermath of the 1987 crash. On many occasions over the past few years we've read the argument that gold will do well in a deflationary environment. In most cases the good performance of gold during the deflationary 1930s is cited in support of this view. This is, however, another example of coming to a wrong conclusion by focusing on similarities while ignoring differences. The most important difference between then (the 1930s) and now is that gold and cash US Dollars were interchangeable during the early-1930s (the deflationary period) by virtue of the fact that the Dollar was defined as a fixed weight of gold. A typical effect of deflation is an increase in the purchasing power of cash. The fact that gold and cash were officially linked during the 1930s meant the deflation caused the purchasing power of gold to increase along with the purchasing power of cash. In other words, under the monetary system that was in effect during the 1930s gold was a hedge against deflation. Furthermore, under such a system the purchasing power of gold would decrease during periods of inflation, that is, when the dollar was defined in terms of gold it would have made sense to shift investment away from gold during periods of inflation. Under the 1930s' monetary system the purchasing power of gold rose and fell with the purchasing power of the US$, whereas under today's monetary system gold will tend to maintain its purchasing power over time. Another way of saying this is that under today's system the US$ price of gold will tend to rise when the US Dollar's purchasing power falls as a result of inflation and fall if, at some point in the future, the US Dollar's purchasing power rises as a result of deflation. It isn't quite that simple since the effects of inflation vary from cycle to cycle. When inflation causes the US$ to lose purchasing power against assets such as stocks and real estate the inflation is not perceived to be a monetary problem and the gold price doesn't respond. However, a mismatch between perception and reality simply creates a divergence that will eventually be closed, usually in a big hurry after enough people recognise the divergence. In summary, under the current monetary system we think the gold price would fall against the US$ if the US experienced deflation. In a deflationary period the debts 'racked up' during the preceding inflation still need to be serviced and assets, including monetary assets such as gold, will be sold in order to obtain the dollars needed to pay off the debts. In any case, as far as the next 12 months are concerned any discussion regarding how gold will perform during a period of genuine deflation (a contraction in the total supply of money and credit) is of academic interest only since the probability that the US will experience deflation is almost zero. There are no signs that the US financial establishment has lost its ability to expand the total supply of money/credit. Rather than deflation, the change that appears to be in the wind is that the inflation is beginning to manifest itself to a greater extent in the commodity market and to a lesser extent in the stock market. Since the beginning of this year the CRB Index has quietly moved higher such that it is now only 5% below the peak reached during the final quarter of 2000. Steve Saville Regular financial market forecasts and analyses are provided at our web site: We aren't offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at: http://tsi-blog.com Saville Archives 321gold Inc |
