Gold has a history as a hedge against inflation, or more precisely, inflationary expectations, but what is not often considered is its role in a deflationary environment.
Since the United States Treasury closed the gold window in August 1971, the world's major economies have been almost continuously in an inflationary environment.
The year-on-year change in the consumer price index (CPI) in the U.S. has been negative in just eight months since August 1971 and all eight of these were in one consecutive period from March to October 2009. In Germany, just 12 months fit the criterion, of which eleven were in 1986-1987.
Now, however, recent figures from the U.S. and China, plus persistent problems in Europe and commercial banks' reluctance to lend, have rekindled fears of an imminent period of deflation.
There has been little hard evidence of gathering deflationary forces. However, the stresses in the banking sector and gold's historical performance during deflationary phases add weight to the argument that any deflationary fears should underpin gold prices.
HISTORY FAVOURS GOLD IN NERVOUS TIMES
Although it may seem counter-intuitive, gold can be as effective a hedge against deflation as against inflation; in fact gold's purchasing power is more likely to increase in deflationary periods than during inflationary eras.
Historical precedents suggest that gold's worth is powerful during deflationary periods.
The most recent deflationary period in the U.S. was 1929-1933 as the depression took hold.
In 1931, Britain came off the gold bullion standard and effectively devalued sterling; then, perhaps somewhat reluctantly, in 1933 the U.S. left the gold standard when President Roosevelt severed the dollar:gold link and banned domestic gold hoarding and gold exports.
Later that year, Roosevelt tried to nudge the gold price higher in the hope that rising gold would dispel depressionary forces. An increase in the dollar price of gold was, in an era when the gold standard had been prevalent, a de facto devaluation of the dollar.
Gold historian and analyst Timothy Green notes in his book The World of Gold that the precise each day was less important than the encouragement of a general upward trend, but also that the move was too gradual and failed to lift the U.S. economy out of depression.
Roosevelt then fixed the dollar-gold price at $35 in 1934 (an effective dollar devaluation of 40 percent) under the newly implemented Gold Reserve Act and the new gold exchange standard was established in the U.S., lasting until 1968 when a two-tier market was implemented, prior to the final severance of the dollar:gold link in 1971.
While gold's role as a medium of exchange may have proved disappointing to Roosevelt in terms of its impact on depressionary forces, gold's purchasing power increased substantially during this period of deflation, as it had in previous deflationary eras.
GOLD LOSES PURCHASING POWER DURING INFLATION
The Golden Constant, written by Roy Jastram over 30 years ago and recently re-released including fresh material by economist Jill Leyland, studies gold over a series of inflationary and deflationary periods, going as far back to the 17th century in England and the 19th century in America.
In England, over the past four centuries, gold lost its purchasing power in every period of inflation; by anything from 21 percent (in both 1675-1695 and 1752-1776) to 67 percent (1897-1920).
The story is similar for four periods out of five in the U.S., from 6 percent (1861-1864) to 70 percent (1897-1920).
The outlier here is the period of 1951-1976 when gold's purchasing power did increase in the U.S., by 80 percent as the price corrected after its sustained period pegged to $35/ounce.
BUT GAINS VALUE DURING DEFLATION
In each of the four deflationary periods since the 17th century in England, gold has increased its purchasing power, by between 42 percent (1658-1669) and 251 percent (1920-1933).
In the U.S. there have been three recorded deflationary periods - and gold increased its purchasing power in each of them - by between 44 percent (1929-1933) and 100 percent (1814-1830).
It could understandably be argued that these results stem from periods when the gold price was fixed, but Leyland notes that while a fixed price could help in the short term, there is a mass of economic experience showing that a price cannot remain fixed in the face of overwhelming fundamental forces.
Roosevelt having to free gold in 1933 (if only temporarily), and the subsequent changes in 1968 and 1971, are cases in point.
More recently, and in a different sphere, one can point also to the failure of the International Tin Council, in the mid-1980s, to sustain the efforts to maintain tin within a price bands an exercise that ultimately caused ructions in the London Metal Exchange and elsewhere.
STRESS IS KEY
In the short term, participants are concerned that any or all of the U.S., Europe or China could be sailing into deflationary headwinds.
History suggests that to sell gold ahead of such a development would be counter to the likely price outlook, as well raising investment risk profile rather than reducing it, especially as a deflationary environment would be likely to undermine equities, while keeping bond yields low.
Continued flattening in the yield curve suggests that the market is still looking for QE3. Such a development could help to dispel deflationary fears, but in mid-2012 they are still hovering in the background.
Finally, the fact that gold is under consideration at the Basel Committee for Bank Supervision for elevation to Tier 1 Asset status for commercial banks is informative enough in its own right, since it flags the continued stresses in the financial system.
Although the opportunity cost of holding gold would remain positive in a deflationary environment, the reduction of risk would be likely to outweigh this final consideration.