How gold performs during periods of deflation, disinflation, runaway stagflation and hyperinflation

“Amid the global crisis in confidence, investors seem to be rediscovering the fact that gold has been used as money for thousands of years. In periods where black swans are no singular occurrences but are practically coming in flocks, the status of gold as a safe haven has yet again proven its worth.” - Ronald-Peter Stoferle, The Erste Group

A few years ago I did an appraisal for a client who was pledging his gold as collateral in a commercial real estate transaction. In the course of doing the appraisal, I was struck with the large gain in value. His original purchase in 2002 was in the seven figures when gold was still trading in the $300 range. His holdings had appreciated 50% after a roughly three-year holding period. (Since that appraisal, the value has risen another three times.) I asked his permission tell his story at our website as an example how gold can further one’s business plans.

"No problem at all,” he wrote by return e-mail, “I have viewed it as a hedge, but also as an alternative to money market funds. Now I can leverage it for investment purposes -- private equity and real estate mostly. The holding has averaged 7%-10% of my total assets. And I do hope to buy substantially more, when appropriate. Thanks again."

It needs to be emphasized that he was not selling his gold, but pledging it as collateral to finance other aspects of his business. Selling it would have meant giving up his hedge -- something he didn’t want to do. Instead, he was using gold to further his business interests in a transaction in which he would become a principal owner.

Upon publishing his story at the USAGOLD website, we received a letter from another client with a similar story to tell:

"I read the article in the newsletter about one of your client’s buying 1 million of gold four years ago and it now being worth $1.5 million. I have a similar true story if you would like to use it. About four years ago, I talked my father into converting about a third of his cash into gold, mostly pre-33 British Sovereigns. I bought for him from USAGOLD-Centennial Precious Metals approximately $80,000 when spot gold was about $290 per ounce. He had the rest of his money in 1-2% CDs in the bank. My father passed away recently and I am executor. He willed my brother $250,000 which was essentially all of his gold and cash. I gave my brother the gold along with the bank CDs. While the CDs had earned barely a pittance in those 4 years the gold had become 41% more valuable.

"So instead of receiving $250,000 my brother really received about $282,800 ($80,000 x 141% = $112,800 or + $32,800). Had my father converted all his paper money to gold my brother would have received $352,500. Ironically my father was very conservative and didn't like to gamble. In this case his biggest gamble was watching those CDs smolder and not acquiring real money -- gold."

(Author’s note: Today this client’s holdings have nearly tripled in value again to nearly $350,000. A modest inheritance has become quite valuable.)

It is interesting to note that both clients view their gold as a savings and safe haven instrument as opposed to an investment for capital gains -- a viewpoint very different from the way gold is commonly portrayed in the media. An interesting sidenote to their successful utilization of gold is that it occurred in the predominantly disinflationary environment of the “double-ought” decade (from 2000-2009) when inflation was moderate -- a counter-intuitive result covered in more detail below.

Now, as the economy has gotten progressively worse, many investors are beginning to ask about gold’s practicality and efficiency under more dire circumstances -- the ultimate black swan, or outlier event like a deflationary depression, severe disinflation, runaway stagflation or hyperinflation. The following thumbnail sketches draw from the historical record to provide insights on how gold is likely to perform under each of those scenarios.

Gold as a deflation hedge (United States, 1933)

Webster defines deflation as “a contraction in the volume of available money and credit that results in a general decline in prices.” Typically deflations occur in gold standard economies when the state is deprived of its ability to conduct bailouts, run deficits and print money. Characterized by high unemployment, bankruptcies, government austerity measures and bank runs, a deflationary economic environment is usually accompanied by a stock and bond market collapse and general financial panic -- an altogether unpleasant set of circumstances. The Great Depression of the 1930s serves as a workable example of the degree to which gold protects its owners under deflationary circumstances in a gold standard economy.

First, because the price of gold was fixed at $20.67 per ounce, it gained purchasing power as the general price level fell. Later, when the U.S. government raised the price of gold to $35 per ounce in an effort to reflate the economy through a formal devaluation of the dollar, gold gained even more purchasing power. The accompanying graph illustrates those gains, and the gap between consumer prices and the gold price.

