I often get asked, “how can gold rise if there is a risk of deflation? I thought gold was a hedge against inflation?”
- The real reason why gold does well when there is sharp monetary deflation is because of the risk that deflation poses to the banking system.
- Under period of sharp monetary deflation, debtors’ nominal debts become burdensome because debt levels remain constant, while incomes fall. A lot of these debtors could actually declare bankruptcy because they have very little hope of paying off the debts.
- If there are numerous bankruptcies, banks aren’t able to recoup the money that they’ve lent out which decreases their solvency.
- Under these conditions people become worried about the bank’s financial position.
- There is also minimal much trade-off between holding deposits in the bank vs. hold hard cash under the mattress.
- Rather than waiting for a possible bank run, consumers withdraw cash and store the money at home
- Gold is much easier to store than actual bank notes!
NB to note that sharp monetary deflation noted above is very different to gradual low inflation/slight deflation on certain products or services. Take an example where CPI inflation is zero % y/y. It’s very unlikely that all goods and services would run at 0%y/y. Some would inflate slightly and some would deflate slightly to cause a net-net 0%y/y inflation. Under these conditions a people just shouldn’t choose to take on debt if they in the business of producing the goods/services that are deflating and they aren’t able to grow the quantity of that they sell of this good or service (if you can grow the quantity sold you can still generate higher revenues and thus pay off debt). For example, the post office that provides a service where demand is falling and the price of the service is also falling. It’s not a good idea for the post office to go into debt. But this makes logical sense to all of us – don’t leverage a dying industry.
Here’s a nice short article by Phillip Bagus that explains positive deflation: https://mises.org/library/defense-deflation-0.