While silver and gold continue to backtrack against the dollar's higher degree rally, my thoughts turned to other things.

First I indulged in some silver housekeeping as I closed all my storage accounts including my participation in the Perth Mint Certificate program. The reasons for that are outlined in the next issue of my newsletter where I look at the potential and real systemic effects of a cash flow problem in precious metal warehouses. It has happened before and it will happen again. I also look at the Perth Mint's credit rating as part of the Western Australian Government.

So, with cash in hand, it also was a good time to convert silver and gold holdings since the metals were in a corrective phase. What to do? Buying the physical metal was the obvious choice and that is the tactic I have pursued so far. However, a few recent articles on the inflation/deflation debate got me thinking about ways to hold silver and gold bullion.

There are two questions that need to be asked. The first is whether a major monetary crisis would be deflationary or inflationary. The second is how silver and gold would perform in a deflationary situation.

The answer to the second question, in my opinion, is that silver and gold will drop in price during a deflation unless two things happen. One, government intervenes to prop up the price (as with gold during the Depression) or a related systemic threat to the fractionally reserved banking system puts the stability and accessibility of paper money in public doubt.

Unfortunately, there are some ifs, buts and maybes involved in the debate. During the commodity deflation of the 1920s and 1930s, silver performed terribly (see my article here) but at the same time gold held firm at $20 an ounce due to the American gold standard. Yet despite silver dropping to 25c an ounce in 1932, a dollar coin still held the same amount of silver.

During that period, gold and silver were used as money; so fleeing to 100oz silver bars and gold Krugerrands would have been a pointless exercise even if such items were available. The main fear was not how money was defined but whether your money was safe and accessible in the vault of your bank. Thousands of banks went bust as the fragility of the fractional reserve system was exposed during countless bank runs.

And so we find ourselves in a different era but with similar worries. Our banks still do not cover all liabilities, but we now have the added "luxury" of money that is a liability itself being back by nothing more than hope in the future.

Fiat money rules the roost and gold and silver have taken a back seat. There has been no major episode of deflation since the 1930s as monetary expansion runs at rates ten times faster than anything seen under a stable gold standard. Deflation seems unlikely as even Japan manages to slow deflation down with a tsunami of yen hot off the digital printing presses.

So how does the investor in gold and silver approach this subject? If inflation is going to be the dominant force on the economic horizon until fiat money is finally dropped as a bad idea, we just hold onto gold and silver. Okay, but how do we hedge against a possible episode of deflation?

As I thought on how to reallocate my liquidated storage accounts, I thought back to the early 1930s when silver was an investment dog. In that time silver dropped, but the Peace or Morgan dollar in people's pockets was still officially valuing silver at $1.29 an ounce. The Roosevelt government reaffirmed this by passing the 1934 Silver Purchase Act, which instructed the Treasury to fix the price of silver at $1.29 per ounce. To eliminate market competition, large stocks of silver bullion were called in and a huge 40% tax was placed on any silver profits.

So what happened in the public perception? By holding onto silver dollars and any other silver currency, they knew the government had pledged to maintain that 0.773 ounces of silver would have the purchasing power of one dollar. That pledge was revoked in 1964 as the inflating of the dollar caused the price of silver to exceed $1.29 an ounce.

Now if we look at one of the last 90% silver coins, a 1964 Kennedy half dollar, we see that the silver content of the coin at today's spot price is $2.57 based on its silver content of 0.362oz. So its silver value is just over five times its 50 cents face value. Nobody is going to spend such a half dollar in their local store at that rate of exchange.

Now look at the Kennedy half dollars minted between 1965 and 1970. They are only 40% silver and contain 0.148 ounces of silver. At today's spot price, they have a silver value of $1.05 or just over two times face value. Once again, this is not likely to appear in a cash register.

How would each coin fare in a real deflationary situation where commodities tank and somehow the Federal Reserve's best attempts to counter-inflate the dollar fails? Let us suppose silver drops by half to $3.50 an ounce. The 1964 half-dollar is now about 2.5 times face value but a 1965 half-dollar has nearly reached face value with a 52c silver value. The 1965 coin has reached an important point. The face value of the coin equals its silver value, and has reverted back to circulating money as there is no incentive to hoard or sell the coin for its melt value.

Now let us suppose deflation takes a greater grip and silver drops to $1.38 an ounce. Now the silver value of the 1964 half-dollar equals face value. But note that even though the silver value of the 1965 half-dollar has plummeted to a paltry 20c, the purchasing power remains at 50c and will do so no matter how hyper-deflationary things get. By purchasing 1965-1970 half-dollars, we have set a floor on the value of our investment at $3.38 per ounce of silver whereas the floor is set at $1.38 for pre-1965 half-dollars.

The win-win situation kicks in at the other end when silver takes off as we expect. Whether your coin is 40% or 90% silver, its value will increase in proportion. The silver equivalent of 100 1964 half-dollars is 225 1965 half-dollars. Whichever of these you hold, both will increase with silver at roughly the same rate. In terms of the premium on holding 40% coins over 90% coins, I note that one popular coin dealer was selling 40% coins at $6.72 per equivalent ounce of silver compared to $7.24 per ounce for 90% bags with free shipping and insurance on both. So it seems you can get your 40% silver cheaper (I don't know their buy-back costs).

So what does this mean in practical terms? If you bought a bag of 1965-1970 Kennedy halves at $5.00 an ounce you are limiting your losses to 30%. If you bought at $7.00, the maximum loss is 50%, so the loss increases as the purchase price of the silver increases. If you are unsure whether deflation or inflation lies ahead then perhaps the 1965-1970 half-dollar is the investment for you.

There is another interesting point about this $3.38 floor price for 40% halves. Pull up a 25-year chart for silver and you will notice that the silver bear market made a double bottom in 1991 and 1993 at about $3.50. The exact intra-day low I believe was $3.51 in March 1993. Could it be that 40% Kennedy halves contributed to this floor in the silver price? Note that at $3.51 an ounce, you could sell a 1965-1970 50-cent coin for 52 cents minus costs. In other words, it is not worth the effort. Did their owners see the price of silver approaching this magical price of $3.38 and stop selling their coins? With over 848 million such coins minted with a silver weight of 125.6 million ounces prior to the great silver melt of the 1970s, was that enough to halt the drop? I don't know, but it looks mighty suspicious to me!

Finally, if you live in Britain or Euro-land, your old silver coins are no longer legal tender and you cannot execute an equivalent deflation play. The alternative you have is to purchase the 40% half-dollars in the same way as American investors but then exchange them for your currency. You would need to check first whether any bank would be prepared to take them plus there is the matter of how the pound sterling, euro and dollar exchange rates would fare in this deflationary scenario. My feeling is that the dollar would outperform the Euro and Pound due to its relatively stronger economy, so you get more local currency for your dollar.

In conclusion, with Peak Oil, Baby Boomers and a general fracturing of the fiat money system ever threatening, the outlook is inflationary. Possession of 1965-1970 Kennedy half-dollars ensures that some of your investment is both inflation and deflation proofed. You have the best of both these calamitous worlds.

Roland Watson writes the monthly investment newsletter "The New Era Investor" that can be purchased for an annual subscription of $99. To view a sample copy of the newsletter, please go to www.newerainvestor.com and click on the "View Sample Issue Here" link to the right.

Comments are invited by emailing the author at newerainvestor@yahoo.co.uk