Top Austrian bank: "Gold is the optimal investment in both deflation and inflation"

History shows that gold is an excellent performer in both inflationary and deflationary economic scenarios.

Author: Ronald Stoeferle
Posted:  Thursday , 24 Jun 2010

VIENNA (Erste Bank) - 

The central question of whether the next few years will be dominated by inflation or deflation still remains unanswered. In periods of inflation, tangible assets are the preferred asset class, whereas in times of deflation, cash is king. Gold is liquid, divisible, indestructible, and can be easily transported. It has a worldwide market and there is no default risk associated with it, which means it is cash of the highest quality. Therefore gold is the optimal investment both in deflation and inflation. 

 The following chart supports this notion. Gold shows a positive performance in the first (deflationary) decile.  It offers the weakest return during times of low inflation, whereas it is a clear outperformer again in the 7th, 9th, and 10th decile of the CPI development. 

 

Nowadays there are a substantial number of experts who regard the concept of inflating the economy as the only possible solution to the excessive level of debt. Kenneth Rogoff, former chief economist of the IMF was already quoted at the end of 2008 in the Central Banking Journal as claiming that a higher but controlled rate of inflation of 5-6% over the next couple of years was healthier than a deflation of 2-3%. Exceptional times require exceptional measures, according to Rogoff. He believes that otherwise taxes would have to be raised by 30-50% in the USA, which is illusory. Thus, inflation is the only feasible "exit strategy". And his successor, chief economist Olivier Blanchard, recommended to the central banks they should accept rates of inflation of up to 4% instead of 2% in the future. This is particularly remarkable seeing as the IMF would traditionally consider monetary stability as no.1 priority.  

Although the inflation rate is currently on its way down, this is not the least due to the statistical base effect. The gold price correlates very strongly with inflation as soon as the latter hits extreme values. From 1971 to 2009 the monthly correlation coefficient of gold and the inflation rate was 0.48. In the period of high inflation from 1978 to 1982 it soared to 0.76. When the rate of inflation in the USA and Europe soared to new highs at the end of the 1970s, so did the gold price. We know a similar situation from history, i.e. from WWI and the Weimar Republic. From 1914 to 1918, the German money supply soared from 8.5bn to 55bn Reichsmark, which paved the way for hyperinflation of historic dimensions. In January 1919 one ounce of gold would have set you back by 170 Mark, whereas by November 1923 the price had shot up to 87 trillion Mark. An important feature of high inflation is the rapid loss of trust in one's own currency.                                                  

The gold standard is proven to offer the best protection against inflation: annual price inflation from 1879 to 1914 was 0.2% at a volatility of only 2.2%. Since 1971 (i.e. the end of Bretton Woods), volatility has been 2.8%, with average price inflation at 4.6%. 

"You have a choice between the natural stability of gold and the honesty and intelligence of the members of government. And with all due respect for those gentlemen, I advise you, as long as the capitalist system lasts, vote for gold"

George Bernard Shaw  

Gold is also an excellent hedge in periods of deflation. What is happening in times of pronounced deflation? Public budgets are strained, the financial sector is faced with systemic problems, currencies are depreciated in order to reflate the system, and the money supply is continuously rising. The creditworthiness of companies and countries is queried, the confidence in paper currencies falls, and gold is subjected to remonetisation.  

Deflation             Gold      Silver    Commodities

1814-1830            100%     89%        -50%

1864-1897            40%        27%        -65%

1929-1933            44%        -5%       -31% 

Sources: Roy Jastram," The Golden Constant" and "Silver, the Restless Metal", Erste Group Research  

In 1933 President Roosevelt raised the gold price - in an effort to re-start the economy - from USD 20.67 to USD 35, and private gold ownership was banned. The confiscations led on the one hand to a booming black market, and on the other hand to the mining sector recording an enormous inflow of funds. According to the US Bureau of Mines 9,000 producing gold mines were in operation in the USA in 1940. Many gold mining shares increased tenfold, including the majors. Today, the US gold reserves are still valued at USD 42.22, but an adjustment to the market price has been demanded by many. Given that the gold price was fixed in the 1930s, the development of the shares serves as a good indicator: 

Price and dividends of Homestake Mining and Dome Mines 1929-1936  

	Homestake Mining	Dividend	Dome Mines	Dividend
Low 1929	USD 65	USD 7	USD 6	USD 1
High 1931	USD 138	USD 8.45	USD 13.5	USD 1
High 1933	USD 373	USD 15	USD 39.5	USD 1.8
High 1934	USD 430	USD 30	USD 46.25	USD 3.50
High 1936	USD 544	USD 36	USD 61.25	USD 4

Source: Ian Gordon, Longwave Group, 19 October 2009

However, the most significant share price increases happened only after the deflationary period (1929-1932) and at the sudden onset of inflation 1932-1935. We can well imagine a similar scenario for the foreseeable future. The stability of the gold shares during the share price crash is probably due to the fact that the gold price was fixed and the revenues of the producers thus remained stable, whereas all other commodities collapsed.  

