Gold Prices – Inflation vs. Deflation

Inflation is the debasement of money by government. The expansion of the supply of money and its subsequent loss in value results in an increase in the general level of prices for goods and services.

Deflation is characterized by a contraction in the supply of money and a decrease in the general price level of goods and services. (What we are currently experiencing is called ‘disinflation’ which is a lower rate of inflation.)

The purpose of this essay is to clarify and explain accurately what to expect regarding gold prices if deflation occurs.

According to Wikipedia: “Inflation reduces the real value of money over time, but deflation increases it. This allows one to buy more goods and services than before with the same amount of money.”

The United States Government, via the Federal Reserve Bank, has been  practicing inflation regularly for over one hundred years. They are good at it. Their efforts have resulted in a ninety-eight percent “reduction in the purchasing power per unit of money.”

The reduction in purchasing power of the U.S. dollar is reflected in the higher price of gold.

In 1913, with gold at $20.65 per ounce, twenty U.S. dollars in paper money was equal to twenty dollars in gold. Today gold is at $1270.00 per ounce, more than sixty times higher than in 1913.

The higher price for gold does not mean that gold has experienced an increase in purchasing power. Rather, its higher price reflects the decline in purchasing power of the U.S dollar.

Deflation is different. It is the exact opposite of inflation.  And the results are different as well.

As we said earlier, deflation is characterized by a contraction in the supply of money. Hence, each remaining unit is more valuable; i.e. its purchasing power increases.

Government causes inflation and pursues it for its own selfish reasons.  A government does not voluntarily stop inflating its currency. And it certainly isn’t going to reduce the supply of money. So what causes deflation?

Government causes deflation, too. Deflation happens when a monetary system can no longer sustain the price levels which have been elevated artificially and excessively.

Governments love the inflation they create. But with even more fervor, they hate deflation. And not because of any perceived negative effects on its citizens. It is because the government loses control over the system which supports its own ability to function.

Regardless of the Fed’s attempts to avoid it, deflation is a very real possibility. An implosion of the debt pyramid and a destruction of credit would cause a settling of price levels for everything (stocks, real estate, commodities, etc.) worldwide at anywhere from 50-90 percent less than currently.  It would translate to a very strong US dollar.  And a much lower gold price.

Those who hold US dollars would find that their purchasing power had increased.  The US dollar would actually buy more, not less. But the supply of US dollars would be significantly less.  This is true deflation, and it is the exact opposite of inflation.

The relationship between gold and the US dollar is similar to that between bonds and interest rates.  Gold and the US dollar move inversely.  So do bonds and interest rates. If you own bonds, then you know that if interest rates are rising, the value of your bonds is declining.  And, conversely, if interest rates are declining, the value of your bonds is rising.  One does not ’cause’ the other.  Either result is the actual inverse of the other.

Inflation leads to a U.S. dollar which loses value over time; hence, this is reflected in a higher gold price.

Deflation results in an increase in value/purchasing power for the U.S. dollar; hence, this is reflected in a lower gold price.

Those who expect gold to increase in price during deflation are wrong for several reasons.

Gold is not an investment. And it does not respond to the various headline items that journalists and analysts continue to repeat erroneously. It is not correlated with interest rates and it does not respond to housing statistics. It is not influenced by world events, terrorism, or the stock market.

Gold is real money. The U.S. dollar is a substitute for real money, i.e. gold.

If deflation occurs, there is no other possibility except for lower gold prices.

(to read more about gold and its relationship to the U.S. dollar, see here)

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