GOLD has been the standout performer in an otherwise bleak
investment market in the past three months as investors punt on the
return of inflation.

The gold price tumbled alongside other commodities until November,
when the talk of a new stimulus package in the US and the election of
President Barack Obama sparked a switch in the investor mood, reports The Australian.

The price has since risen by a third to almost $US1000 ($1569) an ounce.

Gold bugs are filling the internet with speculation of prices north of $US2000 an ounce, while broker Merrill Lynch has tipped it will top $US1500 in 12 to 15 months.

Gold investors are betting that the policy flexibility being
exercised by governments and central banks worldwide, led by those of
the US, will result in their loss of control over the value of money.

This up-ends the prevailing wisdom about the Great Depression: that
its severity was caused by policy inflexibility created by the rigid
link between currencies and the gold standard.

The gold price fell from its all-time high of $US1009 an ounce in March last year to a low of $US706 by November.

It was up to $US810 by the middle of last month but has since
climbed strongly, reaching $US950 last week amid concern about US
policy action.

The US stimulus package is likely to push the US budget deficit
towards $US2trillion, or almost 15 per cent of its shrinking GDP.

In principle, this should have no implications for inflation. The
deficit is simply an effort by the public sector to offset some of the
rise in private-sector savings resulting from the collapse in consumer
demand.

Concern that difficulty in funding the deficit may lead to a collapse of the US dollar is also likely to be misplaced.

The fall in US treasury bond yields last year, with 10-year bonds
dropping from 4 per cent to a 2.1 per cent, was driven by massive
demand.

Economist with the Council of Foreign Relations Brad Setser says
outstanding treasury bonds rose by $US1.7 trillion last year, of which
China accounted for only about $US375 billion.

Even if foreign demand for US bonds falters in the face of the
massive supply, the slack can readily be taken up by the US Fed, which
is already considering the option of investing in US treasuries.

However, it is the idea of central banks stumping up the funds
needed by governments to cover their deficits that has gold bugs
worried by inflation.

Morgan Stanley
s well respected global fixed interest economist
Joachim Fels says high inflation, and even hyper-inflation, defined as
prices rising by more than 50 per cent a month, are outside
possibilities as the global crisis unfolds.

"The root cause of hyper-inflation is excessive money supply growth,
usually caused by governments instructing their central banks to help
finance expenditures through rapid money creation,

he writes.

He says there are three preconditions.

First, the rapid expansion of the monetary base under way in the US,
Britain and Europe would have to continue and lead to an expansion of
money in the hands of the general public.

Secondly, governments would have to face difficulty financing their
stimulus and bail-out packages through taxes and bond issues to the
public, resulting in political pressure for central banks to pick up
the shortfall.

And finally, the combination of sustained monetary growth and big
fiscal deficits would have to undermine public confidence in their
governments
ability to service the debt without resorting to the
printing press, and in the central bank
s ability to withstand
government pressure to oblige it.

"A surge in inflation expectations on the back of such a loss in
confidence would induce people to reduce deposits and cash holdings and
pile into real assets,

Fels says.

"The velocity of money and inflation would rise and the
government/central bank would have to keep printing ever more money to
finance government spending.

This scenario is not totally fanciful and elements of it have indeed been discussed by US Federal Reserve chairman Ben Bernanke.

In a speech last month, Mr Bernanke acknowledged that the Fed
s
support for financial markets had resulted in rapid growth of the
bank
s balance sheet.

This had boosted the narrow definition of money supply-bank reserves
and currency in circulation-by more than 10 per cent in the past year.

However, the banks were leaving their excess reserves idle, in most
cases on deposit with the Fed, with little finding its way into
consumer or business hands.

In the 1930s, governments were hamstrung by the gold standard, which
obliged their central banks to redeem currency for gold at a fixed rate
for anyone who wanted it.

As Mr Bernanke
s own research into the Depression has shown,
countries were forced to raise rates to stop their gold reserves coming
under speculative attack.