The spectre is haunting America. The spectre of deflation.

With no apologies to 19th century’s dialectical materialism, I have chosen the quote to describe the increasingly uneasy feeling US monetary authorities express regarding the mid-term prospects of America’s economy. With the vocally dissenting exception of Kansas City’s Thomas Hoenig, the Fed has once again expressed this week its relative malaise vis-à-vis the slowing growth. Bernanke & Co also showed how limited the DIY toolbox is to counter the Japanese scenario. The markets reacted accordingly.

Yet the oft-quoted “Japanese scenario”, or “defure jidai” (era of deflation) is poorly understood. There is now considerable interest in the mechanism of Japan’s recurrent deflation and gold investors should heed some of these lessons as well.

First, it is important to stress that Japan has not been mired in deflation without interruption for two decades since the collapse of the property bubble. Rather, there have been two distinct periods of deflation – the first one during 1999-2005 (following the banking crisis of 1997-98) and the second one in 2009-10 (triggered by the global recession).

Secondly, deflation alters investors’ behavior. Deflation is particularly damaging to debtors, who, in the context of falling real incomes and prices, must make interest and amortization payments in nominal amounts. No wonder that Japan’s corporations focused on debt minimization rather than profit maximization. Private investment stalled and marginal efficiency of capital collapsed. But the debt repayment obsession continued even at near 0% rates during the periods of positive CPI, as in the mid-1990s. Japanese investment behavior durably changed because investors believed that the pre-1989 asset prices were “wrong”.

It is impossible to understand what role gold has played in such an environment without tracking the performance of the Japanese Yen. The Japanese love story with gold was a short but boisterous affair. Despite the country’s efforts to diversify energy imports after 1973, the second oil shock triggered a major panic in Japan. In January of 1980, gold hit JPY6495/g. By the time deflation set in nineteen years later, the combination of a strong Yen and uncoordinated sales from central banks brought the prices to JPY917/g. For a deflation-gripped Japanese household, whose cash tomorrow was worth more than cash today, gold offered just another route from riches back to rags.

It’s from this low point that a more interesting story unfolds. Between 1996-98, during the first spell of carry trades (when the Yen lost 25% of its value), gold remained flat at around JPY1400/g. The second period of carry trades – between 2001-08 – saw the reversal of fortunes. Now the Yen barely diverged from the mean of 114 to the dollar, while gold gained 230% in Yen terms. Despite spells of interest registered by Tanaka Kikinzoku, most gold buying during this period occurred overseas. The most recent period of a stronger Yen has seen much more modest gains of about 4.6%. Remarkably, Japan – with little domestic gold mining – has now become a gold exporter! In other words, the first bout of deflation in Japan was accompanied by gold’s gains, while the second one has so far sent mixed messages – in line with gold’s significant volatility in JPY terms.

In fact, the fluctuations of the Yen exchange rates matter more for a deflation-bruised Japanese investor than the relative value of assets and liabilities exacerbated by the recurrent liquidity trap. The reason behind the limits of the Japanese experience lies in the asymmetry of the global exchange rates. The Yen is a structurally strong currency. The Hondas and Toyotas sell for dollars and euros (ah, yes, and the renminbi), which then have to exchanged into the Yen – boosting the demand for the Japanese currency. US and European corporations do not have the equivalent need to sell Yen proceeds from the current account (i.e. trade account and proceeds from overseas investments). Instead, the solutions to weaken the Yen were periodically sought in the capital account. Although Mr “Yen” Sakakibara’s efforts to weaken the currency were first spurned by Larry Summers, Japan’s ultra-low interest rates offered the global markets a cheap way to finance investments elsewhere. These carry trades were there to stay until all hell broke loose in 2008. But as 2009 showed us, the low US Libor reduced the attractiveness of the Yen as a funding currency. At the same time, the demographically challenged Japanese corporations have now moved to build and control vast swathes of Chinese industrial capacity, thus reducing the dependence on the weak Yen. All this will limit Japanese appetite for gold, even if the current rebound in industrial production does not immediately warrant a durable escape from deflation.

Deflation happens when saved money is not (productively) invested. Low interest rates in a weak economy, lack of credit growth, excess corporate savings, overcapacity – all these themes echo from Marunouchi to Wall Street. Yet, it is impossible to gauge whether the usually optimistic American extroverts will ever consider the pre-2007 house prices “wrong”. In the meantime, what matters more is the relative performance of the currencies. The currencies benefiting from risk aversion (the Yen, the Swissie) and from Asian growth engine (again the Yen, the Taiwanese dollar, the Won, the Aussie) are not friends of local gold investors, especially in a deflationary setting. On the other hand, the US dollar and the Euro are structurally weak, even though the dollar’s vast fixed income market will periodically make it the destination of risk-fleeing capital. European and American investors have thus little choice but continue to add to their gold holdings to offset the competitive erosion of their currencies’ value. For as long as the continued pressure on the labor markets does not derail the global trade, this recurrent weakness of Euro and Dollar should help counter the deflationary pressure.

Finally, it is worth remembering that investment in economically inert gold is, ceteris paribus, deflationary. Luckily, with barely $350bn of equity gold available worldwide and about a $1 trillion in private vaults, the global deflationary risk of flight into gold is a doomsday scenario better shelved with the Mayan calendars.

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