Tuesday, December 02, 2008

Japan's deflation, gold, & liquidity

The picture above shows a 5 year chart of gold during Japan's first 5 years of deflation. The author of the blog who posted this chart made some interesting conclusions that I would tend to agree with:

(1) Genuine deflation is a sustained contraction in the total supply of money and credit, NOT a fall in the general price level
(2) It's actually more accurate to say that gold is now an effective hedge against the loss of confidence in fiat currency sometimes caused by inflation because during those times when the money-supply growth rate is high but the inflation is not perceived to be a problem -- during the late-1990s, for example -- gold does not perform well

Looking at point (1), the money supply actually grew in a period where government real GDP fell. When we actually see TMS start to fall significantly, we will start to actually see inflation. On point (2), since gold is not readily exchangeable to pay debts, it will probably continue to decline until people or companies that held gold stop liquidating it to pay off credit and other asset losses. This what Goldman Sachs had been doing recently to unwind their credit losses.

This is a good reason to believe that markets are not efficient. During times of "crisis" it is nearly impossible to have a market accurately price the value of an asset due to liquidity concerns by individuals. It is bad for people who made bad bets and had poor risk management, but this is good for value investors who will ultimately make a lot of money through this crisis.

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