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Montreal, Canada

Gold has traditionally been viewed as the best inflation hedge since the creation of fiat coins under the Roman Empire. When deficits became too large – namely to fund foreign conquests – the Romans simply chipped-off parts of the coin.

Nothing has really changed since the last Roman Empire dissolved around 293 AD. Today, countries regularly devalue or revalue their national currencies on a regular basis, rendering the global exchange-rate system largely dysfunctional, unpredictable and costly to maintain for businesses, individuals and governments alike. The trend is getting worse since the dollar peaked in 2001. And gold has noticed, rising from $253 an ounce in 1999 to over $1,000 now.

Inflation leads to the debasement of our purchasing power and ultimately reduces our long-term standard of living. No other monetary phenomenon has plagued central bankers more than inflation – except for deflation – the worst of two evils.

Deflation, not inflation, has gripped the world economy since the asset “bubble” pricked in July 2008. Stocks, bonds, commodities, real estate and even fine art and the most expensive French red wine vintages have all declined sharply over the last 20 months. Despite a massive recovery since March for most of these risk assets, investors are still sitting on double-digit losses since January 2008.

Deflation has also gripped wages and consumer prices.

More than two dozen countries worldwide, including China, are still grappling with falling prices. Real estate busts in places like Spain, Ireland and the United States have intensified deflation. Even if we exclude crude oil prices from the CPI calculation – oil prices have crashed from $145 a barrel in early July 2008 to $71 now – consumer prices are still in negative territory.

It’s fundamental to point out that since the beginning of this decade U.S. consumer prices (CPI) have risen a cumulative 25% — not an insignificant number but not mind-blowing awful, either. The 1970s, and to a lesser extent, the 1980s, saw much higher inflation. In the 1990s, disinflation dominated the economy or an environment of slowly rising inflation.

If gold prices are tied to inflation then why has spot gold risen a cumulative 300% this decade compared to just 25% for U.S. CPI? Something doesn’t give. True, gold should exceed inflation but that rate of excess performance belies a different story behind this rally.

Gold is on the move again this month for several important reasons. Plunging fabrication demand in countries like India, Russia and China have been easily offset by soaring demand for gold ETFs, European private bank gold purchases, U.S. mint sales and hedge fund accumulation. Why? Because there is a growing distrust of paper currencies amid a deluge of massive government deficits since late 2008.

All paper currencies are no good and are rising vis-à-vis the dollar but declining against gold since 2005. The dollar might be the biggest drunk at the bar but the euro and other currencies are drinking their way to devaluation against gold.

Since 2002, the euro is widely seen as a safe-haven against the dollar; I’m not sure that premise is justified because it’s highly possible that the euro-zone will witness a break-up or a collapse over the next several years under the weight of a strong currency, bulging deficits, rigid labor markets and soaring unemployment. Also, the banking crisis in Europe hasn’t bottomed. Banks across Europe are largely starved for capital and will remain on government life-support for years to come.

Europe is not a safe-haven. Investors tend to forget that prior to the euro’s introduction in 1999 that its predecessor, the ECU (European Currency Unit), was devalued in September 1992 when the British and Italians exited from the ERM or the European Exchange Rate Mechanism. True, the euro is a physical currency now and circulating worldwide compared to the synthetic ECU back in 1992 — but that doesn’t mean it can’t be devalued.

Gold is rising because the post-Breton Woods exchange rate system doesn’t work. More than ever, governments are loading up on debt as a result of bailing-out their respective banking systems. There is a price to pay for this profligate spending. And gold sniffs trouble.