Gold and Deflation

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The standard
refrain is this: "Gold is an inflation hedge." The problem
with this refrain is 1980—2001. Prices in general doubled,
but gold’s price fell from $850 to $257. The only investment worse
than gold was silver.

If we define
inflation as "an increase in the money supply," then gold
is usually not an inflation hedge. The Federal Reserve System
is almost always increasing the monetary base, which in turn leads
to an increase in the various definitions of money. Yet gold did
not rise, 1913—1934, then rose because the U.S. government
re-defined the dollar from one-twentieth of an ounce of gold to
one-thirty-fifth of an ounce, i.e., devaluated the dollar by 43%.

From 1934 until
1971, the official price of gold did not rise. The dollar’s purchasing
power fell.

The number
of years in which gold’s price has risen over the last century are
few and far between: 1971—74, 1976—1980, 2001—2006.

Why wasn’t
gold an inflation hedge through most of these years? First, when
the U.S. was on a government-defined gold standard, the government
bought and sold gold in a narrow trading range. Gold was not a free
market commodity. It was a rigged commodity. That is what a government-enforced
gold standard is: a rigged market.

Second, gold
became a bubble commodity, from 1976 until January, 1980. The bubble
burst as a result of the Federal Reserve System’s tight-money policy,
launched in October, 1979. Gold fell so far that it did not recover
when the FED reversed policy in August, 1982, when the Dow Jones
Industrial Average fell below 800. The Mexican government threatened
a default on all international loans to its banks. The FED inflated,
bailing out the Mexican banks.

Gold went down
after January, 1980, as did most commodities. Anyone holding commodities
for two decades lost his shirt. Yet monetary inflation never ceased.
Neither did price inflation.


There are sellers
of gold who say that not only is gold an inflation hedge (which
it rarely is), it is also a deflation hedge. Historically, it really
has been a deflation hedge, for the same reason that it was not
an inflation hedge. Its market was rigged by the U.S. government.

During the
periods in which the U.S. government operated a gold standard, it
guaranteed a fixed price for gold. The famous $20 gold piece was
a $20 gold piece because the U.S. government stood ready to redeem
it for $20 in paper.

If prices in
general fell in a depression, people could protect themselves by
hoarding currency. This included gold.

Any currency
issued by a bank was at risk. The bank could go bankrupt (bank +
rupture). Whenever this happened, the certificates it had issued
fell in value, often to zero. Under such circumstances, the safest
currency to hold was gold. Coins were more convenient than bullion,
but both worked.

In 1862, the
U.S. government began issuing its now-famous greenback dollars:
U.S. Notes unbacked by gold or silver. These served as legal tender
(compulsory) currency. The wartime issues were limited to $450 million.
They began to be redeemed by the government in 1866, but the recession
of 1867 halted this. A total of $356 million were allowed to remain
in circulation. They are still in circulation. They are not common.
Federal Reserve Notes are the common currency.

Prior to 1862,
currencies were private, and private currencies varied in value.
There was no agency to guarantee their value. There were no legal
tender laws. Nobody was compelled to accept any bank’s currency

When gold coins
circulated, they were familiar to most Americans. They were perceived
as money. So, they were money. They functioned as money in exchange.

In times of
monetary deflation, which meant failing banks, gold did well. It
was the safest currency to own. Prices fell in relation to gold
coins. So, gold did well in deflations. A
detailed article on this is here.

There is much
talk in "gold bug" circles about gold’s performance in
a future deflation. All such talk is sheer speculation. There is
no historical data to back it up. The following facts make comparisons
with the past illegitimate:

  1. Prior to
    1933, American banks were allowed to go bankrupt, taking depositors’
    balances with them. No longer. The FDIC officially insures deposits
    up to $100,000.
  2. The United
    States government was legally obligated to pay a fixed amount
    of paper money in exchange for an ounce of .999 fine gold. This
    was a legal price floor for gold.
  3. Gold coins
    circulated as money. The public was familiar with gold.

Today, paper
currency circulates. Gold coins do not. A handful of tiny retail
coin dealerships make a market for gold coins. No one except gold
bugs and coin collectors know the price of gold coins.

Today, credit
cards function as money most of the time. These cards are issued
by banks that are protected and regulated by the Federal Reserve
System, the Comptroller of the Currency, and the FDIC. No one worries
about the solvency of his bank, other than investors in the bank
and its officers. They can lose if the bank goes under; the depositors
can’t. Or so everyone believes.

There is never
monetary deflation for as long as 12 consecutive months. A tight-money
policy produces recessions, which in turn threaten incumbents. So,
we occasionally get a few months of monetary deflation. Then the
Federal Reserve returns to the policy of inflation.

Prices year
to year have not dropped in the United States for over half a century.
The last time they did, for one year, in 1955, they dropped about
one percent.

Yet throughout
the entire period, there have been forecasters who have predicted
price deflation. They have been wrong for 50 years. This does not
faze them. Then they die.


Ever since
Bernanke became Chairman in February, the FED has been in tight-money
mode. For several months, there was actually monetary deflation.

The result
of this policy, if pursued, will be price stability. But this policy
will produce a recession. Bankruptcies will rise. Home
foreclosures, already at a million units this year, will rise.
figure was 650,000 in 2005.

This is why
there will be bipartisan support for a policy reversal.

The FED’s monetary
policy has begun to have the inevitable effect: Price inflation
is slowing. I use the Median CPI, published by the Federal Reserve
Bank of Cleveland. In June and July, it rose at .4% per month. Then
it fell to .3% per month. In November, it fell to .2%.

