There is an irrational fear of deflation that exists in our world.  Perhaps it is because of the Great Depression, where there was a deflationary effect due to bank failures.  It was a reversal of the fractional reserve lending process.

There is an association of deflation with a bad economy, but that is only because the so-called deflations we get now are associated with the central bank and the artificial business cycle.  If the Fed didn’t inflate in the first place, there would be no correction to deal with.

In much of the 19th century – ignoring the era of war in the 1860s – there was mild price deflation.  This was due to a relatively stable money supply with an increase in productivity.  It was a major benefit to people, as their earnings and savings had greater purchasing power.  It meant an increasing standard of living.

Although we do not currently have deflation in prices, or monetarily speaking, the Fed and other central bankers around the world are desperately trying to get higher price inflation.  The Fed has this ridiculous target of 2%, as if we are better off losing 2% of our purchasing power every year.

The main reason price inflation has stayed relatively low in Europe and Japan, despite easy money and low (even negative) interest rates, is because of fear.  People are holding on to some of their money due to a bad economy and perhaps expectations of continued trouble ahead.  People wisely don’t want to go into major debt or buy things they don’t need.

The U.S. is a little different.  The Fed has actually had a tight monetary policy over the last year and a half, despite the low interest rates.  So low price inflation right now actually makes sense in regards to the business cycle.  But price inflation was relatively low even during the several rounds of so-called quantitative easing.  Again, fear is a big reason.  It keeps velocity low.  Money changes hands less frequently.

There are some people who think that deflation is inevitable at this point.  We hear phrases such as “pushing on a string”.  And this isn’t a bad description of what is happening now.  But it is important to realize that the Fed (or any central bank) can create positive price inflation at any time, as long as it has a monopoly over the money supply.

Ben Bernanke said in 2002, prior to becoming Fed chair, the following:

” But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation .”

Bernanke has been wrong on many things, but on this point he is precisely correct.  The Fed could announce tomorrow that it will add $10,000 to every checking account per individual in the United States within the next month.  And if this didn’t do the trick, the Fed could say that it would continue this practice every month until it decides to stop.

This would ultimately bid up prices.  Upon such an announcement, certain commodities would likely jump dramatically almost instantaneously.  Gold would probably double in price in a short time frame, if not more.  Prices all over would be extremely volatile as the marketplace tries to figure things out.  But the general trend would definitely be up for prices.  Just the anticipation of massive price inflation would be enough to bid up prices.

The point here isn’t that the Fed would do something so dramatic.  It would probably lose a lot of credibility in an instant if it did such a thing.  Ironically, it might be less of a ripoff with this monetary inflation as compared to its past schemes of bailing out companies and funding government deficits.  Still, such a scheme of handing out money to everyone would redistribute wealth in a different way, and it would severely distort economic activity.

The main point here is that the Fed can produce positive price inflation at any time if it is really determined.  The Fed is not desperate right now.  It is content as long as the economy seems to be humming along.

The key is to figure out what the Fed will do if we hit a major economic downturn.  We can’t read minds, but we can look at incentives and past performances.  All indicators point to another round of money creation if things get bad enough.

And that is the number one case for owning some gold.