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Gold in a Deflationary Economy - Part- IX

March 1, 1999

The American Experience Conclusions

I begin with a brief summary of conclusions stated by Jastram in1976, then elaborate on them to include my continuation of his study through 1997. I also update forecasts, both as a result of this report and from our years of forecasts on gold and the global economy from The Global Market Strategist that continue to come true.

Jastram's conclusions (quoted verbatim along with my own notations] in 1976 were:

  • Gold is a poor hedge against major inflation [note: Jastram's study and corresponding conclusions were performed with gold never having yet moved above $175 per ounce. He could not have seen the full benefit of the freely fluctuating price of gold as a vehicle to retain operational wealth that was discussed in the preceding section].
  • Gold appreciates in operational wealth in major deflations.
  • Gold is an abysmal hedge against yearly commodity price increases [again, the benefits of allowing investors to own gold in a freely-fluctuating market offer today's modern investor a unique opportunity not seen in the 4 centuries of the Jastram study].
  • Nevertheless, gold maintains its purchasing power over long periods of time, for example, half-century intervals. The amazing aspect of this conclusion is that this is not because gold eventually moves toward commodity prices but because commodity prices return to gold.
  • A curious but not contradictory characteristic of gold is that, although it consistently loses purchasing power within inflationary periods, it tends to hold its operational wealth reasonably well from peak to peak inflation.
  • Four pronounced price deflations took place in the four centuries recorded. In all four price recessions operational wealth in the form of gold appreciated handsomely. When one sees that just by holding gold for 13 years from 1920 to 1933 operational wealth would have increased 2 1/2 times, one realizes that gold can be a valuable hedge in deflation, however poor in inflation.

The American Experience: The Entire History 1800-1997

My conclusions after another 22 years of data and with the benefit of participating in a new, more globalized economy and associated information-age revolution, are follows:

