The gold trade

Enough people have been bullish on gold that I wanted to write something about it so as to help myself think about this trade. 

I'm on the deflation camp of the inflation vs. deflation debate. The case for gold in the event of inflation as a result of loose monetary policy is obvious. It is the argument that gold would appreciate even in the event of deflation that I'm not comfortable with. I would say it is conceivable or even plausible that gold can appreciate in an unstable deflationary environment. It is also fair to say that when the Fed prints money to counteract deflation, the psychological net effect would be to bolster people's confidence in gold as a store of value than other fiat currencies. But these arguments somehow just don't sit well with my intuitive brain. That gold would appreciate in a deflationary environment just doesn't stand on sound enough logic that for me to risk my money on. But what do I know? Hedge funds bought gold at $800 which are up almost 20% now and I didn't. So I can be justifying myself out of missing a good trade. But below are the reasons why I think not.

It all boils down to what kind of deflation we're talking about.

In neo-classical economics, the Fed has a God-like control of money supply and on inflation. If we're in a mild deflation which the Fed has the wherewithal to break, then the result would be the Fed increasing money supply, causing gold to appreciate.  But if we're in a kind of deflationary spiral that the Fed is powerless, the outcome might be very different. In short, neo-classical economics fail to describe our current predicament.

In a debt-based money system, debt is money and money is debt. This point is so beautifully illustrated by Steve Keen. When debt to GDP ratio in the US is at 350%, money supply has been expanded massively beyond any sustainable level. This $50 trillion of debt-based money supply is beyond what the Fed can control through its $1 trillion money base. When the society as a whole wants to deleverage, it means money supply is poised to shrink, no matter what the Fed does. When money supply shrinks from such historic proportion, it is not going to be just a mild deflation that the Fed can reverse. What does this shrinking of money supply mean for gold prices in money terms? After all, gold is a good store of value because its supply does not increase arbitrarily like fiat money does. But what if the money supply is shrinking and gold's is not? When one economic quantity is shrinking while the other one is not, the one that is shrinking (money) is likely to rise in value versus the one that is not (gold). The deleveraging of the economy also means that people are scrambling to repay debt and repair their balance sheet. They would sell whatever assets they can sell for cash to pay down debt. If gold is what they have and what they can sell, so be it. Because you can only pay down debt with cash but not gold, cash will be more sought after than gold in a deleveraging world. 

Right now the market is not pricing in deflation, judging from the breakeven yields of TIPS and the strong performance of gold. But we will see if gold retains its value if deflation takes hold.