Can Gold go up in a deflationary environment?

Robert Wutscher
The Shadow Economist
Posted Apr 6, 2013

Obviously it did during the Great Depression. But that was because gold was the backing to money. Today, or so the argument goes, it is not. It trades pretty much as any other commodity. It is therefore subject to the same vicissitudes and moods as any other commodity.

Deflationists Robert Prechter and Harry Dent argue (or have for a long time been arguing) that the price of gold in Dollars will fall along with the price of all other asset classes. The underlying premise is that gold is not money, but trades with the same vicissitudes as other asset classes, where the monetary unit is the Dollar. Robert Prechter bases his theory on swings in social mood and Harry Dent on lifecycle generational changes (baby-boomers having an appetite for less goods–or changing typology of goods–and more money as they go into retirement). An auxiliary premise is that at times of deflation all asset classes move together against the currency unit; proving that gold stands on the other side with all asset classes. Prechter is, however, a bit inconsistent in his definition of the gold/money question. In one sense he regards gold as money, for example, when measuring the Dow in terms of gold to demonstrate how much it has already fallen against gold. But then again it is not money when juxtaposed against the monetary unit in which all prices including gold are measured. Could it just be the case that gold is “technically” not money today and was not for so long as our monetary system remained afloat?

Is money a stock or a flow variable?

I would suggest that the problem lies in the definition of money. There is no concrete definition of a monetary unit (only one of belief). Differences in opinion arise because of the adoption of (or the need to adopt) a concrete definition of money. Paradoxically, any concrete definition one chooses to adopt becomes akin to a limiting belief. Here’s the rub. Is money a stock or a flow? Clearly something cannot be both a stock and a flow at the same time. This question reminds me of the quandary faced by quantum physicists when trying to determine the nature of light – is it a wave or is it a particle? It cannot rationally (in a Newtonian world) be both at the same time, yet it is both depending on how you conduct the experiment or how you choose to measure the results. In much the same way when thinking about the value or price of gold we can be accused of inconsistency when conceptualizing in one way or the other–getting to logical, but inconsistent conclusions.

If money were a stock then an increase in its quantity relative to all other goods should by all accounts lead to an increase in prices. Such a concept leads to gold equal to $10,000+ figures on the basis of simple back of the envelope calculations by dividing the amount of money or debt in the world by the physical ounces of gold available. But if it were a flow (as the word currency can be derived from current), then it becomes a question of the velocity of money. But there is no fixed relation between its stock and prices. Since QE to date we are experiencing an increase in the supply of base money, but an overcompensating decline in its velocity–which is the reason we have QE 2, 3 and may continue to have 4, 5 and so on if the velocity of money continues to taper off. 

Inflationists argue that it is only a matter of time before velocity kicks in and the central bank will be unable to reign in the amount of money it has created as fast as it has been let out. Or that future QEs will break the dam of the massive build up of central bank reserves.

The case against runaway consumer price inflation

My contention is that conditions continue to favour deflationary forces. This is because the increase in money supply continues to skew wealth distribution in favour of the rich (I have not tried to prove this assumption. This is merely my assumption. If I am wrong then my theory falls apart on this assumption regardless of whether the outcome is proven correct by the evidence of a continued lack of runaway inflation). Money cannot chase goods if increasing amounts of it end up in the hands of fewer and fewer wealth owners. The increasingly impoverished lower and middle income earners simply do not get to build up any meaningful increase in wealth beyond what they had (or perceived to have had) during the first decade of this Century; despite the overall increase in various measures of notional wealth (such as money supply or stock market rebounds).

Such notional increases in wealth have merely become concentrated in fewer hands. For this reason there is no increase in bargaining or purchasing power to drive up the price of basic goods (one could argue that there has been an increase in the prices of basic goods because of an increase in their scarcity–but this is due to less employment or lower productivity–not grounds for runaway inflation which would suggest that people are falling over each other to get rid of their money). The increasingly concentrated pool of increasingly rich do not need to compete for more of their basic needs which are already being met, while the increasing population whose living standards are falling have less money to chase fewer goods.

