Most investors understand well that gold can be used as a hedge against inflation based on gold performance during the Great Inflation of 1970s. However, few understand that gold is also a hedge against deflation.
Inflation vs. Deflation
In simple terms, inflation (rising prices) is a phenomenon when the supply of goods and services is unable to meet the aggregate demand. For example, if the supplier of a good is not able to produce enough to satisfy the demand due to a) lack of labor, and b) lack of input materials, the wages increase, and the price of input material (commodities) increase - inflation. Also, higher wages further increase the demand, which causes the vicious cycle of inflation. In such a scenario, central bankers raise the interest rates to "cool-off" the economy. What tamed the inflation of 1970s? One of the key variables was the new wave of globalization that started the cycle of outsourcing the production to emerging markets - an increase in (cheap) labor force.
How do you explain deflation? In simple terms, deflation is when, in aggregate, too many goods are produced, or in other words, the aggregate demand falls below the aggregate supply. What happens next? First, the inventories rise, second, the prices fall (deflation), third, the production stops - fall of commodity prices, and next, lay-offs of labor. Finally, due to oversupply of labor, the wages fall. Falling wages cause and even further drop in aggregate demand, and the vicious cycle of deflation starts. During deflationary cycles, the governments try to boost the aggregate demand by lowering the interest rates, and by fiscal stimulus.
The same forces that ended the great inflation of 1970s - outsourcing and globalization, and now causing the deflationary pressures. Specifically, China is able to produce much more that the world is able to consume, all at low prices. Thus, there is oversupply of goods. At the same time, there is also oversupply of cheap labor due to outsourcing to emerging markets (China, India, Mexico...) which is keeping the wages down.
How to you tame these deflationary pressures? One way would be simply to reverse the globalization and bring the manufacturing back to the US. However, this is politically impossible and it would crash the global economy. Thus, governments decided to boost the aggregate demand by lowering the interest rates and by fiscal stimulus. Was this a sustainable policy? No. First, people got into more debt that they were able to service, which led to the financial crisis of 2008. But recently, the governments got into too much debt, which led to defaults and bailouts of many countries (Greece, Cyprus, Ireland,...), which led us to the current situation - endless QE and zero interest rates with no end in sight.
Inability to fight deflation leads to the political instability, street riots, collapsing governments, and finally, collapsing systems. Simply stated, deflation leads to the doomsday scenario. The only evidence of deflation is the Great Depression of 1930s. Ben Bernanke is a student of deflation - that's his specialty, and that's why he is the Chair of the Federal Reserve. We recommend that all investors read his speech on deflation: Deflation - Make Sure It Does Not Happen Here.
Gold and Deflation
How do you hedge the "doomsday scenario"? The stock market crashes during deflationary cycles (SPY). Governments collapse, and with them currencies and government bonds (example Greece). Commodities used in production collapse in price, but not versus paper currencies, but versus gold, which becomes the ultimate currency. Gold remains the only safe haven in a chronic deflationary cycle.
How serious is the current deflationary cycle?
There is no need to buy gold to hedge the doomsday scenario of deflation if the worst of the crisis is behind us. Are we past the worst point of the crisis? As we stated in our other articles, the Federal Funds futures don't see the end of the current zero-interest rate policy. The defaults in the EU are not over, as the recent Cyprus example shows, and the EU progression to the political union, which is necessary to solve the crisis, is painfully slow. Japan is basically all-in in attempts to fight deflation, which is a sign of desperation. So, we think at this point, it's very difficult to argue that the worst is behind us. All policies aimed at fighting deflation seem to be only temporary patches.
What should investors do?
We still recommend that investors hedge the risk associated with the current deflationary cycle by having a portion of their portfolio invested in physical gold, the Gold ETF (GLD) or gold futures. The current correction is an opportunity to increase the position in gold at cheaper prices.