Deflation is the unknown that scares gold bugs the most. The typical hoarder of gold is contemptuous of paper assets in general and of fiat currency in particular. He is hostile toward the very idea of central banking, convinced that the bankers, by pushing easy credit, have brought the global financial system to the brink of collapse. And he believes, most fervently of all, that only a hoard of bullion will see him through hard times unscathed.

But what if deflation produces times so tough that even bullion sinks in value because it has become unaffordable? Gold bugs should be comforted that bullion’s purchasing power held up well during the Great Depression. Moreover, at the time, gold had competition from a fundamentally sound dollar that, to put it mildly, no longer obtains. In fact, with no gold or silver behind it, the dollar has become intrinsically worthless, bereft of any backing save the blood, sweat and tears of earnest taxpayers.

So how, then, will this supposedly worthless cash become “king,” as the textbooks say it must in a deflation? Actually, the textbooks will have to add a new chapter, since this will be the first time in history that debt deflation will have occurred in a world drowning in bogus money. Some would argue that it is a case of the irresistible force meeting the immovable object – i.e., that the existence of one precludes the other. But if you wipe out all of the credit money and run the economy on cash alone – which is what I believe will happen – cash money will become sufficiently scarce to rival gold in purchasing power.

Waking Up Broke

Whatever happens, gold bugs are unlikely to bear the full brunt of a deflation. As I have implied above, they will possess an asset that probably can do no worse than hold its purchasing power. But if the global economy plummets into darkness, don’t expect a few ingots and doubloons to finance a retirement in Switzerland.

My reservations about gold are rooted in the fear that we will experience an actual plunge, rather than a gradual slide, into economic winter. I used the word “precipitous,” and I meant it quite literally. To put it as bluntly as I can, I believe there is a more-than-negligible chance that we will awaken one morning to a financial cataclysm that has left us all flat broke – meaning, for one, bereft of liquid savings that could conceivably be exchanged for bullion.

It might take a few months to fathom the extent of the damage, and years for securities markets and real estate valuations to fully reflect it, but it will nonetheless come to pass if deflation implodes the financial system. Securities markets will be frozen in place while the bean counters attempt to sort out the mess. Ultimately they will fail in this task, since re-sequencing debt maturities so that everyone gets paid in due time will be like trying to retrofit the lower floors of the Trade Towers while the buildings were ablaze.

Bailout Impossible

Although nearly everyone seems to think the Fed will effect some sort of bailout before a meltdown occurs, the fact is, there is no practical way to do so. An administered hyperinflation is most certainly not the answer, since it would destroy savers and lenders as a class, rendering the bond markets largely inoperable for perhaps a generation. Far more likely is that liquidations will simply be allowed to run their course, punishing sinners more or less in proportion to their sins.

A global financial panic is certain to stampede savings into Treasury paper. But gold bugs may be deluding themselves to think that any subsequent disintermediation would favor gold assets above all others. In the first place, cash credit for the purchase of precious metals will have been reduced by liquidations to a tiny fraction of the amount currently available. Secondly, what crumbs remain of the world’s liquid savings will likely go not into bullion, but toward survival. Whether you are a firm or an individual, you’re going to use every scarce dollar you can lay your hands on to keep the bill collectors at bay and a roof over your head. Well down the financially flattened household’s list of budget priorities will be the need to purchase bullion to protect one’s paltry remaining net worth from the ravages of inflation.

The Post-Mortem

When the workout teams tote up assets and liabilities, the post-mortem will show that America’s economic engine had been running on fumes for years and that most of our supposed wealth was merely a credit-induced mirage. Hard to believe? Then ponder this: Derivative debt instruments currently in play total $248 trillion, according to the most recent figures from the Bank of International Settlements. This compares with a global economy in real goods and services amounting to a little less than $40 trillion. It’s not a case of the tail wagging the dog, but of the tail wagging an entire financial cosmos.

A look at the corporate microcosm is instructive, since it shows how we’ve been able to clone hundreds of trillions of dollars of metaphysical wealth from the seeds of debt. General Motors, a manufacturer that has entered its death spiral, has a market capitalization of about $16 billion but supports debt of more than $300 billion. Every penny of it sits on someone else’s books as an asset. But make no mistake, the entire sum – and, no doubt, billions of dollars downstream of it – could vanish in an hour if there’s a systemic meltdown. 

In the event, gold can be counted on to hold its value relative to all else, and that’s why physical bullion, if not necessarily shares, should be in every investor’s portfolio. But  $1,000 an ounce? That could be hoping for too much in a worldwide depression that has virtually wiped out savings and pushed Europe’s, Asia’s and America’s middle class to the threshold of destitution. 

No Time to Panic

Some would argue that plenty of smart guys will see it coming and that their ensuing scramble for gold will push quotes to exorbitant levels. Perhaps. But my fear is that the collapse will unfold so quickly that there will be no time to panic, much less secure one’s assets against the unknowable. Under the circumstances, it’s worth asking what kind of shape you’d be in if you were to awaken on Monday to news that the markets, because of some epic crisis, have shut down indefinitely. To be sure, you’ll be no worse off for having a roll of Krugerrands stashed in a safe deposit box. But as for the rest of your assets, including your home, they may not be worth much in barter. You’d be living from paycheck to paycheck -- assuming you were lucky enough to still have a job. 

For now, deflation’s overwhelming power will remain submerged until the dollar’s climb begins to accelerate. When that happens, the burden of debt for all who owe dollars will increase commensurately. Few could want this outcome, but it is all but unavoidable – a manifestation of Murphy’s Law in a world that cannot afford to pay back what it owes with dollars that come any dearer than they are now.

Unfortunately, evidence that the dollar is primed to go the “wrong” way could not be more obvious. In the chart below, you can see that it has been in a mild uptrend for most of 2005. If you had known at the beginning of the year that America’s budget would be subjected to the shock of two catastrophic hurricanes, a still-burgeoning trade deficit, a $350 billion war and an unprecedented spending binge on Capitol Hill, you’d have thought the almighty buck was headed into a perfect storm.