Gold and Deflation

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 notes.

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:

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.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.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. The 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 perspective.

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 controls.

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.

Unfortunately, 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 plastic.

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 hedge.

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!

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

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 again.


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.”

Be 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.

December20, 2006

Gary 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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