As the
deflation versus inflation debate rages on, both sides present reasonable
arguments that sound plausible. I am in the camp that believes stocks,
commodities, corporate bonds and real estate have much further to fall. Now
falling prices are not the same thing as deflation, but they are a visible
symptom. To be honest, I am a pragmatist. I am not as concerned about getting
my exact definitions right as I am understanding what to do with my savings.
I believe
all major asset classes are deflating in value relative to Gold and will
continue to do so for at least a few more years. Cash in the form of US
Dollars, since it is the reserve currency of the world (for now), should do
fine as well for a while but presents significant risk as the deflation
grinds on. This all goes back to a concept I have embraced known as Exter's
liquidity pyramid. See here for some background info and below is a reproduction
of a common rendering of this pyramid floating around in cyberspace:
When you
think about the end stages of this deflation/liquidity pyramid, you realize
how similar deflationists and hyperinflationists are in an idealized model. When
a fiat credit bubble pops, assets at the top of the pyramid decline in value
and "liquidity" flees these asset classes and scrambles down the
pyramid towards the apex for safety. The moves are not always orderly, but as
deflation intensifies, physical cash in the form of currency notes and Gold
become highly valuable relative to standard investment asset classes like
stocks, commodities, real estate and corporate bonds.
This fits
with the classic saying "cash is king" during deflation. The
problem is that you have to hold the right kind of cash. Almost no one alive
today has lived under a true Gold standard where paper cash notes could
readily be converted into physical Gold in the same manner that paper dollars
can now be converted into quarters and dimes. I don't mean buying Gold at a
coin shop, I mean exchanging paper notes for Gold at a bank or government
office without incurring fees or paying a premium.
Now many
scoff at this notion and think it is antiquated/quaint, restrictive or just
plain bat shit crazy as a monetary system. The fact that otherwise rational
and sane people laugh at the concept of Gold as money just goes to show how
truly off course and ignorant America in particular has become regarding
monetary issues. There are very few who don't experience at least some
cognitive dissonance when the government keeps spending more and more money
it doesn't have and promising more and more things we can't afford as a nation.
These things happen because we have decreed as a nation that paper promises
are the same as money and indeed they function this way for day to day
transactions and will continue to do so for quite some time.
And
during a bad deflation, paradoxically, the value of this intrinsically
worthless paper becomes more valuable. In a sense, it is a cyclical bull
market for cash in the midst of a perpetual secular bear market that
characterizes all fiat currencies. No market moves in a straight line. It is
not so much that cash is more intrinsically valuable, it simply falls in
value slower than other asset classes so that cash can buy more assets.
For the
saver and investor, it is thus prudent during deflation to hoard cash, as
that cash can buy a greater number of assets later. In other words, if one
moved to cash before the housing crash started, then one could buy a bigger
house than 2 years ago. House prices are deflating relative to cash. Again,
there is monetary inflation and deflation and there is asset price inflation
and deflation. While they are not the same, I am not a high level economist
in the academic world. I am trying to figure out where to keep my savings and
investment money. If oil goes down to $20/barrel, does it really matter if
the inflationists are technically right because the base money supply
continues to expand through it all?
So,
unlike many who harp on the subject, I am not as concerned with getting the
academic concept correct as making sure my money is betting on the right
asset classes over the next 5 years. So, in a sense, I actually am more
interested in the symptoms rather than the underlying disease when it comes
to investing. Having said that, I still think we are in a strong net
deflationary environment right now. A modern fiat system is credit based and
credit was functioning as a money substitute during the previous bubble. Now
that credit is contracting at a scary pace, it is overwhelming the
bureaucratic efforts to "reflate" the system.
Where the
argument of the deflationists and hyperinflationists come together is at the
very apex of the pyramid. Those who shun the notion of Gold as money are
going to feel the pain when history repeats yet again. Because in the final
painful layer of deflation, people flee paper fiat notes for true
non-debasable and non-debt based cash. That's where only Gold comes in handy.
You see, at the apex of Exter's pyramid, paper fiat cash notes deflate
relative to Gold, which is paradoxically inflationary in a sense as it
requires more paper cash to buy Gold if this phase comes to fruition (and I
believe it will).
In a
sense, this is somewhat akin to itulip's "ka-poom" theory where a
deflationary crash (they call it "disinflationary," but whatever)
is followed by a currency crisis that re-ignites inflation in a hurry. This
is also somewhat akin to Trace Mayer at runtogold.com talking about fiat
currency evaporating as the credit contraction intensifies. In the 1930s (the
last deflationary/credit contractionary depression the United States went through), this event occurred via a re-pegging of the US Dollar to Gold
after making private Gold ownership illegal. Overnight, by government decree, people's savings we re-valued
lower by 70%!
So in the
end, both the deflationists and inflationists will be proven right in a
pragmatic sense, but I think we have to go through further deflationary pain
before the step of a one-time rapid currency debasement occurs. Now this
debasement could occur intentionally by government decree or via capital
flight from the United States and either is possible. One of the reasons this
is predictable in my opinion is because every wave of deflation is followed
by more and more intense fiscal stimulus that is less and less able to be
supported by underlying economic reality. In the end, something's gotta give.
This is
not gloom and doom and I don't think the world is going to end. This is an
actionable thesis that is worthy of investment consideration. Gold provides
portfolio insurance that is growing more valuable by the day. Maybe this time
is different. Maybe Obama and Ben Bernanke are so amazing that they can go
ahead and spend another $1,000 trillion and no one will care and the rest of
the world will buy our paper promises with an increasingly rabid appetite. Maybe
unrealistic paper promises can be made ad infinitum and all economic
realities will be suspended forever. Maybe we can re-inflate the credit
bubble again and everyone can have a house, a car and a plane with no money
down regardless of income and plus get a $1 million signing bonus at the time
of closing. I'm guessing not, though.
Switching
some of one's savings into physical (not paper) Gold now, while it can still
be readily found, provides insurance against what is now an almost
unavoidable future currency debasement event. Only the timing is still
unclear in my mind, but you can bet that such an event won't be announced in
advance and you won't be able to find physical Gold as a retail investor when
it happens. Cash will ultimately deflate further relative to Gold and when it
happens, the move will likely be fast and powerful. I think a dip of the Gold
price to the low 900s or high 800s is dead ahead and will provide another
great buying opportunity.
Adam Brochert
GoldVersusPaper
|