Should you hold gold or cash in times of deflation?

September 27th, 2007

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In our earlier article, What should be your fundamental reason for accumulating gold?, we said that:

If you cannot remember anything else, please remember this: gold is a hedge against loss of confidence in fiat paper currencies.

Such loss of confidence manifest itself in the form of hyper-inflation, which is what is happening in Zimbabwe right now.

Now, what about in the situation of deflation (the bad kind of deflation due to economic malaise, not increase in productivity)? If you can recall, in The mechanics of deflation- increase in demand for holding cash, we elaborated on deflation:

Deflation happens when liquidity dries up. This can happen in a period of severe economic pessimism when the apprehension of the future drives people to increase their holdings of cash for the sake of peace of mind. When that happens, the quantity of money in circulation decreases, which means there are fewer money chasing after a given amount of goods and services. Consequently, prices have to decrease to accommodate for the decreased supply of money in circulation.

Thus, as we said before in Warning: gold price can still fall significantly

When the inevitable liquidity contraction occurs, gold price will fall as well. On that day, we will be ready to swoop in with cash to buy even more gold.

So, a good question to ask is this: in times of deflation, wouldn’t it be better to hold cash instead of gold?

The short answer is this: In theory, yes. In reality, no. If you want to know the long answer, read on.

Yes, in deflationary times, the purchasing power of cash increases. But when deflation occurs in times of severe economic pessimism, there will be asset price deflation, high unemployment, collapsing businesses, bankruptcies, bank runs and so on. In such an environment, is your ‘cash’ really safe? Remember, for the vast majority of us, most of our ‘cash’ does not exist in the form of cold hard physical paper. Most of them exists in the form of bank deposits. As you may recall in 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?, because of the fractional banking reserve system, every physical dollar deposited into a bank account will eventually result in multiple times the value of bank deposits into the financial system.

That is where the trouble starts.

You see, the ‘cash’ that you had deposited in a bank is an asset to you but a liability to the bank. In times of severe economic conditions (e.g. during the Great Depression), can your bank honour its liabilities? If it can’t, then your ‘cash’ is in grave danger (if it can due to the government guaranteeing deposits via printing money, then we have inflation problem)!

If you hold physical gold (in bullion form, not jewelery), it is a different story. It is your asset and nobody’s liability. In times of deflation, even though gold prices may fall in nominal terms, its physical presence gives you the assurance that abstract ‘cash’ cannot provide. For this reason, you may still want to hold gold even in times of deflation.