Below is an extract from a commentary originally posted at www.speculative-investor.com on 8th May 2005:

In our 13th April commentary we explained that under the current monetary system gold would not be an effective hedge against deflation (a contraction in the total supply of money and credit). Our conclusion, based on the facts as we saw them, was that when the official link between gold and the US$ was broken in 1971 gold went from being a hedge against deflation to being a hedge against inflation. Or, to be more accurate, gold went from being a hedge against deflation to being a hedge against the loss of confidence in paper currency that inevitably results from persistent inflation.

We get the impression that many gold bulls have bought into the idea that gold will protect them if a sustained period of deflation were to occur in the near future simply because it performed well during pre-1971 deflationary periods. Therefore, our main objective in writing the aforementioned piece was to prompt people to question whether past was necessarily prologue in this case given that gold's position within the monetary system is now very different to what it was during all prior deflations of the past three hundred years. Having briefly explained our thinking we weren't intending to spend any more time on this topic because we think the probability of genuine deflation occurring over the next few years is extremely low, but because our arguments have been inaccurately portrayed in a recent article by Bob Landis at http://www.goldensextant.com/Gold%26Deflation.html#anchor126324 we are going to re-visit the topic today. If nothing else, doing so will hopefully allow us to clarify some important points.

The first point is to once again state our view that under the current monetary system gold is not a hedge against inflation, but, rather, a hedge against the loss of confidence that eventually stems from inflation. For example, gold performed exceedingly well during the inflation of the 1970s -- a period when confidence in central banks and their currencies was falling -- and did not perform well during the inflation of the 1990s (a period during which confidence was rising). Over the past five years we have, however, begun to experience the bad consequences of the 1990s' inflation, and this has led to a drop in confidence and a rise in the gold price. We don't blame Mr Landis for missing this distinction of ours because it was just a footnote in the "Gold and Deflation" piece to which he was responding. It is, however, something we've addressed in more detail in other commentaries.

Secondly, we'll re-emphasize our strongly held view that gold is money and that the monetary demand for gold is by far the most important determinant of the gold price. Long-time TSI readers would be very familiar with this view of ours, but once again it wouldn't be fair to blame Mr Landis for not fully understanding our stance if our 13th April "Gold and Deflation" piece represents his only exposure to our analysis. Where we do think Mr Landis is remiss is in jumping to the conclusion that someone who believes gold to be a hedge against inflation, and not deflation, must also a) believe that gold is just another commodity, and b) be a supporter of state-controlled money. We are living proof that this is not the case. In fact, gold's performance during the 1970s is consistent with the view that gold trades primarily as money, because, as the below chart of the gold/CRB ratio clearly shows, the gold price moved sharply higher relative to the general level of commodity prices during this inflationary period. In other words, as inflation fears ramped higher during the 1970s the market appears to have attributed a substantial MONETARY premium to gold.

Gold's performance during the 1970s creates a huge problem for the view that gold continues to be a hedge against deflation rather than inflation. Mr Landis acknowledges this problem when he states: "Although gold's purchasing power followed the typical pattern up until 1970, after 1970, the price level rose, and so did gold's purchasing power. This had never happened before." However, after admitting that gold did something during the 1970s that it had never done before Mr Landis decides to sidestep this gaping hole in his argument. Rather than addressing the inconsistency he suggests that more research needs to be done before we can dismiss the detailed historical analysis of Professor Jastram.

For the record, we are in general agreement with the findings of the Jastram study mentioned by Mr Landis. It does, in fact, support our view that prior to 1971 gold was an effective hedge against deflation and fared poorly in times of inflation. What we can't fathom is why it is so difficult to believe that when the monetary system was turned on its head in the early-1970s the old relationship between gold and inflation/deflation was also turned on its head. Gold, after all, went from being the linchpin of the OFFICIAL monetary system to being a form of money that exists OUTSIDE the system.

On a side note, one possibility worth considering is that gold's explosive up-move during the 1970s was simply a reaction to the fact that the gold price had been held at an artificially low level for so long. That is, that gold was not really reacting to burgeoning fears of inflation but was, instead, just correcting the imbalance caused by the preceding price suppression. This possibility doesn't stand up under close scrutiny, however, because Paul van Eeden has shown that by mid-1973 the gold price had moved up to a level that fully accounted for all the monetary inflation that had occurred over the preceding 25 years (refer to http://www.gold-eagle.com/editorials_04/vaneeden030204.html for details). The huge rise in the gold price from mid-1973 until January of 1980 cannot therefore be explained by the price suppression that had occurred prior to the 1970s.

The final point made by Mr Landis is that the inflation/deflation debate takes focus away from the real issue, which is, according to him, whether and when we face monetary collapse. Our view on this subject is that every paper currency concocted throughout history has eventually collapsed to the point of worthlessness and today's bunch aren't going to be any different. In other words, we think monetary collapse is inevitable. Monetary collapse, by the way, is a consequence of rapid and sustained inflation (no currency has ever collapsed due to a REDUCTION in its supply).

However, although the odds are strongly in favour of an eventual monetary collapse there's no telling when it will happen. In fact, it might not even happen in any of our lifetimes. We agree that holding some gold as insurance against such an outcome is reasonable, but if, like us, you want to make money in the financial markets this year, and next year, and during every year between now and the time of the inevitable monetary collapse, then it would certainly behoove you to understand the intermediate-term probabilities of inflation and deflation as well as what investments are likely to do well during each set of circumstances.