Second, since gold acts as a stand-alone asset that is not another’s liability, it played an effective store of value function for those who either converted a portion of their capital to gold bullion or withdrew their savings from the banking system in the form of gold coins before the crisis struck. Those who did not have gold as part of their savings plan found themselves at the mercy of events when the stock market crashed and the banks closed their doors (many of which had already been bankrupted).

How gold might react to a deflation under a fiat money system is a horse of another color. Economists who make the deflationary argument within the context of a fiat money economy usually use the analogy of the central bank “pushing on a string.” It wants to inflate, but no matter how hard it tries the public refuses to borrow and spend. (If this all sounds familiar, it should. This is precisely the situation in which the Federal Reserve finds itself today.) In the end, so goes the deflationist argument, the central bank fails in its efforts and the economy rolls over from recession to a full-blown deflationary depression.

During a deflation, even one under a fiat money system, the general price level would be falling by definition. How the authorities decide to treat gold under such circumstances is an open question that figures largely in the role it would play in the private portfolio. If subjected to price controls, gold would likely perform the same function it did under the 1930's deflation as described above. It would gain in purchasing power as the price level fell. If free to float (the more likely scenario), the price would most likely rise as a result of increased demand from investors hedging systemic risks and financial market instability (as was the case globally during the 2008 credit meltdown).

The disinflationary period leading up to and following the financial market meltdown of 2008 serves as a good example of how the process just described might unfold. The disinflationary economy is a close cousin to deflation, and is covered in the next section. It provides some solid clues as to what we might expect from gold under a full deflationary breakdown.

Gold as a disinflation hedge (United States, 2008)

JUST AS THE 1970s REINFORCED GOLD'S EFFICIENCY as a stagflation (combination of economic stagnation and inflation) hedge, the 2000's decade solidly established gold’s credentials as a disinflation hedge. Disinflation is defined as a decrease in the inflation rate over time, and should not be confused with deflation, which is an actual drop in the price level. Disinflations, as pointed out above, are close cousins to deflations and can evolve to that if the central bank fails, for whatever reasons, in its stimulus program. Central banks today are activist by design. To think that a modern central bank would sit back during a disinflation and let the chips fall where they may is to misunderstand its role. It will attempt to stimulate the economy by one means or another. The only question is whether or not it will succeed.

Up until the “double oughts,” the manual on gold read that it performed well under inflationary and deflationary circumstances, but not much else. However, as the decade of asset bubbles, financial institution failures, and global systemic risk progressed, and gold continued its march to higher ground one year after another, it became increasingly clear that the metal was capable of delivering the goods under disinflationary circumstances as well. The fact of the matter is that during the 2000s even as the inflation rate remained relatively calm, gold managed to rise from just under $300 per ounce in January, 2000 and rise to well over $1000 per ounce by December, 2009 -- a rise of 333% over the ten-year period.

Following the collapses of Bear Stearns, AIG and Lehman Brothers in 2008, gold rose to record levels and firmly established itself in the public consciousness as perhaps the ultimate asset of last resort. As the economy flirted with a tumble into the deflationary abyss, it encouraged the kind of behavior among investors that one might have expected in the early days of a full deflationary breakdown with all the elements of a financial panic. Stocks tumbled. Banks teetered. Unemployment rose. Mortgages went into foreclosure.

Gold came under accumulation by investors concerned with a major breakdown in the international financial system. In 2009, U.S. Gold Eagle sales broke all records. Reports filtered into the gold market that bullion gold coins simply could not be purchased. The national mints globally could not keep up with demand. In September, 2008 when the crisis began, gold was trading at the $750 level. As 2010 drew to a close, it crossed the $1400 mark as investors reacted to an announcement by the Federal Reserve that it would begin a second round of quantitative easing (money printing) to deal with the very same crisis that began in 2008. All in all, gold proved to be among the most reliable assets under stubborn and trying disinflationary conditions.

Gold as a hyperinflation hedge (France, 1790s)

ANDREW DICKSON WHITE ENDS HIS CLASSIC HISTORICAL ESSAY on hyperinflation, "Fiat Money Inflation in France," with one of the more famous lines in economic literature: "There is a lesson in all this which it behooves every thinking man to ponder." The lesson that there is a connection between government over-issuance of paper money, inflation and the destruction of middle-class savings has been routinely ignored in the modern era. So much so, that enlightened savers the world over wonder if public officials will ever learn it.

