10 Jan 2010

Gary North Tackles the Deflationists

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Today LRC ran a Gary North article in which he took on the deflationist camp. Although his official target is a guy named John Exter, the apparent grand-daddy of the viewpoint, North’s critique applies perfectly to someone like Mish who claims that there will be a general deflation yet a constant / rising gold price because “gold is money.” (I am pretty sure that’s what Mish’s view is, but please correct me if I’m off.)

Some great excerpts from North’s column (emphasis mine):

Anyone who really believes in Exter’s scenario should recommend paper money rather than gold for investors with less than $10,000 to invest. The investors with more money should buy T-bills. Why? You don’t have to pay taxes on your capital gains with paper money and T-bills. Legally, there are no capital gains. In fact, there are: everything costs less, and you have cash to spend.

Any investment advisor who predicts inevitable price deflation who does not recommend T-bills and paper money is faking it. He doesn’t really believe his position.

According to Exter, gold is more liquid than anything else. This is wrong conceptually. Gold is not money today. Therefore, you must pay a commission to buy or sell it. If you pay a commission, the asset is not truly liquid. One of the three characteristics of liquidity is the absence of any commission. This means money. Any asset that can be exchanged only by paying a commission is not money.

Gold’s price will fall in a time of deflation. It will fall because gold is not money except for central banks, and they hold it mainly for show, as I shall explain. It is a mass inflation hedge. It is not a deflation hedge.

We have never had an opportunity to test Exter’s theory of gold as a hedge against price deflation, because there has yet to be a single year in which the CPI has fallen.

Say that you buy a share of stock at the market price. Let us call the company Madoff, Inc. You buy it for $100. You write a check for $100 to your broker. The $100 goes from your bank account to the broker’s bank account, and most of that money then goes to the bank account of the person who sold you the share.

Then bad news hits regarding your stock. The company has cooked the books. It turns out that the company is an empty shell of debt. The share price immediately falls to zero. You take a 100% loss.

You are a big loser. The person who sold you the share is a big winner: he got out in time.

The money supply has not changed.

What is the effect of the collapse of Madoff, Inc. on consumer prices? Nothing.

Why not? Because the price of Madoff, Inc. was an imputed price based on a few sales. Until the bad news hit, not many people bought or sold Madoff, Inc. There were millions of shares outstanding, but only a few thousand traded on any day. The price at which the latest share traded was imputed by the market to all the others. The money involved was limited to the handful of actual trades.

You lost the $100 on the day you wrote the check. You received an asset that you thought was worth $100, which it was, very briefly. Then it wasn’t.

You say “I lost $100 when the stock fell to zero,” but this is a mistake conceptually. You are applying the loss to the value of the share. You lost your expected future value on the share.

Yes, you lost money. You lost your money on the day you bought the share. You gave up money for a dream. The market value of your dream then collapsed. You did not lose money at that point. You lost it when you wrote the check. What you lost when the stock’s price collapsed was value. You did not lose money. The asset was not money.

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