Gold, Inflation and Deflation

Many participants in the gold market also watch the ongoing inflation and deflation debate. Gold bugs tend to be arch inflationists claiming that excessive money printing will lead to super or hyper inflation and also assume gold is a hedge against inflation.

The deflationists argues that we are witnessing a huge destruction of credit as more and more countries, corporations and individuals default on their debt. Because this debt is denominated largely in dollars then this means the number of dollars in circulation is decreasing thus will push up the value of the dollar and create deflation and a resultant crash in the price of gold.

Here are some problems I have with both sides of the argument.

1) Gold is not really a hedge against inflation. A yearly inflation rate of 5% does not result in a concomitant 5% rise in the price of gold. There have been times in history such as the 1980s where there was very high inflation but the gold price crashed. Gold is only protection against inflation because historically over time it retains its purchasing power. Gold buys roughly today what it bought 500 years ago and 1000 years ago but it may fluctuate in the mean time.

2) Gold is money - in a deflationary time the value of money increases therefore the gold price should increase not decrease or at the very least retain its purchasing power. So yes gold may drop 10% in value but it will still buy the same because all other prices will also have dropped.

3) Our money today is backed by nothing other than confidence in governments and the financial system. Yes debt destruction may reduce the number of $$$ in circulation and thereby making then theoretically more valuable BUT the increasing level of national, state and corporate defaults undermines the confidence in the system and thereby reducing the value of the currency. It is possible to have a complete currency collapse because no one has confidence in the system anymore. This is where gold's true role comes in as a hedge against political crisis - its value then can only go up.

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