White’s essay tells the story of how good men -- with nothing but the noblest of intentions - can drag a nation into monetary chaos in service to a political end. Still, there is something else in White's essay -- something perhaps even more profound. Democratic institutions, he reminds us, well-meaning though they might be, have a fateful, almost predestined inclination to print money when backed against the wall by unpleasant circumstances.

Episodes of hyperinflation ranging from the first (Ghenghis Khan’s complete debasement of the very first paper currency) through the most recent (the debacle in Zimbabwe) all start modestly and progress almost quietly until something takes hold in the public consciousness that unleashes the pent-up price inflation with all its fury. Frederich Kessler, a Berkeley law professor who experienced the 1920s nightmare German Inflation first-hand, gave this description some years later during an interview: “"It was horrible. Horrible! Like lightning it struck. No one was prepared. You cannot imagine the rapidity with which the whole thing happened. The shelves in the grocery stores were empty. You could buy nothing with your paper money."

Towards the end of “Fiat Money Inflation in France,” White sketches the price performance of the roughly one-fifth ounce Louis d’ Or gold coin:

“The louis d'or [a French gold coin .1867 net fine ounces] stood in the market as a monitor, noting each day, with unerring fidelity, the decline in value of the assignat; a monitor not to be bribed, not to be scared. As well might the National Convention try to bribe or scare away the polarity of the mariner's compass. On August 1, 1795, this gold louis of 25 francs was worth in paper, 920 francs; on September 1st, 1,200 francs; on November 1st, 2,600 francs; on December 1st, 3,050 francs. In February, 1796, it was worth 7,200 francs or one franc in gold was worth 288 francs in paper. Prices of all commodities went up nearly in proportion. . .

Examples from other sources are such as the following -- a measure of flour advanced from two francs in 1790, to 225 francs in 1795; a pair of shoes, from five francs to 200; a hat, from 14 francs to 500; butter, to, 560 francs a pound; a turkey, to 900 francs. Everything was enormously inflated in price except the wages of labor. As manufacturers had closed, wages had fallen, until all that kept them up seemed to be the fact that so many laborers were drafted off into the army. From this state of things came grievous wrong and gross fraud. Men who had foreseen these results and had gone into debt were of course jubilant. He who in 1790 had borrowed 10,000 francs could pay his debts in 1796 for about 35 francs.”

Those two short paragraphs speak volumes of gold’s safe-haven status during a tumultuous period and may raise the most important lesson of all to ponder: the roll of gold coins in the private investment portfolio. According to an International Monetary Fund study by Stanley Fischer, Ratna Sahay and Carlos Veigh (2002) "the link with the French revolution supports the view that hyperinflations are modern phenomena related to printing paper money in order to finance large fiscal deficits caused by wars, revolutions, the end of empires and the establishment of new states." How many Americans can read those words without some degree of apprehension?

Gold as a runaway stagflation hedge (United States, 1970s)

IN THE CONTEMPORARY GLOBAL FIAT MONEY SYSTEM, when the economy goes into a major tailspin, both the unemployment and inflation rates tend to move higher in tandem. The word “stagflation” is a combination of the words “stagnation” and “inflation.” President Ronad Reagan famously added unemployment and inflation together in describing the economy of the 1970s and called it the Misery Index. As the Misery Index moved higher throughout the decade so did the price of gold, as shown in the graph immediately below.

At a glance, the chart tells the story of gold as a runaway inflation/stagflation hedge. The Misery Index more than tripled in that ten-year period, but gold rose by nearly 16 times. Much of that rise has been attributed to pent-up pressure resulting from many years of price suppression during the gold standard years when gold was fixed by government mandate. Even after accounting for the fixed price, it would be difficult to argue that gold did not respond readily and directly to the Misery Index during the stagflationary 1970s.

In a certain sense, the U. S. experience in the 1970s was the first of the runaway stagflationary breakdowns, following President Nixon’s abandonment of the gold standard in 1971. Following the 1970's U.S. experience, similar situations cropped up from time to time in other nation-states. Argentina (late 1990s) comes to mind, as does the Asian Contagion (1997), and Mexico (1986). In each instance, as the Misery Index rose, the investor who took shelter in gold preserved his or her assets as the crisis moved from one stage to the next.

