Rationale For Owning Gold In The Coming Deflationary Bust

People mostly think that gold protects purchasing power during periods of inflation. While that is true, it is not the only truth. The investment narrative does not consider gold’s value during deflationary periods.
Why should anyone be concerned about deflation when the monetary base of key Western economies is inflating like never before in history of mankind? The short answer is that deflationary and inflationary forces are currently working simulataneously in our economy. At the basis of this phenomenon are boom-and-bust cycles, which are driven by central banks (prohibiting the proper working of free market forces). Loose monetary policies of central banks do not allow a recession to clean out the inefficient resources and investments in the economy, resulting in intensifying deflationary forces.
Jim Rickards recently has explained deflation and inflation this way:

“You have deflation which is perfectly natural and what you would expect in a depression. A depression means among other things that people are deleveraging; when you deleverage you sell assets; selling assets pushes prices down; that makes things worse and prices go down more. Against that, we have inflation from the Fed money printing. These two forces are pushing against each other: deflation and inflation at the same time. It hasn’t been possible to estimate precisely, but in rough numbers we might have 4% deflation and 5% inflation at the same time which net out to about 1% inflation in the CPI.”

Investor and economic scholar Marc Faber takes the deflationary idea one step further. In a recent interview (see video below) he appears convinced that a deflationary bust is inevitable. The only uncertaintly appears to be timing. In his own words: “It could happen tomorrow, in five or ten years time.”

“In a collapse, over time, everything goes down but some assets go down more [in price] than others. Traditionally, it is best to hold cash. The key question is: what kind of cash and in which form? For instance, one could hold its cash in bank deposits, but not all cash will be repaid. Cyprus is a good example. You will get your cash on a bank deposit back in some sovereign countries but not in others, depending on the quality of banking system (although in a collapse, most likely, all banks would suffer). Moreover, one needs to make a choice of the currency. The dollar could look good for the time being, but eventually it could become the worse currency (which is what I expect). The question here is the meaning of “weakness” … a currency is weak against what exactly? As all central banks are printing money, their value all go down simultaneously. In such an environment, gold is a good solution. This is the rationale to hold some money in the form of [physical] gold. Cash is not necessary the best investment.

There you have the rationale on owning gold and even accumulate it when the signs of a deflationary collapse would pop up.
Although  Faber did not mention it explicitly, it is interesting to see how his view is in line with Exeter’s inverted pyramid (also, Exeter’s golden pyramid). The pyramid visualizes the organization of financial asset classes in terms of risk and size. Gold forms the small base of most reliable value, and asset classes on progressively higher levels are more risky. Wikipedia notes that while Exter’s original pyramid placed Third World debt at the top, today derivatives hold this dubious honor.
Professor Fekete provided an explanatory note back in 2007:

“The grand old man of the New York Federal Reserve bank’s gold department, the last Mohican, John Exter explained the devolution of money using the model of an inverted pyramid, delicately balanced on its apex at the bottom consisting of pure gold. The pyramid has many other layers of asset classes graded according to safety, from the safest and least prolific at bottom to the least safe and most prolific asset layer, electronic dollar credits on top. (When Exter developed his model, electronic dollars had not yet existed; he talked about FR deposits.) In between you find, in decreasing order of safety, as you pass from the lower to the higher layer: silver, FR notes, T-bills, T-bonds, agency paper, other loans and liabilities denominated in dollars. In times of financial crisis people scramble downwards in the pyramid trying to get to the next and nearest safer and less prolific layer underneath. But down there the pyramid gets narrower. There is not enough of the safer and less prolific kind of assets to accommodate all who want to devolve. Devolution is also called flight to safety.”

The scramble for safety in the form of physical (!) gold is not new, although people in the West mostly do not recognize gold’s monetary value. Sound money expert Claudio Grass from Global Gold Switzerland points out that throughout monetary history the investment focus has always shifted from capital growth to capital preservation during periods of profound deflation. “Deflation thus always comes with falling confidence in the (perceived) root cause of the crisis (governments, banks, speculators, etc.) and their rating. Therefore the purchasing power of Gold gains also within a deflationary scenario.”