Conventional Wisdom Is Wrong About Deflation and Gold Prices

NEW YORK ( TheStreet) -- All the lip-flapping these days in Europe is about deflation. And if you're listening to it -- and even if you're not listening to it -- you should buy gold.

Pundits are worried that because the European economies have slowed and prices have retreated a bit, deflation therefore is stalking the Continent like Jack the Ripper stalking London's East End. Sweden fanned the flames last week when that country's central bank cut interest rates to 0%. Not near-zero, like in the U.S. ... literally, 0%. It did so even though there is no indication that deflation is anywhere near the Viking land.

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In that world, gold -- supposedly -- is odd man out.

History, though, tells a different tale. It tells you that gold is the asset to own if you believe deflation is real.

But Wait, I Thought Gold Was Going Down...

It's not easy being a gold investor today. As I write this, gold is off more than $30 per ounce to less than $1,200, its lowest level since 2010. It has the gold haters saying "I told you so!"

But this is playing out exactly as it should. Gold should fall when the dollar rises. It's the necessary proof that the two are on opposing sides of the same see-saw -- and that gold will rise again when the dollar resumes its decline ... which it will. The dollar is rising these days simply because the Fed is soon to raise interest rates even as Japan overnight launched a new round of stimulus and as the European Central Bank brings euro rates down. That's a temporary state of affairs.

Also temporary is all this jibber-jabber about deflation, which only emerged after European economies weakened going into the fall ... and that happened only because of the Russia/Ukraine crisis and the tit-for-tat economic sanctions that -- again, temporarily -- have undermined economies.

In short, true deflation will not happen. Period.

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But ... for fun, let's assume the deflationistas are not lunatics. What would deflation really mean for gold?

If America's greatest bout of deflation is any guide, then gold is an asset you must own to offset the decline in your stock portfolio.

What Happens to the Price of Gold During Deflation?

This chart tells you all you need to know about gold during periods of deflation:

The chart shows gold vs. the Dow Jones Industrial Average during the height of the Great Depression. Now, this isn't gold bullion. That price was fixed by government, so it's a useless comparison. Instead, the gold price is represented by shares in Homestake Mining, the blue-chip mining company of the day.

One dollar invested in the Dow just before the Great Depression ravaged the economy fell to less than 50 cents by 1935. That same dollar invested in Homestake Mining, a good proxy for gold, soared to more than $5.50.

Gold, it turns out, is a fabulous foil for deflation.

And the reasons make sense when you think about it.

Three Reasons Gold Rises During Deflation

First ... people lose faith in fiat currencies since those currencies are backed by nothing but government promises. And deflation -- the bad deflation that central bankers fear the most -- is proof that the government and its monetary agents have done a horrific job of managing an economy. Faith is lost.

That's precisely what the Great Depression showed. The dollar was backed by gold until America's socialist-minded president of the day, Franklin Roosevelt, stepped in with a currency-devaluation scheme that effectively turned the hard dollar into a fiat dollar ... which is why Homestake Mining raced sharply higher between 1932 and 1934.

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Second ... since people have no faith in fiat currency, they demand a proven store of value. Gold haters are simply wrong when they say gold has no intrinsic value beyond its use in baubles and a few technology processes. Gold has value because societies going back more than 2,000 years have ascribed value to it -- rightly or wrongly. Until the mentality of man changes, gold will always have intrinsic value as a replacement currency.

And, third ... people are smart. They know central bankers and politicians hate deflation because of its impacts -- particularly its impacts on debt. Deflation is a disaster for those who are indebted because the dollars needed to repay those debts are deflating away, making the debt ever-harder to pay off. Think about the country with the greatest debts, and the size of those debts ... and then imagine the challenge the political leaders in Country X will face in a deflationary world.

People know that if deflation really does emerge, monetary officials in the U.S., Europe or elsewhere will do everything and anything to kill it. FDR's team, for instance, confiscated gold and devalued the dollar. In doing so they gave government the ability to battle deflation by spending drunkenly on socialist programs ... through the use of a new fiat currency that could be easily manipulated through the creation of credit and new currency units. Gold-based currencies cannot be expanded without the cost of mining and processing additional gold.

For those three reasons, the true value of gold soared during the greatest deflationary crisis in America ... which is why Homestake Mining's shares exploded higher. It was the markets telling the world that gold was increasingly valuable, even as deflation raged.

If deflation really does arise, you will absolutely want gold in your portfolio.

But even if deflation isn't as big a deal as everyone's saying it is ... if you have any sort of hesitation about the long-term well-being of the U.S. buy gold now. It's cheap.

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This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.


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