Most people think of gold as an inflation hedge. As deflation protection? Not so much.
Over the past year, we’ve seen crashing commodity and energy prices, global stock market meltdowns, and near-zero inflation in the world’s major economies. This deflationary trend has central bankers, finance ministers, and government planners worried. Deflation threatens the stability of the global banking system.
The gold price would probably drop in a full-blown deflationary crisis, at least initially. But here’s the thing: gold investors will still win.
There are three reasons why gold will defend your wealth if we’re hit with serious deflation. I’ll start with one you probably haven’t thought of:
Since the '08-'09 global financial crisis, consumers and economies have seen rolling bouts of deflation and disinflation. Nothing that serious, though, and more of a tease. In a true deflation, or full blown depression, all prices would fall dramatically, and everyday consumer products would be markedly cheaper.
The gold price would likely fall, too, but other factors will be in play. Fear of bank failures, for example, will force people to seek alternative ways to store their wealth—such as gold ownership. And it will only take a modest drop in the gold price from current levels to render most gold mining operations unprofitable. That would mean a fall in gold supply, which would subsequently help support its price.
In our view, it is not unreasonable to think that the price of gold will fall less, in relative terms, than consumer prices.
In this scenario, the purchasing power of your gold would be greater than it is today, despite the fall in its nominal price. Deflation would lower the price of things we buy. Holding a meaningful allocation of gold would raise your living standard, as each ounce of gold would purchase more goods.
And here’s the kicker: you’d get a tax deduction for selling your bullion at a loss!
Plus, if your bullion is stored at the Hard Assets Alliance, your storage fees would decline, since it’s based on the value of the metal stored.
I call that a win-win-win.
The only true instance of US deflation is the Great Depression.
The US was on a gold standard at the time, but the behavior of both the government and investors tells us that the gold price might rise in a debilitating deflation.
First, the gold price was fixed at $20.67 per ounce in 1929. Then, on April 5, 1933, President Roosevelt issued an executive order that forced “delivery” of gold owned by private citizens to be made to a bank. Less than nine months later, he raised the gold price to $35.
So, in the midst of one of the world’s most severe deflations, the US government raised the gold price.
Second, the only way citizens could really own gold after Roosevelt’s confiscation was to buy gold stocks. They crashed with the broader stock market in 1929, and then rallied into April 1930. However, when the bear market resumed in the summer of 1930, all securities sold off again—except gold stocks. Gold shares stayed flat until early 1931, when their appeal to the masses kicked into high gear.
Here’s how Homestake Mining, the largest gold miner in the US at the time, and Dome Mines, Canada’s senior producer, performed during the Great Depression.
|Company||Stock Price - 1929||Stock Price - 1933||Total Gain*|
|*Returns exclude dividends|
So while the stock market and living standards crashed, investors fled to the only form of gold they could own at the time.
We don’t know what a floating gold price would have done during the Depression. But history shows that during a period of extreme crisis, gold is sought as a refuge. Regardless of its nominal price, gold would retain its purchasing power during a deflation. Consider how valuable that would be when most other assets are in decline.
Today, every paper currency in the world is fiat, meaning each is backed by nothing other than confidence.
This precarious situation enables central banks to manipulate national currencies during periods of crisis. Since 2008, they’ve certainly shown that this is one of their core strategies.
If we descend into a deflationary morass, it is a near certainty that global central banks will react with inflationary policies. And the greater the deflation, the more extreme that reaction will be.
Although the gold price might fall in the initial stages of deflation, the response by central banks could trigger sudden inflation—an outcome that would see gold soar. Even if the outcome resulted in a 1970s-style stagflation, gold would still do well.
Deflation will not signal the end of the gold story. The reaction by global governments could ignite an inflationary crisis, a circumstance that would see investors flee to bullion.
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