Gold in a Deflationary Economy - Part- VIII

The American Experience
Period 5: Inflation of 1933-1997

Duration: 64 years
Commodity Prices: +1013%
Purchasing Power of Gold: +51%
Monetary System: Gold Exchange Standard, then Fiat

During this period of time, all past monetary experience was discarded. As Milton Friedman describes, "For millennia the only effective limit was provided by the link between money and a commodity. That link provided an anchor for the price level....That experiment [the great experiment in which the world is engaged to see whether it can fashion a different anchor] is less than twenty years old as I write...the verdict is far from in on whether fiat money will involve a lower cost than commodity money."

Although the classic gold standard of 1897-1914, to which many economists use as a model gold standard period, was abruptly ended by World War I, and although a form of the gold standard-the gold exchange standard-existed until the Bretton Woods agreement of 1944 was abandoned in 1971, it is these last 27 years that has seen inflation soar and purchasing power destroyed.

Even before 1971, purchasing power was lagging. During the period between 1933 and 1997, the same wholesale price index used by Jastram to analyze prices in the 16th century soared a whopping 1013% but gold's purchasing power increased only 51% (although there were periods of better performance, such as the late 1970s). If it were not for the fact that during the same period real wages (adjusted for inflation) have risen sevenfold since 1700, the deterioration in purchasing power of the 20th century fiat currency system would have sent humankind back to the Stone Age in terms of poverty and strife.

Never before in history has inflation and gold prices soared as they did in the post-Bretton Woods era, and never before has a 100% government-managed fiat currency system been used globally outside of wartimes. After 1971, the gold exchange standard was dropped and this "great experiment" with government-managed fiat currencies began. This era is not yet resolved-a situation likely very dependent on the severity of the deflationary cycle that follows (and that likely began in 1997) and on the reaction of the Asian countries presently still involved in currency crises.

In fact, Jastram indicates that rough calculations made from the Abstract of British Historical Statistics and the Annual Abstract of Statistics of the Central Statistical office in London show that money wage rates of manual workers increased by 4600 percent between 1700 to 1972. This is how he was led to derive the statistic given above that indicates that the value of a hour's labor increased sevenfold during the nearly three centuries being considered.

However, our monthly market letter, The Global Market Strategist(R), has discussed many times the increasing likelihood of currency crisis and economic strife as we progress through the 1990s, the Decade Of Currency. From the collapse of the British pound and Italian lira in 1992, to the Mexican currency crisis leading to the collapse of the peso in 1995, to the collapse of the Asian currencies of 1997, the 1990s time and again have proven that a fiat currency system is not only difficult to manage, but is not working. This is because, in part, emerging countries into the unifying global economy do not have the experience of an Alan Greenspan Federal Reserve, for example, in managing their currency and making the necessary economic structural changes to maintain a stable economy. It is this global currency instability, along with the advent of the new European single currency, the euro, in January 1999 that will very likely provide the political force and incentive to move off the fiat currency system and back onto a form of the gold or bimetallic system. It will also likely help increase sentiment against the U.S. dollar's status as the "official" world reserve currency and lead to a change in the system. The euro will very likely be a key catalyst since, already, talk is that countries such as Russia will convert reserves over to the euro as soon as is feasible. This will begin a period of time in which power is drained from the U.S. dollar and the advantages of seigniorage to the United States diminish.

Getting back to Period 5 (1933-1997), the latter 21 years of which I continue the Jastram study and bring gold's characteristics into the present, note on the charts on pages 12 and 13 the period after 1971 when the U.S. abandoned the gold exchange standard and moved to a pure fiat currency system. This move allowing gold to fluctuate freely in the world marketplace and allowing citizens to again own gold resulted in a skyrocketing gold price to well above the Index of Commodity Prices where it presently remains. Jastram's Retrieval Phenomenon, then, has been at play yet again as the Commodity Price Index subsequently soared, chasing gold higher after it's post-1971 explosive advance. Throughout the 18-year bear market in gold since its 1980 peak, commodity prices have continued to play catch-up to the price of gold, as the Retrieval Phenomenon maintains would occur.

Yet the most significant development of the post-1971 period that makes it much different from other periods of inflation in the last four centuries is that, with the gold standard removed and a pure fiat currency system in play for the first extended period of time in history, investors can for the first time in history during an inflationary period retain operational wealth even though the purchasing power of gold has not kept up with commodity prices. This is an extremely rare historic opportunity since it marks the first time investors have been able to invest in gold in a freely fluctuating market during inflation, enabling them to gain operational wealth from an advance in gold's nominal price, not just in its increasing purchasing power. This important factor leads us to the final sections of this report-to its conclusions and recommendations.