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.
__________
**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.
For a free subscription to our newsletters,
please click here.
Michael J. Kosares
USAGold - Centennial Precious Metals, Inc.
www.USAGold.com
Michael Kosares has over 35 years experience
in the gold business and is the founder/owner of USAGOLD-Centennial Precious
Metals. He is the author of The ABCs of Gold Investing: How to
Protect and Build Your Wealth With Gold as well as numerous magazine and internet articles. He is frequently
interviewed in the financial press and is well-known for his ongoing
commentary on the gold market and its economic, political and financial
underpinnings. For a free
subscription to USAGold’s
newsletters, please go to the USAGOLD NewsGroup
page.
|