It tends to benefit from ultra-loose monetary policies, cannot be debased by central banks at will, and is well-shielded from political fortunes
The last few years have made investors globally pretty used to stable financial conditions, low inflation levels, and to the idea that interest rates on their bank deposits and loans are fairly predictable and under control.
Prima facie, the theoretical structure of the monetary authority in the form of independent central banks, i.e., central banks are in-charge of creating money, and function independently of governments – the money spenders – seems to be working well.
First let’s understand what the academic argument for this separation of power to create, and power to spend money is. Well, a central banker’s agenda is to maintain low and stable inflation. On the other hand, irrespective of what they claim, a politician’s agenda is to stay in power. World over, this agenda is usually achieved by ensuring the voters like the ruling politician. And how do they do that? They show voters a prosperous time marked by high employment and spending.
Economic cycles and elections
But unfortunately for governments, periods of economic booms and busts do not always coincide with their political terms. This puts a big question mark on their re-election, especially if voters go to the ballot during an economic downturn.
No wonder then that governments resort to becoming generous and accommodative during the pre-election years. They cut interest rates and print more money to boost employment. The result? People are thrilled, and the ruling government is back in power.
They’re generally not worried about the long-term economic consequences of this populist move, which results in high inflation, when they remain focussed on short-term political ambitions.
Logically, when the power to create money is merged with the power to spend, i.e., when governments influence central bank operations, there is possible misuse and abuse of monetary policy. And the main reason for this is the mismatch between political timelines and those needed to execute long-term monetary policies, creating an inherent conflict between the objectives of both, and making it essential to keep both separate.
But today, with the rise of populist leaders around the globe, we see this prudent set-up being increasingly threatened.
For instance, when the Turkish President’s demands for a rate cut were not heeded to by the central bank, he ended up firing Governor Murat Cetinkaya. President Trump is seen frequently and publicly lashing out at Fed Governor Powell for not doing enough to revive the American economy, going to the extent of threatening to fire him. The ECB faces criticism from Euro Zone political leadership for their monetary policy. Closer home, Governor Urijit Patel supposedly resigned after clashing with the government about the policy of imposing tough regulations on struggling banks.
In fact, Argentina, Zimbabwe, Turkey and Greece are examples of economic crises caused due to weak central banks being overpowered by ruling governments to fulfil their agendas.
But let’s shift focus to the home of the international currency – the dollar. If you observe, the US Government has increasingly become a larger part of the economy. Currently, US Government spending to GDP ratio stands at 38 per cent. All thanks to the Federal Reserve, which allows the government to spend by creating new money.
Precarious government debt
The growth in government spending is enabled because a government with a captive central bank will never run short of money, irrespective of how large its deficits are and how indebted it becomes. The US Government’s debt to GDP ratio is currently at a whopping 106 per cent. Such a high debt to GDP ratio indicates that the US economy doesn’t produce and sell goods and services sufficient enough to pay back debts without incurring further debt.
The value of the US dollar is thus based on unlimited debt creation and money printing. The U.S. national debt exceeded $22 trillion in February 2019, a major increase compared to $12 trillion a decade back. Simply printing more and more money to repay its debts could lead to a significant fall in the value the dollar, accompanied with global loss of confidence in the currency. This could have catastrophic consequences in financial markets all over the world and deal a major blow to its creditors, throwing the world into economic disarray.
With the U.S. going into elections next year and staring at a slowing economy, it isn’t rocket science to understand what this could potentially mean for gold prices. So yeah, buy it.
And it’s not just the United States. Much of the developed world has effectively mortgaged its future and we are gradually moving closer towards the day of reckoning.
In addition to the long-term economic well-being of a country, central bank independence also gives investors more confidence in a country’s monetary and financial stability, thus attracting investment flows. That’s understandable because no one would want to buy into a politically influenced and short-sighted monetary policy marred by interest rates uncertainty. This can potentially lead to long-term investment funds being withdrawn from debt markets of governments that do not have truly independent central banks due to fear of erroneous policy making, which can have significant economic implications and thereby impact asset markets and currency.
For low-risk allocation in their portfolio, long term investors can then be expected to turn to a more stable monetary asset such as gold, as it tends to benefit from ultra-loose monetary policies, cannot be debased by central banks at will, and is well-shielded from political fortunes.(The writer is Senior Fund Manager-Alternative Investments, Quantum Mutual Fund)Get access to India's fastest growing financial subscriptions service Moneycontrol Pro for as little as Rs 599 for first year. Use the code "GETPRO". Moneycontrol Pro offers you all the information you need for wealth creation including actionable investment ideas, independent research and insights & analysis For more information, check out the Moneycontrol website or mobile app.