  1. Commodity prices move toward the price of gold, not vice versa. This is called The Retrieval Phenomenon by Jastram and implies that investors should look toward this phenomenon in their trading and investing decisions. In a free market economy in which gold prices freely fluctuate, this information is of paramount importance to investors since gold not only has always retained purchasing power and operational wealth over time, but now it also provides investors with the opportunity to speculate on nominal price fluctuations, adding to operational wealth and personal profit if one is correct on the direction of gold. Also important is to buy gold for these reasons now-after an 18-year bear market decline. Buying after sustained price weakness or in the initial months after a bear market low is important to the success of any strategy to gain operational wealth from a period of rising nominal gold price.
  2. Gold is the loadstone for commodity prices, which trace out patterns of rising and falling prices around the gold price but always return to it before wandering off again.
  3. It is during these periods when gold wanders away that investors can speculate on the price of gold and commodity prices. As a separate strategy, investors can retain operational wealth by holding gold during periods of rising prices or by dishoarding after long bull markets. The periods of time between cycles can be long, though, and as such after the 18-year bear market in gold prices ending thus far in 1998 investors can now buy gold for both speculative and for operational wealth reasons. We can speculate that this buying opportunity after gold's long price decline means that investors will likely be holding and/or accumulating gold for years to come. In 1997, deflation returned, with the U.S. Producer Price Index falling 1.1% that year accelerating to an annual rate of deflation of -3.5% in the first quarter of 1998. Therefore, two fundamental scenarios allow for the following strategy in a freely fluctuating gold market:
    • To Preserve Operational Wealth: As a general rule, buy and hold gold after it's deflationary nominal price decline has ended (as thus far is the case in 1998) in order to retain operational wealth during deflation, and continue to hold the amount of gold you've set aside for this reason until it is ready to enter a cycle in which it loses purchasing power. Typically this loss of purchasing power would occur after a long bull market advance in gold that occurs in the years after the deflationary cycle has ended and part way into the next inflationary cycle. It is at some point during the inflationary cycle that gold does not keep up (because commodity prices are catching up due to the Retrieval Phenomenon) and holders of gold begin to lose operational wealth.
    • For Investment Reasons: Buy and hold gold for speculative reasons after its deflationary price decline has ended in order to capitalize on its nominal price advance (as has been the case since 1971). This reason for purchasing gold is different than the reason for holding gold for operational wealth reasons because operational wealth can be gained during deflation even if gold prices hold steady, such as is the case during a period of fixed prices during the gold standard. This is opposed to a situation in which one can potentially profit from price appreciation in gold when prices fluctuate freely, adding to gold's appeal.
  4. Think of deflation as a time when gold rises in value relative to commodity prices, not just as a time when commodity and asset prices are declining. In fact, the stock market typically likes mild deflation and mild inflation. It does not like periods of extreme inflation or extreme deflation. Unfortunately, the global fiat currency system now in operation exacerbates both periods of inflation and deflation and, as such, the stock market will likely have periods of severe bear market decline as deflation becomes more extreme.
  5. The Gold Price Index currently stands above the Commodity Price Index (see chart) as it has for years. This implies that any continued decline in commodity prices, such as that which has been occurring in 1997 and the 1998 when deflation returned, will later strongly rebound to return to the price of gold according to the Retrieval Phenomenon. This may in turn imply that governments of the world managing the fiat currency system will panic and reinflate the global money and credit supply such that a return to inflation occurs in the near future. Our regular 62-month cycle of commodity price lows bottomed in April 1998, implying a rebound in commodity prices. The next few years, in fact, will be important in gauging how various governments act to combat the rampant deflation spreading from the Pacific Rim area. However, see also #6 below.
  6. Related to the above, the cycle of deflation typically lasts several years, so a return to inflation now would be premature and would likely mean that the next cycle bottom in commodity prices due in 2002/2003 will occur after another yet deflationary decline. After a strong advance in gold prices from the 1998 low, investors will likely see a fall in gold prices again into that 2002/2003 time frame, but it is not likely that gold will fall below its price lows of 1998. Thus, prepare for another round of falling asset prices after the turn of the century, but the deflationary period it characterizes should be accompanied by an increase in purchasing power of gold, which is still attempting to catch up to the post-1971 free market environment, and rising nominal prices.
  7. Even though Jastram concluded that gold is a poor hedge against major inflation, he could not have foreseen a nominal price of gold near $900 in 1980 and a situation in which that nominal price remained above soaring commodity prices in the post 1971 economic environment. Therefore, gold should still be purchased and during times of inflation for two reasons. First, over the long run gold holds its value and therefore remains the best store of value known to humankind. Second, although hard assets such as real estate also appreciate during inflation, there is not much else to buy during times of inflation that hold value enough to keep up with inflation. There are periods of time when hard assets skyrocket in price, but all in all inflation eats away at operational wealth yet gold has always retained its long-term value.
  8. As Jastram concludes and as I agree, it is important to recognize that one cannot forecast the price of gold just on the data from the Jastram study or our continuation of that study, or by drawing too many conclusions from a long history of the gold standard now that an unprecedented period of fiat currency management is underway. In other words, the Retrieval Phenomenon does not in itself forecast the direction of gold prices (just because commodity prices chase gold prices doesn't mean they will be chasing gold in an upward direction. Both may be falling!). Other factors such as those which are regularly considered in our precious metals research and analysis in The Global Market Strategist must also be used (i.e., what is the state of the business cycle, of commodity price cycles, of global central bank policy, of Treasury policies, of gold inflows and outflows during the gold standard, of deflation, of market psychology, etc.).
  9. Gold is truly a constant, as this report combined with my continuation of the Jastram Study and other research shows. The only times it has temporarily failed to preserve wealth are during part of the time major inflation occurs, and during war. Gold's price movement during wartime comprises yet another concept misunderstood by the general public, who throughout history has grabbed onto gold and buried it in the proverbial back yard during times of war in an attempt to preserve value. Yet gold has always lost value substantially during times of major war (as a relevant aside, though, one must consider the fact that citizens of a country hosting a major war would, in spite of this historic tendency, need to hoard gold since it is perhaps the only store of wealth in existence for them during war).
  10. Watch for some of the greatest episodes of monetary change in history as we end the 20th century and move into the 21st century. A review of these changes is beyond the scope of this report, but The Global Market Strategist will be covering in its regular issues, as well as in special reports, such events as the likelihood of a return to the gold standard, the biggest monetary event since the Bretton Woods agreement of 1944 was abandoned in 1971, and the great influence on global economics upon the adoption of the new currency in Europe, the euro. This currency will immediately upon its inception become the second-largest currency in the world, and the block of European countries managing it will help change the world since the U.S. dollar will now for the first time in decades have a rival. As I have indicated, we can speculate at this time that it is probable that this rival currency and the European powers that be that manage it will push the world back onto a form of the gold standard, removing the United States as the sole beneficiary of minting the world's reserve currency and changing global economics forever.

Presently, no country is powerful enough to accomplish this alone, but given a formidable rival to the dollar and the need for the Europeans to protect themselves against loss of operational wealth due to seignorage in the U.S., along with the need for Europeans to capture the confidence of the globe in its new currency, the push toward a gold standard may very well in retrospect be attributed to the euro. Indeed, the euro is the most critical challenge to a world superpower since the U.S. dollar challenged and overtook British pound sterling earlier this century.

The melting point of gold is 1337.33 K (1064.18 °C, 1947.52 °F).
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