Taking into account the fear of deflation and numerous texts and speeches by Ben Bernanke (e.g. "Deflation: Making Sure "It" Doesn't Happen Here") we believe that further interventions are likely. The natural shakeout during a deflationary recession will probably be fended off at all costs. This scenario should ensure a sustainably positive environment for gold.  

CRITICISM ON THE CONCEPTUAL DEFINITION OF INFLATION  

The discussion about inflation nowadays focuses mainly on the effects of the price increases rather than on the causes. The fact that the expansion of the uncovered money supply is to be blamed for the rising level of prices tends to be forgotten. The focus is now on the development of the basket of goods, which only highlights the symptoms of the price increase. 

The reported inflation data are definitely questionable. According to Shadow Stats gold would have to rise to USD 7,494 in order to reflect the real value of 1980. In 1999 the CPI calculation was drastically changed. The geometric weighting (N.B. rising prices are attached a lower weighting than falling ones) and especially the hedonistic calculation have reduced inflation in the years 1999-2003 by more than 20%. This method takes quality improvements of products into consideration. For example, more powerful PCs cause the reported inflation to fall drastically. Say you buy a PC for USD 1,000: in the hedonistic approach, the inflation rate would be recorded as -50% (for this sub-component of the basket of goods) two years later when you buy a new PC for USD 1,000 that is twice as powerful and thus offers twice the power for the same price. Even alleged "quality improvements" in bananas and milk have a negative effect on inflation, whereas a deterioration in quality has no effects on the inflation model.

Also, the weightings in the basket of goods are dubious. For example, healthcare costs account for close to 17% of GDP, but for only 6% of the price index. On top of that, the development of asset prices is not taken into consideration either, as the basket of goods only contains consumer products. And we also criticise the fact that the increased tax ratios have been ignored in the contents of the basket. Why would one wish to report lower rates of inflation? - Elementary: a large part of the expenditure that hinges on social security expenditure, transfers, wages in the public sector, meal vouchers etc depend on valorisation. Also, low inflation makes it easier to justify (too) low interest rates.  

A few samples taken from daily life show that the (at least, felt) inflation substantially exceeds the reported one: the price of a gallon of  gasoline has increased by 2,150% since 1960, and an average house sets you back by 1,400% more. By comparison, the monthly social security taxes have increased by 1,900% since 1970.

Also, inflation affects people at different degrees. The Cantillon effect describes the fact that newly created money is distributed neither equally nor simultaneously among the population. This means that people handling money partially benefit from inflation and partially suffer from it. Monetary expansion is not neutral. Market participants who receive the new money early and exchange it for goods benefit in comparison with those who get the newly created money later.

We can see a transfer of assets from late money users to early money users.

WHY THE INFLATION-ADJUSTED HIGH OF USD 2,300 IS OUR TARGET PRICE 

A look at the inflation-adjusted gold chart puts the most recent price increase and the passing of the (psychologically) important USD 1,000 mark into perspective. On an inflation-adjusted basis, the high of 21 January 1980 (USD 850) amounts to USD 2,300/ounce. Of course this calculation is based on the official data of the Bureau of Labor Statistics.  On the basis of the old Shadow Stats calculation model of 1980, gold would have to rise to USD 7,494 in order to exceed the 1980 high in real terms. And when resorting to the MZM (money with zero maturity) supply of 1980, we find that gold would have to soar to almost USD 10,000. 

However, one has to be aware that the USD 850 mark in 1980 was a short-lived spike. On the basis of the average price of USD 675 in January 1980 therefore the price today would have to rise to USD 1,897 on an inflation-adjusted basis. But one thing is sure which is the fact that nominal comparisons are of little explicative value. The quality of one US dollar today differs profoundly from that of one dollar in 1980 or in 2000. 

While the gold price reached levels of up to USD 850 at the end of the 1970s and beginning of 1980s, the average American household income amounted to USD 17,000 per year. Nowadays an annual income of USD 17,000 would put a family of four below the poverty line. The level of debt has also increased dramatically over the past decades. Whereas private households were USD 10bn in debt in 1987, this amount has now increased to USD 28bn. This means that a nominal comparison of the gold price over decades is of limited significance, which is why our target for the inflation-adjusted price is USD 2,300.  

Crude oil showed in 2008 that it was normal for a commodity to set new all-time highs on an inflation-adjusted basis during a bull market. The oil price exceeded the inflation-adjusted high at the end of the cycle in its parabolic phase by more than 50%. By analogy, gold would have to rise to an inflation-adjusted USD 3,450                

                        

The above article is abstracted, with permission, from the Erste Bank 85-page analysis of gold and the gold market prepared by Ronald Stoeferle and entitled Special Report Gold - In Gold we trust (2010)