Credit Deflation Makes Me a Raging Gold Mining Bull

Most people think you buy gold and gold shares as an inflation hedge. I will agree that gold is a good inflation hedge, although perhaps not as good as silver and some other hard assets. But seldom is gold thought of as a good asset to own during a credit deflation. 

The Real Price of Gold Rises as Credit Bubbles Deflate

History demonstrates otherwise. Bob Hoye has gone back 300 years to take a look at five credit expansion/contraction timeframes, and he has found that in each case, the real price of gold (i.e., what an ounce of gold will buy) has increased dramatically during the contraction phase of the cycle.

Since Britton was on top of the world as a leading economic power, the first four cycles shown above were UK-centric. After World War I the U.S. became the leading economic power; thus, the fifth cycle contraction—the Great Depression—is shown above as a U.S.-centric event. Of course, what we care about most is the current cycle. Unfortunately the chart for the current cycle is a bit out of date. Since the equity and commodity markets bottomed in March of this year, gold’s real price has declined, to an extent. I spoke to Bob earlier this week and he expects to publish updated charts in his Pivotal Events in the near future. As soon as he does, I will share that with you in my weekly letter. For now however, I will do the next best thing and show you how much gold has risen, vis-à-vis the Rogers Raw Materials fund. Hoye has created his own commodity index, which excludes gold from it since it makes no sense to include the yellow metal in both the numerator and denominator of the relationship. 

In any event, to demonstrate that the same dynamic is once again in play during the current credit contraction, note the chart on your left, which measures the price of gold, relative to a diverse basket of commodities contained in the Rogers Raw Materials Fund. The main rise took place immediately after the Lehman Brothers failure in mid September of 2008. On Friday, September 12, 2008, just before the failure, one ounce of gold would have purchased 20% of a unit of the Rogers Raw Materials Fund, which includes oil and gas as well as soft and hard commodities. At the bottom of the decline on Feb. 20, 2009, an ounce of gold would have purchased 44% of a unit of the Rogers Raw Materials Fund. Currently, with the “risk trade” back in play, gold’s purchasing power has declined to just 35% of a unit of the Rogers Raw Materials Fund. However, that is still a 75% increase in what an ounce of gold will buy since the current credit contraction began to bite down hard on the U.S. economy.

The charts on page one illustrate that what is happening now, although not recognized by almost everyone, is not unusual. It is in fact very predictable. And unless you dismiss history and suggest that “this time it is different,” there is no reason to think the great credit contraction does not have a long, long way to go. In which event, I would submit to you that gold has a long, long way to go, in terms of increased purchasing power.

I might mention that Robert Prechter, who is perhaps the best known deflationist anywhere, agreed with me on my radio program that gold would increase in purchasing power, although he believes it will decline in nominal terms, vis-à-vis paper money. In fact that is exactly what happened last year following the Lehman Brothers decline. Gold in nominal dollar terms decreased in value, which meant, at least for a short period of time, the dollar gained strength, relative to gold. I do not rule that possibility out, going forward. But from my point of view, the important thing to realize is that in a serious credit contraction, such as the one we are currently in, gold’s purchasing power increases, relative to almost everything else.

Jay Taylor
Gold Investor