Will gold mining shares hedge against deflation again since the Great Depression?

January 31st, 2010

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During the Great Depression, gold mining stock prices were the only bright light in the darkness. As one of our readers found a 1931 newspaper quote,

Gold mining stocks have been among the strongest performers since year-end; earnings this year seen exceeding both 1930 and 1929; miners are benefiting from stable price as production costs decline.

As we quoted the most deeply buried Austrian School 1936 classic (originally written in German), Crises & Cycles by Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?,

Leaving aside the industry of manufacturing books on crises and cycles, there are two big industries likely to prosper inversely to the depression, the armaments industry and the gold-mining industry.

Does that mean that gold mining shares are going to do well in times of deflation because it did well during the deflationary period of the Great Depression?

No.

Here, we have to be careful in applying the lessons learnt from history correctly. There is a reason why gold mining shares did well during the Great Depression. Unfortunately, that reason does not apply in today’s context. What is the difference between today and the Great Depression?

The gold standard.

You see, back in 1931, one ounce of gold was defined as approximately US$20. Back then, as we introduced the history of money in our book How to buy and invest in physical gold and silver, currencies (e.g. dollar, pound, franc) were merely warehouse receipts for physical gold. In a sense, the central bank was a government granted monopoly gold warehouse.

In other words, the Federal Reserve was the only institution in the world that would buy and sell gold at a guaranteed fixed price (because the US was the only country still under the gold standard). The were two implications:

  1. There was an infinite ‘demand’ for the produce of gold mining companies.
  2. The price of the what the gold mining companies produced had a minimum price.

As the Great Depression was a period of deflation, prices of everything were falling. That means the costs of gold mining companies were falling as well. So, if you have a business in which the things that it produces:

  1. Have infinite demand
  2. Have a guaranteed minimum price
  3. Are getting cheaper to produce

Wouldn’t that be a windfall for you business? Indeed, that was the fortunate position faced by gold mining companies back then. That’s why their share prices were rising. Today, no country is under the gold standard and thus, currencies are backed by nothing. Therefore, gold mining companies are facing an entire different situation:

  1. Their produce have finite demand
  2. Prices of their produce fluctuate
  3. Costs of producing are increasing

Even if real deflation is to happen today, falling cost of production will be accompanied by a fall in price of gold.

So, if you find any experts, tip-sheets and research reports justifying buying gold mining shares as a hedge against deflation by using the example of the Great Depression as the basis of their recommendation, then you know what to do.

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  • Pete

    Great article CIJ 🙂

    Answers a lot of questions I could pose on this topic…thank you.

    It is also a good reminder (for me) to not expect the past (eg Great Depression) to completely reflect the future. This is only the case if the situation/environment is the same.

  • Our feeling is that some people may not like this article. Any guess as to reason why?

  • anon

    There are a number of investors who tout the same reasoning – but gold is still viewed as a safe haven during economic uncertainty in places e.g. China, India, Asia at large. I am not sure if its monetary function has entirely ceased.

    Marc Faber certainly thinks of gold, gold equities as a good deflation hedge:

    http://news.kontentkonsult.com/2007/11/gold-def

    https://www.kitcomm.com/showthread.php?t=20106

  • Pete

    Vested interests?

  • Dreamnjoel

    Did any insiders know gold was going to be revalued in 1933?…could that be why the price also rose so rapidly?

  • Anonymous

    wrong…. gold does not fall in deflation when real interest rates are negative and the whole world is devaluing their currencies in a race to the bottom.?