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Category: Money

How gold transcends inflation, deflation, and government misdemeanour

Commentator and financial writer Dominic Frisby, writes for Glint on why inflation and deflation are in themselves misconceptions and why gold can...

28 August 2017

Dominic Frisby

Commentator and financial writer Dominic Frisby, writes for Glint on why inflation and deflation are in themselves misconceptions and why gold can protect you from the pitfalls of government debt

“Gold goes up during periods of inflation” — that’s what you seem to hear so often. “Look at the 1970s, there was rampant inflation and gold went from $35 to $850.”

If only life — and investing — were so simple.

If you are considering buying or selling gold, I’d strongly urge you not to think along these lines. There are too many holes in the logic.

The main problem is the word inflation itself. The word has been corrupted by over-use and mis-use (and by flawed measures), and it means different things to different people. One of the reasons no two economists seem able to agree on whether inflation or deflation looms is that they’re both thinking with a different definition.

When you inflate something, you blow it full of air — you expand it. Similarly when you deflate something, you let the air out — you collapse it. So inflation used to mean: the expansion of the supply of money and credit leading to higher prices. And deflation meant the reduction in the supply of money and credit leading to lower prices.

After (and during) the First World War, Germany printed lots of money — they inflated the supply of money — and this lead to dramatically higher prices in the early 1920s: Weimar hyperinflation.

Above: a woman feeds a stove with Papiermarks during Weimar Germany’s period of hyperinflation

The collapse of credit following the Wall Street Crash of 1929 led a decrease in the supply of credit and falling prices — and we got the Great Depression of the 1930s.

However, these simple, comprehensible definitions have changed over the years, so that now inflation simply means rising prices and deflation the opposite. To monitor inflation — rising prices — central banks and other government bodies have developed various measures. In the UK, for example, we have the consumer price index (CPI) which tracks the prices of something like 700 commonly used goods and services: from shoes to fried chicken to transport costs. Based on CPI (and other readings), the Bank of England then sets interest rates.

Thinktank Positive Money’s research shows that the supply of money grew dramatically in the ten years between 1997 and 2007, but only 13% of that money went into the goods and services measured by CPI. So CPI only tracks the consequences of 13% of that increase in money supply.

All sorts of things are not included in official measures — and if you’re of a conspiratorial bent, you would say these omissions are deliberate so that rates can be kept low. The prices of houses, for example, aren’t included. House prices in the UK rose by over 300% in the ten years between 1997 and 2007, but inflation, we are only told, was moderate. Not if you wanted to buy a house it wasn’t.

The 1980s and 1990s experienced inflation, but because it was not as bad as the inflation of the previous decade, it was described as disinflation and the gold price fell for 20 years. The inflation of the 1970s was stagflation: inflation combined with the stagnation of economic growth — the gold price rose. In the deflation of the 1930s the price of gold and, especially, gold shares rose.

The period since 2008, thanks to quantitative easing (QE) and other policies, has seen huge growth in the supply of money as central banks print more money, but CPI has been low, because the goods measured in CPI have mostly fallen in price (in relative terms) because of dramatically improved productivity and the decline in the prices of most commodities. Yet there has, in this period, been rampant inflation in the prices of stocks, shares, bonds, fine art and prime real estate, especially since 2011. The gold price rose after 2008 but it fell from 2011 to 2016.

In the world at present we have huge forces of inflation at work and we have huge forces of deflation — a tsunami of both cashing up against each other, and the result is falling prices in some areas of the economy and rising prices in others.

Robots, AI, tech, improved efficiency, the mass movement of people — these are hugely deflationary forces which have caused lower prices in everything from taxis (Uber), to hotel rooms (AirBnB), to wages (cheaper immigrant labour). On the other hand QE, suppressed rates and all the other monetary interventions that have gone on, are hugely inflationary (asset prices).

So to gold.

Gold has many qualities of a commodity, in that it is something that occurs naturally in the ground and is mined, but it is not used and consumed, like oil or copper. It has many qualities of a financial asset and it has a long historical relationship with banking, but it pays no yield and carries no liability. It has many of the qualities of money in that it still acts as a store of value, but it has not been used as a medium of exchange for a century, in fact, its role as medium of exchange began to be usurped as much as 500 years ago with the emergence of paper money. It has something of everything, but all of nothing. All in all, gold is a category — an asset class — in itself.

It’s also an extremely political metal. Those who believe in the large government model by which society is run in the West, tend not to like it. Those in favour of a small state and individual responsibility, often become aficionados. Some say gold is an antiquated historical irrelevance that has no use beyond jewellery. Others say it is the future. All in all, it is a metal full of contradictions, and yet it has a purity in and of itself. Some call it the only form of honest money.

Gold is not your hedge against inflation or deflation. I hope I’ve shown that the words are all but meaningless. But gold is your hedge against government. When society is working well, government is well managed and the economy is buoyant, such as in the 1990s, we don’t need gold. There are far better investments to be had.

But when things look like they’re getting out of control, gold has a role to play. Whether in Weimar Germany, 1930s America, or in the 1970s across the West, gold was one of the best assets to hold from an investment and preservation-of-wealth point of view.

In 2016 in Britain we saw perhaps the closest thing we will see to a revolution in our lifetimes here: the Brexit vote. Despite the almost full weight of the establishment in favour of maintaining the status quo, 52% of the British people — more people than had ever voted for anything ever — voted the other way, and the establishment lost its grip. When that happened gold rose by 45% against the pound.

So, looking forward. With Trump and Brexit, have we reached “peak division”? Is this as far as things go and do they now start settle down?

UK national debt as a percentage of GDP. Source: ONS

Or are things going to get worse? Will we see political divisions, both domestic and global, widen and escalate? Is the grip central bankers have had on interest rates going to get weaker, might the chickens of government debt (illustrated above) finally come home to roost and will we begin to see the manifestation of turbulence in the bond market?

If your view lies towards towards the former, then you have no need of gold in your investment portfolio. If, however, you lean towards the latter, then gold is the place to be. If, like me, you see a bit of everything, then a smaller allocation to gold as insurance makes sense.

But I hope I’ve convinced you to ignore the meaningless word that is inflation and, instead, think along these lines: gold is your hedge against the mis-management of government.

Dominic Frisby writes for MoneyWeek on gold and commodities, is a private investor and is the author of Bitcoin: the Future of Money? and Life After The State.

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