A Dear Reader asks:
“I am a New Zealand subscriber to Markets and Money and a reader of Empire of Debt.
“I realise many of the arguments for inflation as being good for gold. Where I have trouble is making a case for gold rising during deflation. The fact that gold rose in value in the 1930’s I believe is not relevant. The U.S.A. is off the gold standard and cannot arbitrarily change the price of gold.
“So, how does deflation increase peoples’ desire to hold gold?”
The case for gold is obvious when consumer prices are rising. Gold tends to rise along with them…and then races ahead, as people turn to gold to protect themselves from inflation.
How about when prices are falling? Isn’t it better to hold onto to cash – even paper currency – rather than gold? Well, yes…and no. Falling prices mean that the currency itself is becoming more valuable. As long as that is happening, gold is not needed for protection – at least, not against falling currency.
But when prices fall, typically, they do not fall alone. Instead, they come plunging down along with businesses, junk bonds, hedge funds, stocks, careers, property values, retirement plans and credits of all sorts. People become worried about the quality…that is, the real value…of their assets. They look for something solid to hold onto…a way to protect their assets from markdowns, defaults and bankruptcies. Gold, the only credit that is not also someone else’s debit, is a good way to avoid depression-style losses. You don’t have to worry about someone making his monthly payments, or a business paying its quarterly dividend or making good on its bond coupons. Gold pays no dividends or interest. But investment returns go negative in a deflationary slump; as we pointed out yesterday, the ‘cost’ of holding gold goes down…and then turns, relatively, positive.
Another thing that happens when economies face deflation is that monetary authorities tend to panic. Pretty soon…up is down…down is up. A genuine consumer price deflation in America or Britain would be so painful our central banks, and our political leaders, couldn’t stand it. Consumers have too much debt. How they’d howl!
This summer, equity prices fell less than 10%. Still, within days, it sent central banks scrambling to get more credit into the system. Imagine what would happen if stocks went down 20%…or 50%! Ben Bernanke said he would drop paper money out of helicopters, if that were what it took to avoid consumer price deflation. We don’t have to tell you want would happen to the value of the currency. Even before the helicopters took off, it would be in freefall…with gold rising on the other side.
Markets and Money