Tuesday, October 20, 2009

The gold price: inflation or deflation?

Excerpts from: Inflation Vs. Deflation by John Tamny in Real Clear Markets

When money is fluctuating in value, the money prices of all investments become distorted and mistakes are made. During periods of inflation, capital moves into the assets of the earth such as housing and gold that are least vulnerable to currency debasement. . . Conversely when money increases in value, earth assets are ignored to the near-term benefit of intellectual producers, . .

inflation and deflation are often misunderstood precisely because both ultimately lead to withering investment environments and tough markets when it comes to finding work. During periods of inflation, capital moves away from job-creating concepts for inflation-eroding nominal returns, while during periods of deflation businesses avoid borrowing to fund future growth, knowing full well that the money they'll pay back over time will be more than what they borrowed.

To simplify both, inflation occurs when the value of money declines--the decline most notable in the rise of the price of gold. Conversely, deflation results from an unchecked rise in the value of money, which shows up in the decline of the price of gold in terms of the currency in question.

What makes this all so interesting right now is that despite the dollar's substantial collapse vs. gold this decade (roughly 300%), seasoned market observers believe that we're currently in a period of deflation. The only conclusion to this is that they're mistaking for deflation negative symptoms that occur during periods of deflation and inflation.

Those who argue that we're deflating point to slow economic growth, high unemployment, falling prices in certain sectors and a difficult capital environment. This jibes well with the modern view that slow economic growth is inflation's cure.

But the problem with this thinking is that inflation has always coincided with slow economic growth. When money declines in value, capital essentially goes on strike. With investors not willing to commit capital to ideas when their value will only be destroyed by inflation, money dries up.

In today's case, those who see deflation in our midst point to a difficult capital environment for businesses. No doubt there is one, but this isn't due to money being too expensive as much as it's the result of capital flowing to non-productive, hard assets that tend to perform best when money is losing value.

Regarding the high level of unemployment, there are quite simply no jobs without capital, so contrary to the widely held belief that low unemployment is the driver of inflation, the reality is the opposite. Inflationary periods frequently coincide with high unemployment because the very investment necessary to create jobs disappears.

Most notably, deflation's advocates point to falling prices for certain goods, such as cars, clothes and hotel rooms, as evidence that the general price level is falling. The problem at first glance is that falling prices in isolation are not evidence of deflation.

More broadly, deflation's proponents miss the greater truth that supply and demand are but two sides of the same coin. No one can demand anything without supplying something first. So since Americans are working less given the difficult employment environment, there is also less supply. These things ultimately balance out such that the price level does not change.. .

Ultimately, deflation's proponents point to Japan in suggesting that we're in the midst of a similar deflationary episode. . .

From 1985 to 2000, the yen tripled in value vs. gold, and--as mentioned earlier--gold has tripled in value against the dollar this decade. The yen's rise demonstrates that Japan most certainly suffered a major bout with deflation, but the dollar's collapse only points to an inflationary episode.

The mistake in all this has to do with a misunderstanding of inflation and deflation. Slow growth, high unemployment, capital constraints and falling prices are frequently the symptoms of both despite inflation and deflation being two different ills.

In today's case, to devalue the dollar more to eradicate a nonexistent deflation would merely add gasoline to the fire, with greater unemployment and bankruptcy the result. What our economy needs now is a stronger dollar, but foremost it needs a stable dollar so that capital can more rationally reach its most productive use, free of the investment distortions and illusions wrought by unstable money values.


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