Gold & Deflation

Gold is a hedge against uncertainty – making it the perfect deflation hedge as well...

DEFLATION is a particularly pernicious economic condition, writes Julian Phillips of the GoldForecaster.com.

Deflation is far worse for economic stability and growth than inflation. Under deflation, prices decline. The impact of this is that anyone with cash sees the buying power of their savings increase, whereas the owner of assets with declining values sees the purchasing power of those assets decline.

This is only the superficial picture, however. Because as bankers and business owners know too well, it takes a long time to establish and grow a business, but a shortage of immediate cash is all it takes to destroy all that hard work. It's terrific business for a bank to take over such a business, if the business can't raise cash (and the banks can control money's availability). The banks can then buy it for a giveaway price.

It's a bit like a large man having a blood circulation problem. Interrupt that flow, and the man dies. But the actual volume of flow – crucial as it is – can be tiny compared to the mass of his entire body.

That's what happens in deflation; the lack of even small sums of cash destroy value and let the carpetbaggers move in. But with that comes loss of economic momentum and momentum equals growth. Lose that and even solid huge businesses – such as the largest car manufacturers – are destroyed.

In inflation, the buying power of cash declines, whereas the cash value of assets rises. Those who can keep their prices rising in line with inflation (and those prices include wages) actually appear to be enjoying greater wealth. Inflation promotes growth of business, provided it is not in a runaway state. Debts lose value over time as the volume of money rises and it becomes easier to repay, making borrowing attractive.

Tempering the availability of that cash – usually done by central banks through interest-rate policy – is all it takes to wind down inflation, and without causing  much damage to the economy, particularly once productive growth has momentum.

During inflationary times, then, economic growth can be controlled far better than it can during deflation, leaving an economy healthy and growing. Deflation destroys businesses, in contrast, which then take several years of healthy economy to replace. Simply put, if you fire one worker, you would have to employ two more to raise confidence to the previous level. And you need confidence to keep an economy at cruise speed. This is now dying. Momentum is starting to slow and threatens a gearshift down.

Deflation & Gold: Step forward the central banks

The Federal Reserve and other global central banks have realized that deflation now threatens. They are taking action to boost liquidity to counter this. The formula to be used is monetary inflation, which is now being harnessed to counter deflation in prices, wages and asset values.

Central banks just cannot afford to wait for deflation to take hold if they are to beat it. They have to act before it strikes in a forceful manner, aiming to raise confidence in the economy and convince the consumer above all that deflation will be averted. If the fight is left too long, the efforts and measure to counteract it have to be considerably greater than if action is taken before it takes hold.

That's why Bernanke and Paulson are staying up late at nights right now. That's why China is flooding their economy with growth projects now rather than later. That's why the G20 group of the world's richest nations agreed in mid-November that concerted action must be taken to turn inflation up to fight deflation.

Outside government, the private banks have been slaughtered by the credit crunch to date, with the bright stars of Wall Street tumbling from the sky. One of the world's very biggest banks, Citigroup, is now fighting for its survival. The $20 billion deliverance they've got from the Fed so far will not inspire them to go out to the broad economy and issue loans to re-invigorate the economy. Their guiding principles of 'prudence with profits' looks at the threat of deflation and says, "Conserve assets restrain loans until the turn around back to growth is firm on the ground."

This roughly translates into "We got saved by the Fed, but we're not lending because it's too risky." The Fed realizes this, and so it must get loans out into the economy directly to stop the rising risk of deflation.

Now that interest rates are dropping, but borrowing is not rising, what to do? The concept of zero or negative interest rates seems ridiculous and abnormal, and it inspires as much confidence as your bank manager paying you to borrow his money.

How does one avoid extreme measures, such as nationalizing the private banks outright? Chairman Bernanke, an expert on avoiding the Great Depression of the 1930s, is instituting a system of "Quantative Easing" of the money supply, dramatically expanding the money supply and keeping interest rates at near to zero levels. This gives private bankers an incentive to get that money out to the broad economy and resuscitate growth, ahead of deflation securing its iron grip. A rebuilding of economic confidence is vital right now and all other methods have not succeeded yet. There's no time to wait for them to do so either.

So yes, "Quantative Easing" is inflationary, but it is hoped that it will conquer deflation in the process...even if inflation overwhelms deflation. Inflation can be cured later, once confidence is restored in economic growth. Or so the theory runs.

Deflation Ahead? Why gold will benefit

With Gold Prices now beginning to recover from their 27.5% drop in Dollar terms, and as oil prices reach a third of their peak level, confidence is evaporating in the global economy. Uncertainty colors all decisions. Indeed, today's financial scene is dramatically different to that of July 2007, just before the crisis began. If we had described today's scenario to you then, you would have said it was impossible!

Gold Bullion fell, as all investors should know, due to the process loosely described as de-leveraging. This led to aggressive sellers pushing prices down as they were forced to close their leveraged bets on the price of gold, triggering stop-loss points and creating more selling, alongside ever-greater margin calls from brokers.

People with investments acquired against borrowed funds (led by hedge funds), were forced to sell despite their belief that the trend in Gold Investment remains up. The initiating aggressive sellers closed their positions on the way down, and then re-opened them on the rallies. But despite this, gold's plunge has been small when placed against other commodities and investment assets.

Some commentators believe that gold is simply a counter to the Dollar or an item that will rise in the face of inflation. Yes, it is surely both of these, but of immediate significance, gold is also a counter-deflationary investment, much like cash itself. This is even truer in a global context.

Gold is no one's promise to pay and is saleable anywhere in this world, for cash. But like cash itself, it gains in value as asset values drop. One has only to look at the fall of the Dow Jones Industrial index or the S&P and look at the comparative steadiness of gold in the face of forced selling. Or look at that most precious of assets that we live in, housing, to see how gold is holding its value.

But what is the reason gold could hold its own or rise in deflation, apart from its cash-value-holding-power? It is a hedge against uncertainty. When the basis for valuing paper assets, including money, become unclear, discredited or confusing, gold remains a solid, nationality-free asset...a "shelter from the storm" investment.

As we look at the market, particularly the source of that aggressive selling in Comex Gold Futures, we see that the "net long" position (bullish bets minus bearish contracts) held by speculative traders has dropped amazingly from well over 600 tonnes to close to 150 tonnes of gold. The aggressive sellers look as though they are now exposed as 'naked shorts', for even when gold was at $300 the net speculative long position was 300 tonnes.

Now, as 'forced selling' peters out, uncertainty is the only bull market left as we face deflation, and yet are attacked by inflationary expansion of the money supply. That's why I believe we will see gold's value rise and rise strongly. As most sellers have already exited the gold market, what are we left with, going forward?