Gold News

What Will Happen With Deflation?

Will there be deflation, what will it mean...?

NEWSLETTER WRITER Michael Berry, PhD, is a respected economic strategists and a frequent to contributor to The Gold Report. On this occasion, Michael's son, Chris Berry, joins the discussion on deflation and protection methods. They address the problems and likelihood of deflation, as well as the ways you can protect yourself from it.

The Gold Report: People are hearing and reading about the potential for deflation. On its surface, paying less for everyday items seems like a good thing, but please paint us a picture illustrating why we should all fear deflation.

Michael Berry: I want to point out that deflation isn't foreordained; it just looks likely. Given the history over the last two or three years, where there's been a lot of money printed, some people have assumed that we would hyperinflate. But when you look at the macroeconomics in the US, you see almost 10% unemployment and in various groups it's much higher. It really looks like we're not going to pull out of this, and then you have the overhang with respect to debt. There's a lot of potential for deleveraging, for a higher Dollar, as Dollars are sought to deleverage.

People fear deflation because basically, nobody's really experienced it since the Great Depression. Central bankers think they can do something about inflation; Paul Volcker did in the early 1980s, but central bankers don't really have tools to deal with deflation. Deflation occurs when the money supply shrinks; prices tend to fall in a deflationary environment, and there's not very much you can do except let it run its course. This is very painful.

The other aspect of a deflationary environment is that if you have a lot of debt, either public debt or corporate debt, deflation works against you. On the other hand, inflation works for the debtor; deflation works against him. In that kind of environment the system wants to deleverage, and consequently asset values fall, demand for Dollars rises as the system deleverages. The value of the Dollar increases; interest rates tend to fall. Basically, the bond market strengthens but not the stock market. It also introduces a completely different investment scenario for individual and for institutional investors.

TGR: If such a scenario did occur, how long would it last?

Michael Berry: That's really a tough question, but a very important one. If you talk to some of the top economists, such as Professor Krugman, who believe that we're going to head into a deflationary spiral, the consensus is two to five years. We're probably a year into that now. When you look around and you see what's happening with Greece and the European banking system, the overhang on growth is significant. You're going to witness significant austerity programs in Europe; growth is going to be restrained. And perhaps the only place on earth right now that wants to continue fiscal spending is Washington. Of course, if you look at the Japanese situation, starting in about 1990, they've never really been able to inflate out of their problem. Deflation can last for a very long time if bankers don't get hold of it.

You remember back in 2002 then Fed Governor Ben Bernanke said we could cure deflation because we have a printing press, meaning that we can print Dollars. They've tried to do that and it's failed. The fiscal programs they've put in place really have not worked to restore growth, and it does not look as if they're going to.

TGR: Given what you said about deflation being a problem for those carrying debt, it seems deflation would have a larger impact on the US than other nations.

Michael Berry: That's an interesting thought; actually, because we have the world's reserve currency, we can continue to borrow for awhile. But at what point does the rest of the world say, "No, we're not going to bank the Dollar anymore?" Then, the level of deficit and the debt to GDP ratios become very, very large and serious. No one knows when that tipping point in the US is; that's the problem.

TGR: What would happen to Gold Prices in a deflationary environment?

Michael Berry: I am not sure. Most people would say that gold works well in an inflationary environment, and it appears to, because it holds its value well; at least some gold stocks did well in the Great Depression. I think there's another rationale in this particular environment we're in now; gold isn't necessarily being viewed as either a deflation hedge or an inflation hedge, but more likely a flight to safe currency or real money. In other words, gold is becoming money because of what people are finally beginning to understand. People distrust the Euro. They really don't trust the Yen. They don't trust the Chinese Yuan; and people are slowly but surely losing trust in the US Dollar. I think under a nascent deflationary environment that we have now, where the Gold Price is around $1,200, it's more a flight to safety than a hedge against deflation.

TGR: In July's Morning Notes, you refer to having precious metals exposure in an ever-weakening economy as another leg of the survivor stool. In your view what's the best way for investors to gain precious metals exposure?

Michael Berry: I think it's pretty critical that you look at what's happening with fiat money. We've only been on fiat money since 1971, thanks to President Nixon. That's 39 years now, and you know fiat money is going the way of the wind. I think you've got to have precious metals, either silver or gold, preferably gold, and you need to have some in-kind. I think you need to own coins or, if you can afford it, some bars and also some exposure to some top-quality stocks.

TGR: Yes, you're a big believer in silver.

Michael Berry: We've spent a lot of time analyzing silver. I was involved in a big gold-silver find a few years ago, which was Penasquito, and that is now over a billion ounces of silver. I think silver is undervalued. Silver was the original money, if you will, that was used in the ancient days. The Greeks used silver from Laurion to defeat the Persians and restore democracy in Athens in the fourth century BC. When FDR sponsored the special silver purchase in 1934 some academics believe he broke the back of deflation. I think silver is very much undervalued, and it will be pulled along with gold. It's very wise to have silver exposure, and with silver you can actually afford to own it in-kind. You can own silver coins. We've seen silver go from $4 maybe eight or nine years ago to about $18 today. Silver hasn't performed quite as well as gold, but it's moved up well.

