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Will the Gold Bull Market Deflate?

Commodities / Gold & Silver Nov 23, 2007 - 12:19 AM GMT

By: Alex_Wallenwein


Best Financial Markets Analysis ArticleOf course not. Ever tried deflating a balloon that hasn't been blown up yet? Kind of hard to do, isn't it?

When we think and talk about things, we often unknowingly accept and attach misleading labels to them, without giving it any thought at all. It's sort of a "garbage in, garbage out" principle. We accept a label others have unthinkingly given a subject, and then we run with it, which means by necessity that we are misapplying it.

It's just that way when we are thinking about gold and deflation.

The usefulness of the answers we get to our questions depend on how well we phrase our questions. Asking whether gold will 'deflate', for example, assumes that it can deflate in the first place. The question also doesn't really capture our main concern.

We don't care whether a gold bar we own will physically shrink in size. What we care about is whether, during a deflationary recession or an outright depression, its value will decrease to such an extent that it loses its utility as a hedge against untoward economic developments. That's kind of the nerdy way to put it.

The underlying concern is: "Will owning gold keep my wealth intact during a deflation?"

To answer that with any kind of intelligence, we have to first make sure we are talking about the same thing. So, the question arises: "What is a deflation"?

Most people think about deflation as a period of shrinking prices. Somehow we have all been taught to fear that - but why? If prices shrink, we can buy more with whatever money we have. Why should we fear that?

Obviously, shrinking prices alone are nothing to fear. Otherwise, we would recoil in horror every time we have to buy a new laptop computer and find out that the darn things became cheaper again! "Oh my God, what shall I do. Where will this all end up? What's the world coming to??"

Nobody reacts like that, right?

So, first of all, it's pretty clear that deflation can never exist without presupposing inflation - just like that silly analogy to the un-inflated the balloon above.

The problem lies in the fact that we have all been trained to accept the notion that inflation is inevitable, sort of like background radiation. We have no way to avoid exposure from radiation coming to us from the universe, so why worry about it? We also have no influence over the sad fact that most stuff gets more expensive most of the time, so we kind of resign ourselves to that as well.

However, inflation is far from inevitable as any gold buff already knows. It's only inevitable if we continue to live in a fractional reserve banking fiat system.

But we all do - so what now?

Most of the increase in apparent wealth we all see around us these days is probably in one way or another a direct result of the inflationary environment we live in.

  • 'Money' (aka debt-based legal tender) is created out of nowhere and circulates;
  • The law says we can buy stuff with it, so we all work hard to earn it or invest to increase it;
  • In the process of doing that, businesses decide to expand their operations by borrowing more - because it's cheap. Interest rates are low.
  • As a result, more 'money' is created as banks enter a 'credit' on the borrowing business' account;
  • Businesses hire more workers to ramp up production, more people make money and so can spend more, ramping up demand for the businesses' products, etc. etc.

Look around at all the shiny new cars everyone is driving, all the new restaurants, movie theaters, new buildings going up everywhere, and people improving their homes. Surely, we are better off than before, right?

Wrong. We are all indentured servants to our creditors, the banks. We have no savings. In the end, all of the glittery and new-looking stuff you see is just - borrowed. We just get to play with shinier toys than those we had before - but they really don't belong to us. They belong to the banks. Our individual, real wealth didn't grow at all. It shrank.

We like it that way, though, and we have all been trained to fear that it might stop someday. Now we are faced with the specter of "losing it all" because the artificially inflated economy might 'deflate.'

What is deflation, then?

A deflation is a credit contraction just like inflation is a credit expansion. Credit is debt, which means it must either be paid or defaulted upon.

When we are good little wage-serfs and pay our credit-masters what they have 'loaned' us (actually nothing), the masters are happy. Because the same people who control the banks that loaned us the money also control the media, the media tell us that we are wealthier, that we are 'better off', that we are 'happy.'

Oh, happy days!

But when we don't pay our masters, we become bad, bad people. They gave up nothing when they entered a 'credit' on our account after approving our loan. The law then allowed us to spend that 'nothing' as if it were real money, and now we have to work to earn more of that same mysterious 'nothing' to pay the bankers 'back' what they never really gave us in the first place.

Such re the mysteries of modern economic life.

Anyway, we have all been trained to regard this state of things as economic 'progress' and now we are faced with a recession.

Back to the real world.

We are living in the beginnings of a deflationary period. Credit is contracting all around us. Banks are even scared to loan money to each other.

The 'credit crunch' is nothing other than the result of homeowners being unable to pay off their mortgages. The mortgages are nothing but debt, but they represent cash flow - the contractual right to receive future payments.

These mortgages were sold to "investors" - mostly other banks - who use them as "assets" to entitle them to pyramid additional loans on top of them (banks are required to keep a certain loan-to-asset ratio which limits their ability to create deposits out of nowhere, so having "assets" is a good thing for them even if these assets in reality only consist of debt).

But now that debt is being defaulted upon, so the banks have to write them off as losses - which inevitably decreases their "asset-base" and therefore their ability to make loans.

And that means they can't make money by putting more people and businesses into debt.

So loans become more scarce, which means businesses can't finance their planned expansions as cheaply as before, so they cut back and lay people off who now don't have the income to make their mortgage payments, and the death-spiral continues.

