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Gold in a Deflationary Global Economy - Part- II

Exactly What is Deflation?

November 23, 1998

There is no common definition of the terms "inflation" and "deflation" and certainly not much agreement even generically as to what they are. Most consumers feel inflation is when they must pay more for goods and deflation is when commodity prices decline. Yet, I have written many times over the years that both true inflation and true deflation are monetary phenomena. Most recently last November in our Forecast 98 issue, The Global Meltdown of 1997: What Is Happening and Why, discussed the monetary causes of inflation and deflation:

Inflation is a monetary phenomenon and occurs...when too much money is created and prices rise. Money can be created not only by an expansion of the monetary base by a central bank through its open market operations, but through an increase in bank lending. In other words, every time a bank lends money, the total money in circulation in that country increases since, in the U.S., for example, Federal Reserve-dictated bank reserve requirements typically require a bank to have on deposit in its vaults only 10% to 15% of the amount of a loan that is created. The rest did not exist before the loan was created. When long-term prosperity has been experienced, overly optimistic (irrationally exuberant?) banks tend to lend too much money to customers. Thus, inflation is not just a situation in which commodity prices rise, but a situation that occurs within the monetary base of a country.

On the other hand, deflation occurs after too much money has been created by excess lending and borrowers cannot pay back their loans. The resulting defaults are, therefore, deflationary because the money that the bank created through its loans was not paid back, and money circulating in the monetary base is destroyed. Thus, bank loans and inflation create money, and debt defaults and deflation destroy money. When money is destroyed, it is literally taken out of circulation-the opposite result from that of loan creation.

The problem in Asia in 1997 began in Thailand when excess lending and speculation began to result in a structural breakdown in the economy such that investors lost confidence and market prices began to fall. Banks in Asia, Indonesia, and Hong Kong had reportedly increased the number of 100% real estate loans [requiring little or no down payment] in the recent past, transferring the risk from the real estate buyer to the bank, thereby making the bank the speculator instead of the buyer. When real estate values decline, so do the assets of the lending bank. Thus, a $100,000 loan on a property that is falling in value to, say, $70,000, puts a $30,000 direct loss on the bank. This means the property is under-collateralized, and the bank must call the loan. Most often, the buyer defaults and the bank must try to liquidate the property in a plunging market at a deep loss, threatening the solvency of the bank. When this occurs on a large scale and when global investors lose confidence in the financial markets of a country that has thrown caution to the wind, currency and stock markets plunge, further exacerbating the situation.

Most economists would likely agree that the above description is oversimplified. First of all, it attempts to describe in a few paragraphs a subject for which economics textbooks require several chapters or more. And, secondly, it describes only part of the picture because it addresses inflation and deflation mainly in a fiat currency system. Yet, it very likely describes twice what the average consumer knows about it, and this is not a textbook!

Moreover, to fully appreciate the concepts of inflation and deflation one must address factors of time as well as exactly what is being used to measure it. Milton Friedman, describing the monetary conditions in the 19th century, says "deflation meant a decline in prices expressed in gold. It was equivalent to a rise in the real price of gold, that is, in the quantity of goods that an ounce of gold would purchase on the market."2 Roy Jastram incorporates a time factor into his definition of inflation ("a period of rapidly rising prices") and deflation ("an interval of swiftly falling prices"3) for the purposes of his statistical study in order to separate his study into periods of time characterized by each. Yet, we must acknowledge that any of these definitions are arbitrary and are subject to semantics. How precipitous is swift? How fast is rapid? Does a period of declining wholesale prices have to be accompanied by the monetary conditions I've described to be considered deflationary?

One cannot argue these points to satisfactory resolution, yet the reader must have some idea as to the period to which I refer as deflationary or inflationary. Thus, while the recommendations and conclusions in this report are designed to address the period of time roughly from 1997 into the early 21st century during which prices are falling and monetary conditions are typical of deflation (i.e., falling asset prices and a contraction in available credit), for the purposes of studying history and continuing the Jastram study for an entire cycle of boom and bust in gold prices after 1976 we must adopt the rather arbitrary schema described by Jastram as periods of rapidly rising prices and swiftly falling prices to separate the periods of history into the two categories: inflationary and deflationary. At the same time, we can note that these periods also meet the Friedman definition that deflation meant a decline in prices expressed in gold.

Whatever the case, the definition, or the esoteric monetary conditions, one thing is absolutely true throughout the over four centuries of wholesale price and gold data: gold is absolutely a long-term store of value that survives periods of inflation and deflation alike. The data show that gold is truly a constant; the only item known to humankind that has survived throughout all of time, all governments, all types of economies, all economic conditions, all panics, collapses, and crashes, and all wars, while still maintaining its long-term purchasing power. This is not to say there are never periods of time in which gold loses value, but it always returns to its relative value expressed in terms of a basket of commodities. In fact, Jastram notes that, amazingly, gold would always return to a certain level of purchasing power with respect to commodity prices-a level he assigned in his study a value of 100 in his Gold Price Index. Amazingly, the price of four pounds of wheaten bread was just a shade higher in London in 1767-1768 than it was in 19344. Thus, commodity prices ventured away from the price of gold many times throughout these four centuries, yet it always returned to the same level of purchasing power. This, Jastram says, should be called The Retrieval Phenomenon (more on this later).


Humankind has always been thoroughly fascinated by gold. Of course, it is not an easy element to ignore, for it is used for many purposes, including jewelry, a medium of exchange, reserves to make credible another medium of exchange (currency notes), a store of value, and safety (many people have historically buried gold during times of war in an attempt to preserve assets and wealth).

Gold is inexorably entwined with two of humankind's primordial needs: the imperative to survive and the desire to possess and enjoy beauty5. Gold nuggets shine from within a stream or from within the ground, broadcasting their value and enticing the observer to pick them up and store them. Its very possession means security, and in turn, survival. It brings credibility to governments, allowing them to issue gold-backed currency that promises to be good. Under a gold standard, consumers can receive gold in exchange for any currency notes. It serves as a financial refuge during times of political and economic crisis.

Gold is like energy: it can neither be created nor destroyed. It can be melted down and molded into several forms without being destroyed. It cannot be created-only discovered-and as such controls the whims of humankind. And in all these respects, gold is truly a constant in more than one sense of the word.

The volume of all the gold ever mined can occupy a cube 63 feet on each side.
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