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Does Gold Protect Against Debt Monetisation?

$13 trillion of existing bonds with negative interest are evidence of the systemic risk within the financial system. As Stanley Druckenmiller, an American investor and hedge fund manager alluded, the Fed’s series of measures to handle inflation and interest rates has led to a series of threatening consequences like debt monetization. In simple words, debt monetization is the financing of extraordinarily huge debt by printing new currency notes by the central bank. Historically, there has never been a situation involving debt monetization that has ended well.

To help mitigate the crises in the coming years, many central banks are buying gold in large numbers. Gold purchases by central banks reached their highest levels in 50 years and the trend is expected to continue into 2019. Russia is the most active buyer of gold, with the yellow metal comprising 20% of the country's total reserves. China is also buying gold, although current levels stand at 3% of the country's total reserves.

Why are central banks all buying gold so aggressively? The answer is obvious: to offer a buffer in the event of another recession. The question is, does gold have the ability create such a buffer? The answer to this question critical to financial policy making for the coming decade.

But its important to consider why central banks abandoned gold as a base for fiat currency in the first place. Alan Greenspan, who earned the name “the Maestro” for his skillful financial expertise (he was even knighted in Great Britain), acknowledged gold as the primary global currency. He is of the view that the gold standard was operating at its peak in the late 19th and early 20th century, which was period of remarkable global prosperity due to stable growth and low inflation at the time. He believes that the popular view that the gold standard did not work during the 19th century is wrong. Instead, it was the politics that failed this era. If the gold standard had remained, he is convinced that we would be in a better position today.

The idea that the gold standard can create currency stability has existed for a long time. Unfortunately, fiat monetary policy is very easy to manipulate. This is the reason that almost all policy makers argue against the gold standard. The primary purpose of the gold standard is to fix a currency's value to a defined quantity of gold. Of the years different governments have adopted different approaches. These institutional arrangements did improve over time. 

Debt monetization has allowed for tenfold economic growth in the 20th century. Fiat money grew faster than gold and hence in 1971 Central Banks were happy to abandon the gold standard. They were happy to be relieved from the responsibility of maintaining the system of managing money according to the quantity of gold. It was a game they could not win or, according to Milton Freedman, a game they did not need to play. Money grew so fast and so extraordinarily that today it would be virtually impossible to replace paper money and non-gold federal reserves with gold. For the world, it would be difficult to return to the 19th-century gold standard system.

A more libertarian and implementable vision for tackling the debt monetization of the central banks is the concept of multiple independent alternative currencies, some based upon bullion and some based upon other criteria. The popularity of cryptocurrencies, like Bitcoin and its imitators (some based upon gold), provide the favored solution to challenge the long-established monopoly of the central banks. However, the digital currency is too volatile to serve as a basic alternative to the monetary system at the moment.

There are also misconceptions around gold. For example, some believe that that there is no currency elasticity when the gold standard is used. In reality, the elasticity of base money is related to the demand for money.

Some policymakers claim that the gold standard can affect the trade of gold, and that imports and exports also correlate to the balance of payments. This isn’t true either. The trade of gold is just like the import and export of any other commodity. Almost all misconceptions about gold exist because people do not understand the real behavior of gold or how market forces work.

‘Gold’ en Solution

No strategists or policymakers have been able to create a system or standard more stable than gold since the Fed cancelled the gold standard. There is little proof that there will be any such alternative in the future. This is because gold can act as both the base of value against any currency devaluation and also as a fence against the threat of debt monetization by central banks, which results in further devaluation.

As Nathan Lewis concluded in his book, Gold, the Final Standard:

“Throughout history, gold has been the money of liberty and sovereignty, justice and morality, prosperity and cooperation. Fiat currencies have been the money of absolutism and tyranny, favoritism and expediency, parasitism and conflict. Governments have devalued, debased and floated their currencies many times for many reasons, but never because gold itself failed to serve its role as a reliable standard of value – not in 1914, not in 1931, and not in 1971. If a crisis is in our future, wiping away the present order, let the solution be one that benefits all of humanity, not one that serves as a new mechanism of global enslavement. We know what that solution is. Would it work? It has always worked. It has always been the only thing that worked.”