Montreal, Canada

Since the emergence of the credit crisis and resultant global crash two years ago, pundits have endlessly debated about whether gold can perform in an environment of falling prices or deflation. I believe it can. Indeed, gold continues to safeguard portfolios from economic uncertainty and the growing threat of currency wars among the world’s largest trading partners.

Despite its historical hedge against rising price, or inflation, it now appears that gold is playing an important role in an age of currency depreciation, credit dislocation and general uncertainty about the global exchange rate system, which is largely dysfunctional and ultimately, inflationary.

There isn’t a single country that desires a strong currency; even those that harbor strong units, like Japan and Switzerland until recently, are selling their currencies to depress speculators and boost exports.

As for deflation and gold, we don’t have much in the way of deflationary history to work with.

Gold has historically been a harbinger of inflation as it tracks the direction of U.S. interest rates. This was the case from 1966 to 1981 and again in the latest bull market that began ten years ago – defined as a period of ultra-loose monetary policy under Greenspan and Bernanke. But we don’t have an active cycle of deflation and the relationship between gold and monetary policy in the 20th century.

Starting in 1933, FDR confiscated gold bullion (Executive Order 6102) while thereafter the government revalued gold for a tidy profit at Treasury but at the expense of the poor, unsuspecting public. So during the latter part of the 1930s – which coincided with a major global conflict and the acceleration of inflation by 1942, gold was not a tradable asset.

One environment that doesn’t work for gold is disinflation or moderating inflation such as occurred during the 1990s. Gold and accelerated disinflation don’t get along. That decade was also marked by heavy central bank gold sales, which also slammed bullion prices combined with a dollar bull market from 1995 to 2001.

What’s bullish for gold is economic uncertainty coupled with rising inflation or mild deflation. The latter, however, remains challenging for gold since an outright collapse of prices might not benefit gold initially as investors scramble for liquidity. This is what happened starting in July 2008 until gold prices hit a floor later that fall.

However, as the United States (and other countries) began to dish-out waves of fiscal stimulus and bailouts, fears of an out of control Federal Reserve amassing a bulging balance sheet began to draw investors back into gold. This episode is what drew hedge fund titan, John Paulson, into gold in late 2008.

At this stage of the economic recovery, disinflation is obviously not in the cards. Inflation, however, is.

In my book, our generation will suffer the worst inflation since the 1970s as more currencies are devalued and, eventually, a major dislocation occurs causing a breakdown of the post-1971 fiat monetary system. Gold senses trouble and it’s not just about inflation or deflation, but a general lack of trust in paper money and government deficits.