Hedging against deflation

October 6th, 2008

Share |

The recent nationalisations, collapses and runs on banks in the US and Europe brings a new dimension of economic uncertainty to many people. The last time such things occur in the developed Western world was during the Great Depression in the 1930s. For this current generation of economists, financial analysts and money managers, a credit crisis is something that is supposed to occur only in textbook studies of the past. But recent financial market events brought such abstract history into real life. Suddenly, the idea that cash is no longer safe is a rude surprise for many. If cash is no longer safe, then where else can you hide?

This is what is technically called “deflation.” Deflation is not as simple as just falling prices. It is, as we explained in Will deflation win?,

A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.

We recommend that you read our guide, What is inflation and deflation? for more information about this topic.

So, if you are particularly concerned about deflation, how should you protect yourself? As we said before in Should you hold gold or cash in times of deflation?,

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.

The key thing to remember is that as long as your asset is a liability of someone else (e.g. bank), you have a counter-party risk. If your counter-party defaults, your asset is gone. In this evil kind of deflation, counter-party default is the greatest risk to your wealth. Therefore, there is only two ways to protect yourself:

  1. Choose your counter-party wisely.
  2. Keep your wealth in a physical form such that it is nobody else’s liability.

We will first explain point (1). Basically, the only supposedly risk-free counter-party is the government because it has the executive power to tax and print money (note that we used the word “supposedly”- the Russian government defaulted on its bonds in 1998). If you store your wealth in the form of government debt (e.g. Treasury bonds), you will be guaranteed a periodic payment from the government. As we explained before in Measuring the value of an investment,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

In times of deflation, government bonds will be so highly sought after that its free market value will rise. Consequently, its yield (rate of return) will fall. On the flip side, government bonds are completely useless during inflation. In times of hyper-inflation, government bonds are as good as toilet paper.

Now, point (2) is already explained in Should you hold gold or cash in times of deflation?. But we would like to add a few more points:

  1. Gold was an excellent hedge during the days of the Great Depression because the US was still under a gold standard. The government would print a specific amount of US dollars to buy the gold that you presented to them. As we quoted Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?, the gold mining industry prospered during the Great Depression because

    So long as there exists at least one country [the US] on a full gold standard, an essential condition of which is freedom to buy gold from or sell gold to the central institution at a fixed price, there is literally an unlimited demand for the commodity at that price. In other words, not only is a minimum price for the product of the industry guaranteed, but there is, besides, no limit to the amount the market will take.

  2. The case for physical gold as a deflation hedge is weakened if the government insures bank deposits. In the US, the FDIC insures up to $100,000 of bank deposits. In Australia, there is NO government deposit insurance.
  3. But if for whatever reason, you (1) distrust the government’s deposit insurance, (2) have more than the amount that is insured by the government, (3) believes that the government will print lots of physical cash to provide for cash withdrawals in a bank run, (4) put a freeze on cash withdrawals to prevent bank runs, (5) government does not insure bank deposits (e.g. Australia), (6) can only trust storing your wealth in tangible form (6) etc, there is still arguably a case for holding gold as a hedge against deflation.
  4. The US government outlawed gold ownership during the Great Depression. It may happen again this time.

Tags: , , , , , , ,