Japanese-style European deflation or US hyperinflation?

Investors in Europe rushing to buy gold because they fear inflation are acting logically to a worry about governments printing money but deflation is actually a far more immediate problem.

The reality of global economics right now is that deflation is coming because the flow of credit is actually contracting all over the world. Governments have stopped some of this decline with their own borrowing but the net money supply is contracting and not expanding.

Money supply contraction

Without more money going into the system, global equity, real estate and bond prices are bound to decline, and will do so until credit expansion begins again, and that will only happen if interest rates are set far higher (which also means lower asset prices). History suggests this is a multi-year process and follows a market correction and realignment of asset prices.

But that does not make precious metals a bad safe haven. If they carry on rising in value – due to higher demand reacting against a relatively fixed supply – then they will perform relatively well, and more than maintain their purchasing power.

For example, if the price of houses falls by 75 per cent and the gold price doubles then one ounce of gold will buy eight times more property than it does now.

Would the central banks allow this to happen? So far the Federal Reserve has led a coalition of the willing to pump up markets as far as possible by money printing. It can be relied upon to continue this policy. But the danger is that US deficits are getting out of control.

US debt mountain

The IMF has recently pointed out that under the Obama administration’s current fiscal plans, the national debt in the US will climb to above 100 per cent of GDP by 2015 – a far larger increase than almost any other country.

The danger here is that the US dollar will collapse under the strain, leading to hyperinflation. This is why Europe is going down the austerity route now with its deficit reduction plans. It is not doing this because governments wish to become unpopular and ferment social dissent. If there was a real alternative it would be quickly employed.

The Governor of the Bank of England stated last week that he and ex-Prime Minister Gordon Brown at least had the option of shifting bank debt on to the public sector in the financial crisis of October 2008, but that cannot be done to solve a sovereign debt crisis.

Printing money only puts off this problem and the economic collapse that follows a bond market crash is something far worse. Is this where US policy will end up?

So both deflation and inflation are coming as asset markets whip-saw and governments try to make a credit contraction as painless as possible. But investors can be easily caught out in this environment and a flight to precious metals is predictable as a preserver of wealth.