Disaster Scenarios

This is the eleventh post in a series entitled Currency, Money and the Economy.

In the last post, we identified a trend between the Dow and gold. In order to understand how to take advantage of that trend, we need to examine each scenario and see how each asset performs. Note that each scenario is measured from the peak of the Dow in 2000, from which the current economic cycle began.

Scenario #1: Deflation
Prices fall like a rock. Gold will hold steady at $1000 an ounce, but in order to reach the 2-ounce ratio, the Dow will crash to 2000. From the 2000 high, that is a loss of 83%. Think that is impossible? In the Great Depression, the Dow dropped 89%. The Japanese Nikkei index was 39,000 in 1989. Today it stands at 9700, a loss of 75%. Well, if gold doesn’t increase in price, how does that help me? It will because the price of everything else will drop, making things much cheaper to buy. Cars will cost $15,000 instead of $30,000 and house prices will also drop by 50%. Yet gold will still be the same price.

Summary: Paper assets: -80%, Costs: -50%, Gold: 350%
Winner: Gold

Scenario #2: Stagflation
This is the scenario that Ben Bernanke envisions as the one he wants to fight. As he indicated, if the Federal Reserve starts to see signs of deflation, they will pump as much money as they can into the system to make sure it does not go down. In the best case scenario, the Dow will stagnate at 12,000. In order to reach the 2-ounce ratio, that means the price of gold will increase to $6000. However, pumping more currency into the system will cause inflation, though not at extreme levels. Costs will increase gradually, but it will make things more expensive, probably 50% over a five-year period.

Summary: Paper assets: 0%, Costs: 50%, Gold: 2150%
Winner: Gold

Scenario #3: Inflation
If the powers that be lose control of scenario #2, then prices will rocket out of control due to runaway inflation. The Dow will surge from 12,000 to 60,000. However, the cost of goods and services will increase 10-fold, stripping away any gains the Dow makes. In order to reach the 2-ounce ratio, that means the price of gold will increase to an unheard of $30,000 an ounce!

Summary: Paper assets: 500%, Costs: 1000%, Gold: 10,800%
Winner: Gold

In every possible scenario, gold outpaces costs, which outpaces paper assets. You may doubt the 10,800% number as unrealistic. However, during the last half century of the Roman Empire, the price of gold rose 4,240,000%! In the final years of the Weimar Republic of Post World War I Germany, the price of gold increased 87,000,000,000,000% (87 trillion)! Therefore, the scenario #3 that we postulated can be considered a “conservative” estimate of inflation. Remember that every empire in history that has battled scenario #3 has lost.