As a result of all this, less 'dollars' (i.e., nothings) are created or they are created at a slower rate, and so less people have enough 'nothings' to support their spending habits, which reduces demand, and that, in the aggregate, causes prices to shrink.

That's why price deflation is so 'bad.' It gets people laid off.

Now back to our question: How does gold fare in such an environment?

Sorry. That's not really our question. Our question is: how does the purchasing power of gold fare in such an environment? We don't really care about gold. We care about how many 'nothings' we can sell it for so we can spend them on the stuff we need and want.

As prices for things drop, they drop for gold as well, so those who own gold are less well off and their friends who always thought they are kind of weird for wanting to own gold in the first place can turn their noses up at them and say: "Ptschhh! So what good does your gold do you now, huh?"

That's what gold owners are afraid of when they ask the question: "Will gold deflate?"

The real question is therefore: "Will the price of gold shrink in the same degree as prices of other things shrink during a deflationary period?"

Actually, that's not really the question, either. The real question is "will the purchasing power of gold decrease relative to the purchasing power of fiat during a deflationary period?"

Fiat becomes more "expensive" during deflations because it is harder to come by, either by working or by borrowing. Therefore its purchasing power increases. So, what about gold? Does its purchasing power increase as well, or does it remain static? If it remains static, holding cash is better and therefore people will sell their gold and cause the dollar-price of gold to drop further.

Before we answer that one, I have a counter-question for you: During inflationary times, do prices for all things go up the at the same rate?

No, they don't.

Look at the stock market and real estate bubbles. Look at health care. Look at rents and food prices. While stocks and real estate boomed and health care prices became a towering inferno, rents and food prices remained relatively stable, all the while prices for electronics decreased dramatically over the past ten to twenty years.

Well, the same thing is true during deflations. Not all prices fall at the same rate. Some prices might even rise as others fall or remain stable. So, which is it going to be for gold?

That depends. It depends on whether we believe the lie that gold is "just a commodity". We all know it isn't, but most people do believe that. The thing is that those who believe that nonsense usually don't own any gold, so their opinion has no effect on its price. They can't sell any.

The only people with any kind of impact on the price of gold are fund managers. Will they sell gold (or actually their contracts for gold or gold stocks that their funds own) during a deflation?That's where the reasoning takes an entirely new turn.

Because of the nature of their business and their holdings, fund managers have neither the incentive nor ability to hold actual cash. What fund managers are talking about when they say they hold cash is that their fund's money is invested in money market funds.

That's as far a cry from actual, physical cash as a gold option contracts are from gold itself.

Money funds are mutual funds that invest in short term, interest bearing debt instruments (what else is new in a world that revolves around debt?). Among the instruments they invest in are those of the commercial-paper variety.

"Commercial paper" comprises short-term debt instruments of the largest corporations around, many of whom are banks and other lenders and institutional investors - and one sub-group of what is known as commercial paper is so-called "asset-backed" paper.

Now, "asset-backed" means backed by mortgages - and many of those are of the sub-slime variety. That means commercial paper is now more risky than ever, and the deflation scenario we are examining assumed that the current credit crisis will continue and deepen.

The process of completely or largely weeding out subslime mortgages from the commercial paper markets is a long and tedious one that leads to lots and lots of companies losing their credit ratings - and those companies already include the world's largest banks.

What's a money market fund to do, then?

In such an environment, these funds are going to be looking to reduce their risk - and what do you think that means?

There are only two choices when it comes to risk reduction: Government securities - or gold.

If they pile into government securities, they drive up their prices and reduce their yields, which means lower interest rates, and that means 'dollars' (nothings) are getting cheaper to borrow again - and that, in turn, means credit inflation and mal-investment and all of the other associated evils.

But that was the root cause of the whole credit collapse in the first place, wasn't it?


Now, the real question is: Will they sell gold-related assets to buy those government debt securities, or will they liquidate other holdings to buy them? Frankly, in a risk-adverse environment, gold is still regarded as the most risk-free asset. It is the ultimate safe haven, and even the money managers know it.

Especially in the current and unbroken uptrend of gold, and in view of the fact that on an inflation-adjusted basis this six-year uptrend has not even led to gold recovering the 50 percent mark of its high in 1980, it would be foolish for them to trade astrongly appreciating, risk-free asset for riskier ones that promise lower returns.

To sum it all up: because gold is not "just" a commodity but is recognized (even by money-managers) as an excellent store of wealth in addition to being a form of money, and because risk-avoidance is the name of the game in a credit contraction, demand for gold will remain supported and its price will not suffer to the same extent as other prices in a deflating economy. (And then there is the international aspect of it all - but this article is already far too long. We will deal with that next week, maybe.)

In other words, gold is as good a form of wealth-insurance against catastrophic deflation as it is against catastrophic inflation. If you are convinced otherwise, you'll sell it prematurely at your own risk.

Got gold?

Alex Wallenwein
Editor, Publisher

Copyright © 2007 Alex Wallenwein - All Rights Reserved

Alex holds a B.A. degree in Economics and a juris doctorate in Law. His forte is research. In late 1996, he began to research how money is used by some to exert political and economic control over others' lives. In the process, he discovered that gold (along with silver) is the common man's antidote to this effort. In writing and publishing the Euro vs Dollar Monitor, he explains the dynamics of this process and how individuals can harness the power of gold in their efforts to regain their political and financial autonomy.

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is the golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

Alex Wallenwein Archive

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