Gold, Money, Wealth

How a rising Gold Price actually signals deflation, not inflation, when it's held as money...

"YOU MAY HAVE green shoots, or whatever you want to call them, and you may have temporary relief, but you are still in a world that's breaking," Black Swan author Nassim Taleb told CNBC's Squawk Box, says Dan Denning in the Daily Reckoning Australia.

"Anything that's fragile like the financial system will eventually crash," he said. "We're in the middle of a crash...So if I'm going to forecast something, it is that it's going to get worse, not better."

Taleb's point is not a popular one. But it is a realistic one. The fiat money and leveraged finance that took Western investment global in the last twenty years provided an epic rise in asset prices (and the debt used to purchase them). There's no doubt that real goods and services have traded hands with world growth. But now we wonder how much of that is sustainable when you take the credit away.

Did we use phoney money to build a world with completely unrealistic levels of growth? Were trillions of Dollars of capital allocated based on final demand that was artificially pumped up by credit, currency manipulation (low US interest rates and global Dollar pegging), and government stimulation?

Well, yes we did! Mind you, the crash of the financial system is not the end of the world. It is a massive calamity to be sure, wiping out the value of retirement assets many people were counting on to make it through their golden years. But as many readers have reminded us in the last few months, there is more to life than money.

Fair enough. But there is more to wealth than money too! Peace of mind, having your assets in forms that can't be inflated away or won't suffer from debt deflation...we would count these as "wealth" at a time like this.

That brings us back to the problem growing at the back of our mind yesterday. Can a massive deflating credit bubble nullify the liquidity measures by central bankers, which are puny in comparison to the nominal value of the assets at risk? "Yes you can!" comes the answer from some of the friends we put the question to.

"I'm tempted to disagree that expansion in government credit won't reach the economy and therefore won't be inflationary," replied Money Morning editor Kris Sayce. "If I'm not mistaken, the Fed is buying up these 'assets' in order to take them off the banks and also to help price them. If the Fed didn't do this then the banks wouldn't be able to lend extra money to customers as they would breach their lending limits.

"It's not so much that the Fed is directly feeding the banks money which flows through to the economy, it's more that the Fed is feeding the banks money which allows them to expand lending which they otherwise wouldn't be able to do. Thus at the very least is preventing prices from falling, or from falling as much as they ordinarily would without the intervention. In effect there is more money flowing in than there otherwise would be. There already IS inflation."

Another colleague in the States replied that, "I am leaning more and more to the idea that the credit-based stuff will deflate (real estate, stock prices) but the cash-based stuff could rise (like foodstuffs, energy). In a way, it's not a debate about inflation or deflation, but which assets inflate and which deflate. There might be a strong dichotomy within the economy between the two."

To the extent that you cannot eat a mortgage-backed security, we see the wisdom in this view. The world has a lot of people. They have a lot of real needs. Regardless of the value of derivatives and opaque financial assets, a certain level of economic activity for a certain kind of tangible good will still be there. The challenge for investors is to determine if you can profit from this in traditional ways (stocks and bonds) or if you have to venture into less traditional asset classes and forms of ownership (land, real commodities, precious metals).

And of course, the thesis could be incorrect. If credit is not money – or if the large lending and government guarantee programs don't reignite a lending boom in the real economy – then you may simply see a lot of wealth disappear down the memory hole.

Finally, a mystery Aussie commentator who wishes to remain anonymous sent this philosophical yet practical reply.

"What is money? Currently, that's what the Federal Reserve (and other central banks) put in the reserve accounts of their member banks. The banks then use this as a base to create their own money, or 'like money'.

"I guess this is also known as credit. So yes, credit is not money. And this bank credit is now contracting as the natural force of the market tries to drive prices lower and correct the boom. The Fed is offsetting this process by swapping 'money' (fed funds) for the impaired assets. But the banks are sitting on the cash, and obviously do not have the risk appetite (or the demand) to lend it out.

"So at this point additional base money is not being lent out as inflationary 'like money'. I'm not sure the Fed has the mechanism to make out-and-out purchases of assets other than through lending facilities, unless they are Treasury or Agency purchases. As far as I'm aware, the Fed can only distribute its newly created money through the banking system, and no other way. The banks have always been the source of inflation, and then need to lend to create this. They will probably use their excess reserves to buy Treasury's in the coming years, and then the Fed can but the Treasury's back off them in time. This will be inflationary.

"Where does Gold Bullion come into it? Well, gold is real money...chosen independently by the people. As trust in the US Dollar continues to evaporate, demand for gold will increase. At some point gold will again be referred to as money. Because the amount of credit (debt) in the world dwarfs the amount of gold, and because gold will be a legitimate extinguisher of the debt, gold will likely rise massively to have the capacity to extinguish the debt. This is a process unfolding over years though.

"A rising Gold Price is actually deflationary in that it represents a rise in the purchasing power of money. So I think deflation is the ultimate force that cures this massive credit bubble...outright deflation if long term faith in the US Dollar remains, or Gold Price-induced deflation should the bottom fall out of US Dollar trust. The quantity of US Dollars may be rising at the moment but the real turning point will be when the perceived quality of the Dollar declines.

Hmm. Gold rising indicates the rising value of cash...because gold is money. But if money is not wealth...and gold is money...does this mean gold is not wealth? Now there is something to think about.