This means
that price inflation is not likely to continue at the rate bequeathed
to us by Greenspan’s FED.

Gold as a commodity
has been an inflation predictor since 2001. Those who bought it
in 2001 have done well. But gold has fallen from May’s $725 price.
That’s because gold’s investors perceived that price inflation would
slow. The gold market did its work well. It took until August for
the Median CPI to verify what gold’s price had forecast. It has
continued to verify this.

Gold moved
upward from its bottom at $561 on October 6. It reached $649 on
December 1. It has skidded since then.

Gold no longer
functions as money. It does function as an inflation predictor.
It is predicting reduced price inflation.


Robert Anderson
replaced me at the Foundation for Economic Education in 1973. He
studied with Ludwig von Mises. He has been an observer of the gold
market ever since the 1960s.

Recently, he
sent me an analysis of this market. He is convinced that central
bankers will not surrender their control over the financial markets.
He thinks that runaway price inflation would doom the central banks’
leverage over the markets.

Then there
is the inertia factor. Voters have short memories and little historical

Inertia is
a powerful force but over time it does wane. It’s been almost
75 years since gold was used as money in this country, and even
longer in other parts of the world. Since long before the industrial
revolution governments have controlled and manipulated monetary
affairs by money issue, banking laws, or both. In the neo-fascist
age of today’s world all monies have become totally fiat with
state control over monetary affairs absolute. Central banking
is established everywhere and government monetary authorities
fully understand that a policy of hyper-inflation in developed
countries would be monetary suicide for them.

These people
are self-interested. The name of their game is power. Their #1 task
is to keep the commercial banking system solvent. Mass inflation
is a form of insolvency. But long before outright insolvency will
come direct controls. What Nixon did in 1971 will be repeated: price

I keep reminding
myself that inflation is a fleeting tool of economic manipulation
in a hampered market economy, which can easily be supplanted by
direct controls as a social order becomes more authoritarian.

In the good
old days, gold was an alternative currency. It no longer is. In
the good old days, depositors could shut down insolvent banks with
a bank run: a demand for gold coins, which took place under deflation
and inflation. Today, this is not possible. Gold no longer serves
as a warning of looming insolvency.

today’s market price of gold is subjectively influenced by fewer
and fewer buyers remembering gold was once money and a belief
it will soon become money again. With the passing of time such
gold buyers will surely decline further.

There are few
gold bugs left in this world of digital money that is accessed by

As we all
know gold’s price has fallen in real terms since 1980, reflecting
a market transition over the years from a perspective of gold
as a former monetary good to gold as a commodity. Given the neo-fascist
world we live in today, it’s possible this market trend may continue
to impose a negative force on the market price of gold as a belief
in a price premium for gold as money continues to diminish with
time. The past divestment of gold by central banks reflects this
belief and ultimately private holders may very well start divesting
their holdings for the same reason.

In a recession,
this is highly likely. Marginal existing holders will sell gold
to get liquidity. In mass inflation, no. They will buy gold as a

We are entering
a recessionary period. While I do not expect actual price deflation,
prices are unlikely to rise as fast as they did under Greenspan’s
last years . . . not until the FED reduces policy to reverse a recession.

The case
for owning gold is in its wealth value as a non-monetary commodity
today rather than in some chimera belief that it will soon become
money again. Certainly gold’s real economic performance as a wealth
form since 1980 has been deplorable with even government bonds
out performing gold!

doesn’t think that hyper-inflation is likely. Neither do

Perhaps you
are more optimistic about the future direction of the world’s
economies than I am, but I simply cannot imagine central bankers
in hampered market economies anytime soon engaging in hyper-inflation,
followed by a return to gold as money. We live today in an age
of fiat monies manipulated by government central bankers who know
it would be an act of utter irrationality to destroy their fiat
monies and, further, know a return to gold as money would destroy
their monetary power.

He is pessimistic
regarding monetary controls of all kinds. Here is the tried-and-true
way of central bankers and politicians: "Close the escape hatches!"

I’m convinced
that today is merely a momentary era which economic forces will
change tomorrow. But rather than a return to economic liberty
and gold as money, I’m equally convinced direct controls by an
authoritarian state will prove to be the chosen alternative to
escape the economic burden of today’s welfare states. Hyper-inflation
is a relic of the "good old days" of interventionist
governments and hampered economic liberty.

He does not
rule out gold as money. Neither do I.

But he sees
it far in the future. So do I.

Of course
gold as money will eventually evolve but, unfortunately, it will
be in some far distant free society beyond our time. For at least
the near future, I believe a monetary price premium in today’s
market price of gold is driven more from past inertia than any
likelihood of imminent hyper-inflation or gold becoming money


Gold will do
well in a time of price inflation at the double-digit level, but
for now, it is subject to the same forces as any other commodity.
It is subject to the business cycle.

Gold should
be part of everyone’s portfolio — gold coins, not gold mining shares.
War is still a threat. If the United States starts a war with Iran,
oil will skyrocket, and gold will move upward with oil. But today,
the pressure is down, not up, on the price of gold and silver.

Those who tell
you that gold is a great inflation hedge should add: "If inflation
is serious and widely unexpected." Those who tell you that
gold is a deflation hedge should add: "Under a gold standard,
where the price is fixed by law."

careful when you buy gold and then hear incomplete arguments that
persuade you that gold is beyond the forces of supply and demand.
It isn’t.

20, 2006

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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