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A number of readers have e-mailed me with versions of this question, so we’ll address it head-on today.

By way of background, a few commentators have laid out the bearish case for gold – but none have pounded the table as hard as a guy named Nick Guarino. (I have been made aware of this by correspondence from readers.)

Guarino, working out of Canada, is affiliated with something called the “Wall Street Underground.”

I don’t know Nick Guarino... I’ve never seen his work or read his stuff. But a handful of you have referenced him as the source of this “deflationary death watch” idea.

Here is the thrust of Guarino’s argument, excerpted from a text that is apparently being passed around:

Some of the dumbest loans ever – to the most unqualified borrowers ever – were made. Now we are suffering a tidal wave of loan defaults. Under our system, that is money destruction. Money is being destroyed like never before in the U.S. As a result we entered a deflation a year ago. As the massive money destruction (loan defaults) has continued unchecked, that deflation has become a full-blown depression.

Banks are not making leveraged loans any more. That's a fact. They are not creating money. They will not be able to do so for a decade or more. They are too busy still trying to cover their massive loan losses, which due to derivatives are literally in the hundreds of trillions of dollars.

So as you are seeing we have money destruction on a massive scale. And we have massive deflation as prices crash on everything in sight. And debt default is money destruction and it is not inflationary by any stretch of the imagination and is [an] unmitigated disaster for the gold bugs who in this fully qualified dish washers opinion will end up holding gold worth under $200 [an] ounce.

I agree with the general thrust of this argument. The logic is mostly correct, apart from the fact that “hundreds of trillions” is a gross exaggeration.

The Asia Development Bank estimates $50 trillion worth of value across all stocks, bonds and currencies was lost last year – roughly equivalent to a year’s worth of output for the global economy as a whole. Various estimates of the CDS (credit default swap) market fall under $50 trillion too... and most of the toxic mortgage assets that have blown up bank balance sheets deserve to be written down sharply, but not all the way to zero. So, basically, there is no way that “hundreds of trillions” applies.

But what about the broader point? Should gold be on its way to $200 an ounce because the scale of “money destruction” we have just witnessed far outpaces any effort to stimulate via printing press?

The short answer to that question is “no.”

Again, I agree that the sharp fall-off in global commerce and trade (and the financial black hole created by vaporized lending activity) is seriously deflationary. I further agree that the world is wrestling with a downward spiral in the price of goods and services as businesses hunker down and shell-shocked consumers cut back.

But the argument and the conclusion have a serious disconnect.

The Cliffs Notes version of my response to the “deflationary death watch” argument goes like this, as quoted from my reply to reader Dan C.:

Outright deflation is "not okay" in the eyes of central bankers. In fact outright deflation is seen as little short of disaster by all central bankers aware of what happened in the great depression.

Therefore, above and beyond everything said [by Guarino], the #1 task of central bankers is to bring back an inflationary environment. Sustained deflation is not acceptable... inflation must return at any cost.

So, when you are at the bottom of a deep deflationary hole and you cannot stay there... when you must get back to inflationary above-ground altitude... what do you do?

You use dynamite. As much as it takes.

The crazy assumption that the central banks will allow deflation to persist Japan-style for the whole world is where he goes wrong. They will not. They'll do whatever it takes.

Now, let’s expand on this answer a bit.

Dirt-Cheap Gold Is a Good Time Phenomenon

To start, think back to what the world looked like when gold was last dirt cheap. Stocks were going up... the price of oil was low... the good times were rolling and storm clouds were nowhere in sight.

There were some serious hiccups in the 1990s – the Asian currency crisis, the Russian default, and so on – but for the most part Alan Greenspan washed them away with a flood of easy money. The world was a shiny happy place for investors.

To wit, gold does poorly when paper assets are doing well – and vice versa.

This makes sense because, in addition to its role as an inflation barometer, gold is also a form of crisis insurance. Who wants to buy crisis insurance when it’s nothing but blue sky as far as the eye can see?

Contrast that rosy environment with now. Crisis insurance is suddenly something we can’t get enough of. Everyone from individual investors to sovereign governments wants protection against the threat of financial collapse.

The euro is showing huge cracks. The U.S. dollar and U.S. Treasury bonds are strong, for now, but both look seriously booby-trapped. Tensions arising from a fall-off in global trade could lead to ugly outcomes. The news flow is not pretty.

That’s the kind of environment where gold shines.

Gold Is Scarce Relative to Long-Run Demand

As mentioned previously in these pages, all the gold ever mined from the beginning of time only adds up to $4 trillion or $5 trillion (give or take). If you took all that gold and stacked it up as a cube, it would fit comfortably inside a tennis court. Keep in mind, too, that only a modest portion of that gold is investable or otherwise for sale.

And so, in terms of its role as an alternative currency and a form of crisis insurance, the supply of gold relative to demand is very small. To say that this picture will change dramatically is to say that the need for crisis insurance – and protection from fiat currency debasement – will disappear in short order.

If Central Bankers Are to Succeed, Positive Inflation Must Return

The threat of deflationary downward spiral is enough to give any central banker nightmares. When a trend of falling prices for wages, goods and services gets locked in long enough, the result can be economic disaster.

