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A Win-Win Scenario For Gold Investors

Published 09/10/2014, 08:14 AM
Updated 07/09/2023, 06:31 AM

Volatility and price drops may be nerve wracking, but the bull market in gold is far from over. In fact, it has barely begun.

To understand why, it helps to look at two prior episodes in the relationship of Gold and money that are most relevant to today. These episodes were a period of extreme deflation, the 1930s, and a period of extreme inflation, the 1970s. History shows that gold does well in both conditions.

Commentators frequently observe that we are experiencing “price stability” or “low inflation” based on the fact that the consumer price index has averaged 2% over the past 12 months. However, this average hides more that it reveals.

The economy is experiencing strong deflationary forces as a result of weak employment and de-leveraging associated with the depression that began in 2007. Simultaneously the economy is experiencing strong inflationary forces as a result of Fed money printing. The deflationary and inflationary forces offset each other to produce a seemingly benign average. But below the surface the forces struggle to prevail with some likelihood that one or the other will emerge victorious sooner than later.

Inflationary forces often appear only with significant lags relative to the expansion of the money supply. This was the case in the late 1960s and early 1970s. The Fed began to expand the money supply to pay for Lyndon Johnson’s “guns and butter” policy in 1965. The first sign of trouble was when inflation increased from 3.1% in 1967 to 5.5% in 1969.

But there was worse to come. Inflation rose further to 11% in 1974 and then topped off at 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981, an astounding 35% cumulative inflation in three years. During this time period, gold rose from $35 per ounce to over $800 per ounce, a 2,300% increase.

The point is that neither the inflation nor the gold price spike happened overnight. It took 15 years to play out from start to finish. The Fed’s current experiments in extreme money printing only began in 2008. Given the lags in monetary policy and the offsetting deflationary forces, we should not be surprised if it takes another year or two for serious inflation to appear on the scene.

Another instructive episode is the Great Depression. The problem then was not inflation but deflation. It first appeared in 1927 but really took hold in 1930. From 1930-1933, cumulative deflation was 26%. The U.S. became desperate for inflation. It could not cheapen its currency because other countries were cheapening their currencies even faster in the “beggar-thy-neighbor” currency wars of the time.

Finally, the U.S. decided to devalue the dollar against gold. In 1933, the price of gold in dollars was increased from $20 per ounce to $35 dollar per ounce, a 75% increase at a time when all other prices were decreasing. This shock therapy for the dollar worked, and by 1934 inflation was back at 3.1%, a massive turnaround from the 5.1% deflation of 1933. In short, when all other methods fail to defeat deflation, devaluing the dollar against gold works without fail because gold can’t fight back.

It is unclear if the world will tip into inflation or deflation, but one or the other is almost certain. The good news for gold investors is that gold goes up in either case as shown in the 1930s and 1970s. Yet patience is required.

These trends take years to play out and policies work with a lag. Meanwhile, investors can use recent setbacks to acquire gold at more attractive prices while waiting for the inevitable price increase to occur.

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