By Ronald-Peter Stoferle, Incrementum AG Lichtenstein

The World Is Now Entering A Period Of Historic Chaos & Crisis

November 12 (King World News) 

The question ‘inflation or deflation?’ has been a key bone of contention in recent years.  Without monetary interventions, the current crisis would be deeply deflationary.  Currently deleveraging is being compensated by unprecedented inflationary policies of central banks around the world.  In our opinion, this is an extremely delicate balancing act....

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The current interaction between inflation and deflation can be compared with the reciprocal pressure of two tectonic plates.  These forces push against each other underneath a seemingly stable surface.  Phenomena such as volcanic eruptions or earthquakes are the inevitable consequence of these forces, colliding deep under the visible surface.  In the world of financial markets, we believe this balancing act between inflation and deflation will become increasingly difficult to manage.  We are convinced that investors should prepare for both scenarios: inflationary periods and deflationary busts.

What happens usually during a period of profound deflation?  Public budgets are over- strained, the financial sector is faced with systemic problems, and currencies are depreciated in order to reflate the system.  The credit quality deteriorates gradually, and the creditworthiness of companies and government is questioned.  The investment focus shifts from capital growth to capital preservation.  The confidence in the financial system and paper currencies declines, while the importance of gold increases and a remonetization takes place.

Deflation thus always comes with falling confidence in the (perceived) root cause of the crisis (governments, banks, “speculators” etc) and their rating.  At first, lending volume falls, lending terms become more stringent, and debtors try to maintain their credit rating.  This is achieved by selling assets in order to be able to service their debt, which only accelerates the downward spiral.  A number of credit defaults finally accelerate the deflationary spiral further and reduce the liquidity in the system.  Gold is hoarded in such periods as a manifestation of a stronger desire for safety.

The graph illustrating this process was developed by John Exeter.  The pyramid named after him shows the liquidity flows between the various asset classes.  In an often-quoted interview, Exeter expected a deflationary collapse, in the course of which gold would significantly gain in importance.

Fiat money has no place to go but gold.” Alan Greenspan to the Council on Foreign Relations, 2010

Source: “Dollar Backwardation”, Keith Weiner, New Austrian School of Economics

In a deflationary depression, as in an hourglass, liquidity flows from the higher part of the pyramid downwards, amid falling willingness to assume risk.  At the upper end, liquidity would dry up due to the lack of buyers and revert from a sellers’ to a buyers’ market.  Since credit is “slumbering mistrust”, creditors try to sell the continuously falling number of liquid assets and head for the lower asset classes as a result of their rising risk aversion.  At the bottom end is gold.  Due to the general skepticism the circulation of gold declines, as it is increasingly being hoarded.  The degree of hoarding always depends proportionately on the confidence in the government and the currency.  Gold is never scarce unless it is hoarded – for good reasons – and deliberately hidden.  Since gold does not hinge on any form of IOU, it is the only alternative to paper money and is thus at the bottom of the upside-down pyramid.

An increase in prosperity and growing confidence would then boost willingness to assume risk again, causing a gradual inflow of liquidity from the gold sector into the higher segments of the pyramid, and a new cycle starts.  Deflation therefore means an improvement in monetary quality, whereas inflation means an increase in monetary quantity.

Hayek has made the difference between the effects of deflation and inflation crystal-clear: “... but it is not that certain that in the long run deflation is more harmful than inflation ... Because moderate inflation is always pleasant as and when it is happening, whereas deflation is direct and painful.  There is no need to take precaution against a situation whose unpleasant effects can be felt immediately and sharply; however, precaution is necessary for a measure that is immediately pleasant or helps alleviate problems but that entails a much more substantial damage which can only be felt later.  The difference is that in case of inflation, the pleasant surprise comes first and is followed by the reaction later, whereas in case of deflation the first effect on business activity is depressive.”

Conclusion:  The crucial question of whether inflation or deflation will be the determining environment in the coming years remains unanswered.  In times of inflation tangible goods are the preferred asset class, whereas in deflation it is cash.  Gold is liquid, divisible, indestructible, and easily transportable. It also has a worldwide market and there is no default risk. It is thus cash of the highest quality.

The fear of deflation as manifested, for example, in numerous essays and speeches by Ben Bernanke (e.g. “Deflation: Making Sure “It” Doesn’t Happen Here”) seems to argue very much in favor of further interventions in increasing magnitude. The natural shakeout during a deflationary recession will probably be avoided at all costs.  This should continue to create a positive environment for gold.

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