We received this letter yesterday from a Privateer subscriber. As "luck" would have it, the next issue of The Privateer (#464 - Early December - published on Dec. 1) deals with the topic of deflation in regard to markets and the financial system as a whole. This is a good opportunity to deal with it as it specifically concerns Gold.
Before doing anything else, we must define our terms. Here are two definitions of "deflation".
The first definition comes from Fed Governor Bernanke and was included in a speech to the National Economists Club in Washington on Nov. 21 entitled: "Deflation: Making Sure "It" Doesn't Happen Here": Mr Bernanke's definition: "... a general decline in prices, with emphasis on the word 'general'."
Here is the second definition of deflation, the real one, the one which appeared in EVERY economics textbook before WW II and which is still the definition accepted by the Austrian School of economics.
DEFLATION IS A DECREASE IN THE TOTAL STOCK OF THE MEANS OF PAYMENT - OR "MONEY"
To "define" deflation as a general decline in prices is akin to defining gravity as an apple falling out of a tree. You cannot "define" a cause as being one of its minor effects. To do so, or to accept such a "definition", makes it impossible to discover what the cause actually is. That, of course, is the purpose of the modern definition of deflation (and inflation).
For a more detailed discussion of what deflation is and how it comes about, we refer you to the early December 2002 issue of The Privateer. For the purposes of this exposition about Gold, suffice it to point out that in a credit-based monetary system where almost ALL the "means of payment" is lent into existence by the banks, the quantity of the means of payment relies on the ability of individuals, businesses, and governments to BORROW - and to SERVICE the debts they have already contracted.
Should an individual or a group of individuals actually decide to start paying DOWN their debt, the total means of payment is reduced. Should an individual or group of individuals be UNABLE to service their debt and go bust, the total means of payment is reduced. This is, of course, deflationary in the true definition of the term. It is also the worst nightmare of commercial bankers, Central Bankers, and governments everywhere. That is why Mr Bernanke titled his speech: "Deflation: Making Sure "It" Doesn't Happen Here".
Naturally, in a deflation, given the fact that the quantity of the means of payment is DECLINING, one of the usual EFFECTS is a pretty general decline in prices. There are lots of other effects too. A cursory examination of the REAL EVENTS of the 1930s - as opposed to modern economists "interpretation" of these events, will bring some to light. There is massive economic hardship, burgeoning bankruptcies, an epidemic of mortgage foreclosures, huge unemployment, a falling off of wealth creation, and a refusal to take financial risks of any kind. On top of all that, there is a mad scramble to convert one's wealth to a medium which is perceived to be SAFE from either losing purchasing power too quickly and/or becoming worthless altogether.
Traditionally, that means a stampede out of financial instruments which represent an UNFINISHED transaction (ie - are based upon debt) into "cash". That is indeed what happened in historical episodes of "deflation" (or "depression") right up until the one in the 1930s, and because it happened then, most people assume that it would happen now.
Unfortunately, that assumption is WRONG. One cannot look for a precedent to the situation which exists today because there is NO historical precedent for it. Today, there is NOTHING, up to and including "cash" (aka Federal Reserve Notes or US Dollars) which is not based upon an UNFINISHED transaction (ie - a debt). All debt contracts become completed or finished in one of two ways. The debt is either repaid - or it is DEFAULTED UPON. In the world's present credit-based system, both of these are DEFLATIONARY.
It has been well and truly said that GOLD (and Silver) is the ONLY historical means of payment, or money, which is NOT someone else's liability. It is only in the past 31 years, from August 15, 1971, when the ENTIRE WORLD has had its monetary system divorced completely from Gold. Yes, in this context we include the Euro. The Euro has Gold as part of its official reserves. But the Euro is NOT convertible into Gold at any fixed ratio. The Euro is NOT a classical "money substitute". It may become one, it is NOT one now.
So, what would happen to Gold in a deflation? It would inexorably be sought out by more and more people as the ONE (yes, along with Silver in a more minor role) means of payment (and therefore store of wealth) which could be confidently expected to retain both its function as a medium of exchange and its purchasing power. Even if the Gold "price" temporarily declined, it is a very "safe" bet that it would decline far more slowly than any paper based means of payment. In such a context, of course, its purchasing power would actually advance on a comparative basis.
In the event of deflation in the US (the world's biggest external debtor), the primary factor would be debt DEFAULT. The US is already in a situation of record bankruptcies and they keep on growing. Rampant debt default in the US would immediately put the viability of the foundation of the entire global financial system - the reserve currency which is the US Dollar - into question. The reaction would be inexorable - the accelerating abandonment of Dollars and Dollar-denominated "assets" into other classes of assets. The Fed would have two choices, sit on their hands or monetise the debt. Mr Greenspan and his fellow Fed governors have already made it clear that they would NOT stand idly by, they would monetise the debt. That would, of course, transform the deflation into a runaway inflation. The end result of either, if carried to its extreme, is identical. It is the destruction of the currency.
If it IS carried to the extreme, only Gold will remain in the US, and in any other nation which persists with the US Dollar as the reserve against a local monetary system ENTIRELY based upon debt. The present global monetary system is a huge inverted debt pyramid resting on an apex which consists of US Dollars. It can implode - deflate, or it can explode - inflate. The end result will be the same.