In many Western industrialized nations, debt has overwhelmed or is about to overwhelm the economy's debt-servicing capacity. In the run-up to a debt crisis, bad debt tends to move to the next higher level and may ultimately accumulate in the central bank's balance sheet, provided the economy has its own currency. The process whereby government or quasi-government debt is taken over by the central bank is called quantitative easing. Many observers assume that, once bad debt is purchased by the central bank, the debt crisis is solved for good; that central banks have unlimited wealth at their disposal, or can print unlimited wealth into existence.
However, central banks can only create liquidity, not wealth. If printing money were equivalent to creating wealth, then mankind would not have to get up early on Monday morning. QE just transfers losses from the previous holders of the asset to the central bank itself. Up to a certain amount, the central bank absorbs these losses by sacrificing its equity and accumulated profits. Losses exceeding the central bank's loss-absorption capacity necessarily lead to inflation. If the central bank's net worth turns significantly negative (as Bernanke discussed and dismissed today), hyperinflation may ensue and a vicious circle may be set in motion.
Only a solvent central bank can halt hyperinflation. The longer governments run large deficits, the longer central banks continue to monetize them, and the longer their balance sheets grow, the higher the potential for enormous losses and thus hyperinflation.
Necessary preconditions for hyperinflation are a quasi-bankrupt government whose debt is monetized by a central bank with insufficient assets. One way or another, owning physical gold is the safest and most effective way of insuring against hyperinflation.
Authored by Caesar Lack of UBS,
Gold - The Ultimate Balance Sheet Equalizer
In many Western industrialized nations, debt has overwhelmed or is about to overwhelm the economy's debt-servicing capacity. In principle, debt is not a negative if incurred to finance sustainable investment, the profits of which can then be used to extinguish the debt. However, borrowed money has increasingly been mal-invested or spent on consumption in recent decades. Mal-investment impairs the productive capital stock, and the growing debt burden strangles economic growth even more. When financial markets realize that the emperor has no clothes and interest rates rise, the economy is exposed as insolvent, and a debt crisis follows.
Bad debt ends up at the central bank
In the run-up to a debt crisis, bad debt tends to move to the next higher level and may ultimately accumulate in the central bank's balance sheet, provided the economy has its own currency. Excessive debt incurred by consumers, homeowners and businesses first moves to the banking system and corrupts its balance sheet. If (rightly or wrongly) the banking system isn't allowed to fail, bad debt is then transferred to the government via bailouts or implicit / explicit guarantees. When exacerbated by the burden of unfavorable demographics and several decades of proliferating welfare spending, it may overwhelm the government's debt-carrying capacity. Should financial markets become unwilling to refinance the government debt at rates acceptable to the government, central banks step in. They monetize government debt in the name of propping up the economy, creating jobs, or weakening the currency to keep government borrowing rates low. The process whereby government or quasi-government debt is taken over by the central bank is called quantitative and qualitative easing: "quantitative" easing denotes the lengthening of the central bank balance sheet while "qualitative" easing denotes the deterioration of it.
Central banks cannot create wealth, only liquidity
Many observers assume that, once bad debt is purchased by the central bank, the debt crisis is solved for good. The implicit assumption is that central banks have unlimited wealth at their disposal, or can print unlimited wealth into existence. However, central banks can only create liquidity, not wealth. If printing money were equivalent to creating wealth, then mankind would not have to get up early on Monday morning. Quantitative easing just transfers losses from the previous holders of the assets purchased by the central bank to the central bank itself. Up to a certain amount, the central bank absorbs these losses by sacrificing its equity and accumulated profits. Losses exceeding the central bank's loss-absorption capacity necessarily lead to inflation.
What is the loss-absorption capacity of central banks?
The non-inflationary loss-absorption capacity of a central bank is limited. European central banks, with the exception of the Bank of England (BoE), regularly retained a share of their profits in the past. The Eurosystem currently discloses capital and provisions of EUR 493bn, equivalent to 17% of its balance sheet total and 5% of Eurozone GDP. The Swiss National Bank (SNB) discloses capital and provisions of CHF 62bn, equivalent to 12% of its balance sheet and 10% of Swiss GDP. The Bank of Japan (BoJ), the BoE and the US Fed, on the other hand, used to distribute most of their profits to their Treasuries. The BoJ discloses equity of just JPY 3.2trn, which is equivalent to only 2% of its balance sheet and less than 1% of GDP. And, finally, the US Fed and the BoE have no noteworthy equity or provisions at all.