Fortunately, the 1970's experience in the United States was relatively moderate by historical standards in that the situation fell short of dissolving into either a deflationary or hyperinflationary nightmare. These lesser events, however, quite often serve as preludes to more severe and debilitating events at some point down the road. All in all, it is difficult to classify stagflations of any size and duration as insignificant to the middle class. Few of us would gain comfort from the fact that the Misery Index we were experiencing failed to transcend the 100% per annum threshold or failed to escalate to a state of hyperinflation and deflation. Just the specter of a double-digit Misery Index is enough to provoke some judicious portfolio planning with gold serving as the hedge.

A portfolio choice for all seasons

A BOOK COULD BE WRITTEN ON THE SUBJECT OF GOLD AS A HEDGE against the various ‘flations. I hope the short sketches just provided will serve at least as a functional introduction to the subject. The conclusion is clear: History shows that gold, better than any other asset, protects the portfolio against the range of ultra-negative economic scenarios, such so-called black swan, or outlier, events as - deflation, severe disinflation, hyperinflation or runaway stagflation.

Please note that I was careful not to favor one scenario over the other throughout this essay. The argument as to which of these maladies is most likely to strike the economy next is purely academic with respect to gold ownership. A solid hedge in gold protects against all of the disorders just outlined and no matter in which order they arrive.

I would like to close with a thoughtful justification for gold ownership from a UK parliamentarian, Sir Peter Tapsell. He made these comments in 1999 after then Chancellor of the Exchequer, Gordon Brown, forced the auction sale of over half of Britain’s gold reserve. Tapsell’s reference to “dollars, yen and euros” has to do with the British treasury’s proposal to sell the gold reserve and convert the proceeds to “interest bearing” instruments denominated in those currencies. Though he was addressing gold’s function with respect to the reserve of a nation-state (the United Kingdom), he could have just as easily been talking about gold’s role for the private investor:

“The whole point about gold, and the quality that makes it so special and almost mystical in its appeal, is that it is universal, eternal and almost indestructible. The Minister will agree that it is also beautiful. The most enduring brand slogan of all time is, 'As good as gold.' The scientists can clone sheep, and may soon be able to clone humans, but they are still a long way from being able to clone gold, although they have been trying to do so for 10,000 years. The Chancellor [Gordon Brown] may think that he has discovered a new Labour version of the alchemist's stone, but his dollars, yen and euros will not always glitter in a storm and they will never be mistaken for gold."

These words are profound. They capture the essence of gold ownership. In the decade following the British sale, gold went from $300 per ounce to over $1400 per ounce -- making a mockery of what has come to be known in Britain as Brown’s Folly. The “dollars, yen and euros” that the Bank of England received in place of the gold have only continued to erode in value while paying a negligible to non-existent return. And most certainly they have not glittered in the storm. What would the conservative government of the new prime minister, David Cameron, give to have that 415 tonnes of gold back as it introduces austerity measures in Britain and attempts to undergird the pound?

Returning to the stories told at the top of this essay, these are just two accounts among thousands that could be swapped among our clientele.** I receive calls regularly from what I like to call the “Old Guard” -- those who bought gold in the $300s, $400s and $500s, even the $600s. Many had read The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold. Some have become very wealthy as a result of those early purchases. The most important result though is that these clients managed to maintain their assets at a time when others watched their wealth dissipate. Gold has performed as advertised -- something it is likely to continue doing in the years ahead. After all is said and done, as I wrote in The ABCs many years ago, gold is the one asset that can be relied upon when the chips are down. Now more than ever, when it comes to preserving assets, gold remains, in the most fundamental sense, the portfolio choice for all seasons.
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**Note to the “Old Guard” - If you would like to share your story about gold ownership with a large audience, please send it to me at mjk@usagold.com. Your identity will be strictly protected. If we get enough responses, I hope to publish them in a special Holiday edition of the newsletter -- a bit of sharing I think we would all enjoy. In return, for each story published, we will send a 2010 U.S. Silver Eagle. (This offer applies to USAGOLD-Centennial Precious Metals clientele only.) All stories must be received by December 15, 2010.

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Michael J. Kosares

USAGold - Centennial Precious Metals, Inc.