Chris Berry: Silver's one main difference from gold is that silver is an industrial metal as well as an investment metal. It sort of depends on your view of where you think the markets are going, but the "poor man's gold" is certainly one way to accumulate hard assets and protect against some of these geopolitical hiccups.

TGR: Going back to Michael for a second, what are the other legs on that stool?

Michael Berry: After I came out of academia and spent some time on Wall Street, I began to realize that despite the fact that some of these markets were moving up significantly, we still had the potential for a deflationary depression. I don't think we're going to have a depression, but certainly we could have a double dip here, so we developed what I believed would be an investment approach for all seasons. We called it a barbell. At one end of the barbell you want to own precious metals, primarily gold and silver, in the forms that we talked about. At the other end you want to be in cash. Deflation is much more likely today than it was a year ago. Following a two-to five-year hiatus of deflation, I think we could inflate out of this and have very high rates of inflation. The barbell portfolio could conceivably work in all economic "seasons."

Essentially, precious metals and cash were what I call two legs of the survival stool at this point.

And then, of course, the third leg. Discovery is going to go on because we have to continue to make discoveries in high tech, resources and biotech. I think you need to own a discovery portfolio that's suitable for your risk preferences, and that's the third leg of the stool.

TGR: You're slated to talk to the Fed about emerging economies, which provide the high percentage economic growth that investors want. Can you tell us a little bit about the importance of emerging economies and some highlights from your presentation?

Michael Berry: You're beginning to see the impact of debt, the overhang of debt, spread to the rest of the world, particularly in Europe. Some of the dangers are coming from countries such as Greece, Spain, Italy and Ireland, and perhaps Austria and France as well. The banking systems are being stress tested, but no one believes the test will be strong enough. Other than Canada–which I think is probably held in the highest regard for not having allowed its banking system to go into freefall–the countries that appear to have weathered the storm are the emerging markets. Colombia, Chile, China, India, Brazil and probably Russia all obviously have a lot of natural resources and growing populations.

At this stage of the game, it seems that the engine of growth will come from the emerging world because the emerging world must provide its citizens, who have been denied a better quality of life, new opportunities. That is where the infrastructure build will be; demand for energy will come from this. I think the emerging markets are going to be very important to global economic growth in the next five to 10 years.

Chris, you're involved in that area.

Chris Berry: I would really echo what you said and add that emerging markets will be important engines of growth for arguably longer than the next five to 10 years. It may be perhaps 20 to 30 years, as the debt burden in the West–we are hopeful–slowly unwinds. Everybody talks about the BRICs (Brazil, Russia, India and China). A huge amount of growth has been, and still is, coming from those four countries in particular, but I see a number of other interesting plays out there as well, Colombia being one of them. Mexico has a lot of problems, but still some substantial economic growth potential from the mining industry there.

Going back to what we were talking about beforehand with deflation, every Dollar of debt you issue is going to have to be paid back, and it ultimately can't be paid back with additional debt. It's going to have to be paid back with organic growth, and when you see China growing at 10% and India growing at 8% and Colombia growing at 4.5%, that's the type of growth an economy needs to sustain to ultimately maintain a healthy fiscal balance. The growth in emerging markets isn't debt-fueled growth the way it has been in the US and in Europe. When you look at it from a standpoint of fiscal balances, it's definitely going to be the emerging markets that lead us out of this over the long run.

TGR: You mentioned Colombia running at 4.5% growth. Michael, you were born in Colombia. Tell us about what's changed in that country.

Michael Berry: I think what's changed is the leadership, and leadership is everything. There's been a freely run election; democracy is now in place. The drug problems are under control. I'm delighted; I've chaired a couple of Latin American mining congresses, and they care about capital coming into the country; they care about safety, about laws, about the environment. Colombia is rich in gold, uranium, emeralds and oil. Oil is another big area in Colombia now, which is where my father was working when he was there in the 1930s and 1940s. In fact, there's a really big stampede into the country to explore for oil. There's plenty of it there.

TGR: Moving north, one of your Morning Notes had a little bit about the Yukon and how it's a hot play. You talked about three categories of discovery companies: incubator, mature and legacy. What are some Yukon plays in each of those categories?

Michael Berry: The Yukon is hot indeed. A huge gold belt goes through it called the Tintina Gold Province, where pretty high-grade gold is near the surface. And of course, it's in Canada. The stars are almost aligning. People want to go to Canada for a good reason; it's a stable country with great resources, and the Yukon is underexplored. I think in a few years this Tintina Gold Province will look like Nevada's Carlin Trend looked in the early days.

TGR: How do you define political will?

Chris Berry: The Yukon has a single window regulatory process so that there's no going back and forth to Ottawa to try to get mining permits; everything happens through Whitehorse (Yukon's capital). This process is known as "devolution" and has made the permitting process much more efficient.

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