It has been argued that the central bank loss-absorption capacity consists not only of present equity and provisions but the discounted value of all future expected profits, and therefore central banks have a non-inflationary loss-absorption capacity much larger than their current equity and provisions. However, we think that incurring losses significantly beyond the banks' current equity and provisions may be dangerous and even pave the way to hyperinflation, as we will argue below.
To be more precise, we think that the loss-absorption capacity of a central bank is the sum of the central bank's equity and provisions plus the monetary base – not the inflated monetary base of today, but the "normal" monetary base before the crisis. Why do we include the monetary base in the loss-absorption capacity? The returns on assets purchased or held in exchange for the monetary base constitute "seigniorage," i.e. central bank profits. Up to a negative equity equivalent to the monetary base, central banks turn structural profits. Only when negative equity exceeds the monetary base do central banks turn structural losses. In Western industrialized countries before the financial crisis, the monetary base usually amounted to 5%-10% of GDP.
What if bad debt exceeds the loss-absorption capacity?
What happens when losses transferred to the central bank exceed its loss-absorption capacity? They make it impossible for the central bank to withdraw all excess liquidity, and they ultimately cause inflation. Why? When engaging in quantitative easing, i.e. when purchasing assets, central banks create money. Over the long term, a loss in the purchasing power of the currency will occur if the new money is not disposed of in due time. Should a central bank suffer outsized losses, it may be unable to withdraw all of the excess liquidity it created during its asset-purchase programs. The amount it cannot withdraw due to a lack of assets determines the amount of inflation that will follow.
There are basically three ways to withdraw excess liquidity. First, the central bank can sell assets and thus reduce the money supply for good. But if the central bank suffered large losses, it may not have enough assets to do so. Note also that the wholesale selling of assets will depress their price. Second, the central bank can immobilize excess liquidity by issuing bills, engaging in reverse repo operations or offering fixed-term deposits. However, such immobilizing requires the central bank to pay a sufficiently high interest rate to induce banks to park funds at it and not chase asset prices higher. If the central bank has considerable negative equity, interest payments on the funds deposited with it may exceed the returns its assets generate. The central bank may be faced then with structural losses that grow ever larger. Third, the central bank can raise minimum reserve requirements, i.e. require the banking system to hold more reserves. However, holding reserves is costly, and if the banking system is close to insolvency it cannot afford to do so, particularly if large amounts are involved.
Only a solvent central bank can halt hyperinflation
If the central bank's net worth turns significantly negative, hyperinflation may ensue. A vicious circle may be set in motion. Rising inflation and inflation expectations lead to an economic downturn, which creates growing government deficits and greater pressure to monetize them, which in turn results in higher costs to immobilize excess liquidity due to soaring interest rates, plus a fall in the value of the assets of the central bank, an increase in its losses and even larger negative net worth. If this death spiral is not halted in time, confidence in the currency may fail and accelerate a flight out of money into real assets, at which point the purchasing power of the currency may plunge toward zero.
This vicious circle can in principle be halted by tightening monetary policy, i.e. by halting government debt monetization and reining in the money supply. However, once the downward spiral has started, halting debt monetization can precipitate a government default, which would inflict large additional losses on the central bank. A government default may also crash the financial system, forcing the central bank to recapitalize it to avoid a general financial collapse. Recapitalizing the financial system means printing even more money, which the central bank will have to withdraw later on so as not to fan hyperinflation. Thus, a central bank can avert the onset of hyperinflation only if it has the assets to withdraw excess liquidity after accounting for losses from a government default and after recapitalizing the financial system. Without sufficient assets, it may not be able to stop printing money once the death spiral of rising interest rates and rising debt monetization has begun. Its hands may be tied by the government or, even if it is free to choose its course, it may keep the presses rolling to prevent an immediate collapse of the financial system and a general liquidation, which might be even less desirable than continuing to print.
How large is the hyperinflation risk?