Deflation is especially scary because the system is designed to have an inflationary bias. There are always new workers coming in, new jobs to be created, new investments to be made, new taxes to levy and so on. The wheels of the capitalist system are greased by a positive price trend as wages and earnings slowly rise.

With deflation, all that gets thrown into reverse. The pain is especially intense for economies that need to steadily add jobs and investment just to avoid popular discontent. (If the labor pool is growing, then a lack of growth means unemployment is rising too.)

This is why deflation is not an acceptable phenomenon. The longer deflation persists, the greater the risk of its long-lasting destructive effects. And so, in Bernanke and Co.’s battle against deflationary pressure, the stakes get a little higher with each passing day.

If the stakes get high enough, we could see some REALLY crazy stuff go down. Which leads to our next point...

The Fed Has Not Gone Crazy Yet

Most of you by now have seen the monetary chart that looks like a hockey stick, showing the huge quantity of reserves the Fed has pumped into the system. We’ve also talked about the multi-trillion-dollar expansion in Fed balance sheets, and everyone by now has heard about the big government stimulus plans.

But you know what? When it comes to inflation-producing efforts, everything so far is just a warm-up.

The big fear is that America winds up like Japan, so let’s use a Japanese analogy: the classic monster movie.

Picture deflation as a 200-foot-tall monster. Mothra, maybe. Except instead of attacking cities, this Mothra is laying waste to whole chunks of the U.S. economy.

What the Fed has done so far is equivalent to standard military response, albeit on a large scale. They’ve called in the tanks and the fighter planes. They’ve sent the bombers in to drop napalm on Mothra’s head. Next up for the Fed is the TALF lending facility. If that doesn’t work, they will be close to running out of options... except for one.

They can call in Godzilla.

If Mothra represents deflation, then Godzilla, by way of our little analogy, represents real inflation... stomping, screeching, fire-spewing, melt-your-eyeballs inflation.

If the Fed and Treasury were to truly go crazy and raise Godzilla up from the deep, what would that look like? Here are a few possibilities:

  • The government could announce a massive payroll tax holiday, at a cost that would blow everyone's mind, that would not have to be paid back.
  • The government could announce a one-fell-swoop effort to pay off tens of thousands or even hundreds of thousands of underwater mortgages.
  • The Federal Reserve could hit the banks with a draconian holding tax – sort of like the vigorish a loan shark charges except in reverse. Every day that goes by where bank ABC hasn’t lent out the $100 million in its reserves, a $50,000 holding penalty is assessed. Or something to that effect.
  • The Fed and Treasury could just say “You know what, screw it. We’re gonna write y’all some checks. Every American citizen age 18 or over with a social security number gets $10,000 – look for that in the mail.”

Why haven’t we seen anything like this already? Because, again, the above options are the equivalent of calling in Godzilla. Could Godzilla kick Mothra’s butt? Oh, most certainly. The problem is, after Mothra is dead you’ve got the little matter of dealing with Godzilla.

Ben Bernanke Knows All This... and So Do the Smart Players Buying Gold

Ben Bernanke knows the Fed can bring about inflation if it wants to. Heck, he openly bragged about it in his famous 2002 “helicopter” speech.

The thing is, gentle Ben really, really, really doesn’t want to let Godzilla loose unless he absolutely has to. Because the kind of inflation we could be looking at to blast our way out of this deflationary hole would be... well... monster-rific.

There are a number of very smart players establishing sizable long-term investment positions in gold now. They have done the math along with Bernanke, and they know where the various roads lead.

So this is why Guarino is wrong. The stuff about the world wrestling with a deflationary downward spiral right now is true. But the idea that we can afford to let this downward spiral persist is a big fat “No Way José.” The longer deflation persists, the more terrified central bankers become – and the greater the risks they are willing to take.

Those risks include calling in Godzilla... doing a true, all-out, mega-blowout consumer-direct “helicopter drop” once the relative half-measures of doling out large chunks of money to semi-insolvent banks has failed.

Deflationary Pressures and Global Crisis Concerns Are Intertwined

Last but not least, there is another possibility... the very possibility that Bernanke and Co. are praying for.

This final possibility is that, through a combination of emerging market domestic demand and stabilization in the west, global growth comes back online.

If the world manages to heal itself, then the trade dollars will start to flow again... commerce will pick up... optimism will return... and deflationary pressures will vanish of their own accord.

But even then, if THAT lucky scenario happens, the pendulum will swing from the deflationary to the inflationary side. The stimulative measures that have already been pumped into the market will have a reverberating effect. This is why Warren Buffett recently expressed his view to CNBC that we could be in for a bout of 1970s-style inflation – AFTER global growth comes back online again.

Investing in Gold Versus Trading Gold

Let me close by adding that investing in gold and trading in gold are two different things.

In the context of trading, gold is likely to proceed with the usual program of aggressive rallies and occasional stomach-wrenching declines. (This is how it was in the 1970s too, so not much surprise there.)

I continue to believe the best investing course for gold is one of steady and slow accumulation, with an understanding that there will continue to be ups and downs. On the trading side, it’s a matter of being nimble and picking one’s spots accordingly.

Source: Is Gold on a Deflationary Death Watch?