It would be different if the increase in money went to the lower income groups and they were in a position to meaningfully increase their wealth at the same time. If not, then any increase in income schemes (through money printing and continued deficit spending) bleeds straight into the notional wealth of the concentrated elite. Through no fault of their own, wealth owners who see no opportunities for profit, choose not to invest in direct production; only on the secondary capital markets. This only further drives up asset prices and reinforces the concentration of wealth.

Consumer runaway inflation can only occur where the increase in money supply is spread out more evenly concomitant with a destruction of wealth. In this case, money represents one of the forms of wealth that needs to be exchanged for more valuable things, ultimately in the form of those things you need to live on now or things regarded as good stores of value. Gold invariably rises in such an environment because it is one of those things whose physical quantity is subject to the least amount of manipulation. It is also one of the most durable forms of goods.

Right now, however, we are on a stage where asset prices are still rising and where there are no signs of declining wealth inequalities that could shift the forces towards a consumer price inflation driven by increasing bids (as opposed to higher offers on declining production; where more money is not being made available to reach those that then become in a position to outbid each other over offers). We are living in a sellers’ market–either pay the higher prices or go home with less. For runaway inflation to occur we need a buyers’ market with the ability to throw an increasing amount of money at goods. Instead the sellers have control of the flow of money and get to throw it at assets instead, outbidding each other over the most outrageous offers on financial assets.

Cyprus, who would have thought?

Cyprus has brought to light what was possibly not imagined by most gold bugs: the outright taxing of bank deposits. Yet there have been historical precedents for such a move in many European countries that had long been forgotten. The confiscation of gold at $20 an ounce and its revaluation to $35 in 1933 also represents such a tax.

What does such a deposit tax mean for investors? Depositors must surely be asking the question: what is money? Especially those in the PIGS countries. If deposits are no longer safe, what is? As most assets are becoming subject to increasing risk (or will be soon if the economy is not raising itself up by its bootstraps as politicians and central bankers seem to be telling us), then what is safe or safest? Is fiat money? Is gold money? Ultimately it is not a question of fundamentals, but of whatever the crowd thinks. The mystics keep telling us, reality is all in the mind. Unfortunately, in this particular case it’s not so much a matter of what’s in my mind that is determining economic reality, but what is in everyone else’s mind as well. Once it begins to click, gold may no longer be sitting on the “all the same markets” side of the fence with fiat money on the other. Yes, fiat money will still be needed to repay debt and pay taxes (assuming there to be sufficient income) and on this account can continue to be deflationary. But will it hold value beyond this need for debt and taxes? It does not seem much of a positive value, does it? If I have no debts to repay and others are desperate to get money in order to pay off their debts, should I hold onto it, not knowing when the game may change given the many possible variants fiat money could morph into? Cyprus provides one of the first examples of an unexpected surprise of one possible variant.

I contend that the need for a (non-productive and non-perishable) store-of-value function of money will begin to grow, thanks to the seed of Cyprus. In an almost perfect analogy, the seed will grow stronger the more you water it with liquidity. It is as if the store-of-value function of money has been so suppressed that we have fallen for the illusion that it was “all” to be found in productive assets; money serving exclusively its currency function as a medium of exchange. I will hazard the guess that gold will stand up to the former role (store-of-value) undermining that of the latter (medium of exchange). People will ultimately find it fairer and more reasonable (as amongst friends) to make exchanges in gold than in a currency whose worth they can no longer assess and whose changing values will even surprise the authorities. But for this to happen, gold must first hold a (mental) space in everyone’s purse and wallet. After all, if we are to believe what mystics have said and what new agers tell us, things first manifest on the mental plane before they manifest on the physical; leaving aside the emotional plane somewhere in between, which can provide for quite a bit of turmoil. 

Prechter and Dent may be technically correct in their underlying assumptions. Gold does not back fiat money. But legalities do not make for sound money. And yet they could be partly correct–currency and gold could rise in value against all else, with the two rising for entirely different reasons.


Robert Wutscher
The Shadow Economist


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