Debt levels (household, corporate, financial and government debt combined) in many Western industrialized nations are a multiple of GDP, while the non-inflationary loss-absorption capacity of their central banks is probably in the single digits if expressed as a percentage of GDP. The potential for losses significantly exceeding the central bank loss-absorption capacity thus certainly exists. The longer governments run large deficits, the longer central banks continue to monetize them, and the longer their balance sheets grow, the higher the potential for enormous losses and thus hyperinflation. Hyperinflation may be triggered by a rise in government borrowing costs, either because financial markets start to question the sustainability of the current arrangement or simply because of rising inflation and inflation expectations.
Hitherto, no major central bank has experienced significant losses on the assets it purchased in the framework of its quantitative easing programs, and all major central banks exhibit positive net worth. However, these facts should not alleviate concerns about hyperinflation. Central bank assets, mostly government bonds, are priced to perfection. Their value may fall drastically once inflation expectations and interest rates rise and general economic conditions deteriorate.
Gold – the ultimate balance sheet equalizer
Necessary preconditions for hyperinflation are a quasi-bankrupt government whose debt is monetized by a central bank with insufficient assets. A central bank with large net wealth could in principle halt hyperinflation, as we have argued above. A central bank with insufficient assets cannot. Only by recapitalizing an insolvent central bank can the choice between hyperinflation on the one hand and a general liquidation on the other be avoided. However, if the government is broke as well, it cannot recapitalize the central bank. Is there another way to create new wealth to balance the central bank's assets and liabilities and avoid that dreadful choice?
It turns out that there is – by revaluing gold. Both the US and Europe own significant gold reserves (US: 8,134t, Germany: 3,391t, Italy: 2,452t, France: 2,435t). Contrary to that of all other commodities, the price of gold is primarily determined not by industrial demand or mining costs but by investors. Gold is worth as much as investors believe it is. If central banks can succeed in convincing investors that the value of gold is greater than today's prices, then it is, and new net wealth has been created.
Can central banks indeed do that? It turns out they can. One can always weaken one's own currency against another currency, and gold can be considered a currency. The SNB proved that last year when it weakened the Swiss franc by declaring its intention to sell unlimited amounts of Swiss francs. To revalue gold, a central bank needs to set a minimum price for it and declare that it will buy unlimited amounts of it at that minimum price. Since central banks can print money at will, they will never run out of their own currency. Therefore, the threat to buy unlimited amounts of gold at a minimum price is credible. If the public does not believe in the sustainability of the new price and sells its gold, the central bank purchases all gold offered at the minimum price by printing money, until it has weakened its currency to such a degree that the gold price rises above the minimum threshold.
Initially, buying gold by printing new money will be inflationary and weaken the currency further. However, once the new equilibrium gold price is exceeded, the currency can be stabilized. The central bank is solvent again and can stabilize its currency by reducing excess liquidity and raising rates. Note that only central banks of large currency areas, such as the ECB or the US Fed, can revalue gold. If a small central bank tried to do so, it would devalue its own currency rather than revalue gold, and thus inflame inflation in its currency area.
How much could gold be revalued by?
The new minimum gold price must be set such that the revaluation gains balance the combined assets and liabilities of the government, the financial system, and the central bank. The US owns 8,134t of gold currently worth around USD 440bn, or 3% of GDP (although US gold is currently valued at only USD 42/oz). The Eurosystem discloses 10,783t of gold reserves worth USD 440bn, or 5% of GDP. Assume that a currency area owns gold reserves equivalent to 4% of GDP, and that the combined balance sheet of the government, financial system and central bank has a negative net worth of 100% of GDP, a not unreasonable assumption given that total debt amounts to 200%-400% of GDP in many industrialized countries. To bring the balance sheet into balance, the gold price would then have to rise by a factor of 25.
What would prevent governments from over-borrowing and revaluing gold again and again? If gold were indeed revalued enormously, it would represent a significant fraction of all assets and would thus regain an important role as a store of value. The gold price would then discipline monetary policy and become the main anchor for fiat currencies. This would significantly hamper the build-up of large imbalances in the future.
Even if central banks do not revalue their gold reserves, gold prices would still rise in a period of hyperinflation. Therefore, the balance sheet gap in those currency areas that own gold may close at some point in time and stabilize their currency. However, by then the currency may have lost most of its purchasing power. By revaluing gold, hyperinflation may be stopped in its tracks or avoided altogether. One way or another, owning physical gold is the safest and most effective way of insuring against hyperinflation.