Most Popular
1. It’s a New Macro, the Gold Market Knows It, But Dead Men Walking Do Not (yet)- Gary_Tanashian
2.Stock Market Presidential Election Cycle Seasonal Trend Analysis - Nadeem_Walayat
3. Bitcoin S&P Pattern - Nadeem_Walayat
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
4.U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - Raymond_Matison
5. How to Profit from the Global Warming ClImate Change Mega Death Trend - Part1 - Nadeem_Walayat
7.Bitcoin Gravy Train Trend Forecast 2024 - - Nadeem_Walayat
8.The Bond Trade and Interest Rates - Nadeem_Walayat
9.It’s Easy to Scream Stocks Bubble! - Stephen_McBride
10.Fed’s Next Intertest Rate Move might not align with popular consensus - Richard_Mills
Last 7 days
Trump or Harris - Who Wins US Presidential Election 2024 Forecast Prediction - 5th Nov 24
Stock Market Brief in Count Down to US Election Result 2024 - 3rd Nov 24
Gold Stocks’ Winter Rally 2024 - 3rd Nov 24
Why Countdown to U.S. Recession is Underway - 3rd Nov 24
Stock Market Trend Forecast to Jan 2025 - 2nd Nov 24
President Donald PUMP Forecast to Win US Presidential Election 2024 - 1st Nov 24
At These Levels, Buying Silver Is Like Getting It At $5 In 2003 - 28th Oct 24
Nvidia Numero Uno Selling Shovels in the AI Gold Rush - 28th Oct 24
The Future of Online Casinos - 28th Oct 24
Panic in the Air As Stock Market Correction Delivers Deep Opps in AI Tech Stocks - 27th Oct 24
Stocks, Bitcoin, Crypto's Counting Down to President Donald Pump! - 27th Oct 24
UK Budget 2024 - What to do Before 30th Oct - Pensions and ISA's - 27th Oct 24
7 Days of Crypto Opportunities Starts NOW - 27th Oct 24
The Power Law in Venture Capital: How Visionary Investors Like Yuri Milner Have Shaped the Future - 27th Oct 24
This Points To Significantly Higher Silver Prices - 27th Oct 24
US House Prices Trend Forecast 2024 to 2026 - 11th Oct 24
US Housing Market Analysis - Immigration Drives House Prices Higher - 30th Sep 24
Stock Market October Correction - 30th Sep 24
The Folly of Tariffs and Trade Wars - 30th Sep 24
Gold: 5 principles to help you stay ahead of price turns - 30th Sep 24
The Everything Rally will Spark multi year Bull Market - 30th Sep 24
US FIXED MORTGAGES LIMITING SUPPLY - 23rd Sep 24
US Housing Market Free Equity - 23rd Sep 24
US Rate Cut FOMO In Stock Market Correction Window - 22nd Sep 24
US State Demographics - 22nd Sep 24
Gold and Silver Shine as the Fed Cuts Rates: What’s Next? - 22nd Sep 24
Stock Market Sentiment Speaks:Nothing Can Topple This Market - 22nd Sep 24
US Population Growth Rate - 17th Sep 24
Are Stocks Overheating? - 17th Sep 24
Sentiment Speaks: Silver Is At A Major Turning Point - 17th Sep 24
If The Stock Market Turn Quickly, How Bad Can Things Get? - 17th Sep 24
IMMIGRATION DRIVES HOUSE PRICES HIGHER - 12th Sep 24
Global Debt Bubble - 12th Sep 24
Gold’s Outlook CPI Data - 12th Sep 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Explaining Central Banks' Gold Purchases

Commodities / Gold and Silver 2011 Dec 02, 2011 - 11:08 AM GMT

By: David_Howden

Commodities

Best Financial Markets Analysis ArticleThe last two years marked a significant shift in central banks' attitudes toward gold. Since 1988, central banks have been net sellers of the precious metal. Lacking convertibility of their paper currencies into the commodity, this occurrence makes perfect sense. Why hold a physical asset with costly storage fees when there is no risk that it will ever be needed? Better to hold an interest-bearing (and easily stored) asset like a government security to earn a profit in the interim. So goes the typical explanation for why central banks load their balance sheets with financial assets instead of physical ones.


Yet over the last two years a dramatic shift in gold purchases has occurred. In the third quarter of this year alone, net gold purchases by central banks amounted to 150 tons — more than double the amount of the whole yearly total of 2010. For the first time in over 20 years, central banks of the world are buying more gold than they are divesting themselves of.

Yet if central banks deal exclusively in nonconvertible (and fiat) money, what explains the sudden change of heart?

Convertibility may bring costs for a central bank, but it also has its benefits. In particular, it solved two problems:

  1. How would central banks maintain independence from their governments?
  2. How much money should they supply?

Without convertibility, these two issues get significantly more complicated. In this short essay, we will focus on only the first of these problems.

Independence for a central bank comes from the government that grants it the monopoly rights to money production in its jurisdiction. Congress provides oversight for the Fed, but no government agent specifically determines the day-to-day operations of the central bank. (This is debatable, of course, but that is a separate issue.)

This independence is coveted, and for good reason. A government in charge of its printing press has an incentive to pay for its expenditures not through taxes, or even by debt, but through the relatively painless act of printing the necessary money. The problem with this is the ensuing inflationary bias that a government-controlled printing press has.

An independent central bank issues currency, which is recorded as a liability on its balance sheet. In an offsetting transaction, an asset is purchased that balances the accounting statement. Though this asset can be anything, it has become the norm that it is a relatively safe interest-bearing government bond. Gold still comprises a portion of most central banks' balance sheets, but because it has its own costs and returns no interest, it is a relatively unattractive option.

If a central bank wants to directly increase the money supply, it increases its liabilities (sells cash) and correspondingly increases its assets (buys bonds). If it wants to decrease the money supply, it decreases its assets (sells bonds), which then decreases its liabilities (by decreasing the amount of cash outstanding).

As a thought experiment, imagine what would happen if a central bank didn't sell any assets but instead had them lose value. As an extreme example, imagine that the bonds it holds default due to the insolvency of their issuer. Cash does not automatically have to adjust by decreasing by an equivalent amount. To maintain the accounting equality, the relevant liability that changes is the central bank's equity. Accounting insolvency is defined as being that moment when your equity turns negative.

It is difficult to imagine a central bank turning insolvent. Indeed, by and large this doesn't happen, though as Philipp Bagus and I outline in our book, Deep Freeze: Iceland's Economic Collapse, recent examples do exist (see also here). A central bank that holds bonds as its assets only maintains its solvency as long as the issuer of its bonds maintains its own solvency.

The problem that develops is what to do if equity turns negative. Recapitalization must result, but by whom? In an extreme scenario, the government can directly recapitalize the central bank. This action is not without consequences. Central banks enjoy, at least in some countries, high degrees of independence because they do not rely on their governments for funding. Indeed, as they remit profits back to the government at year's end, they are revenue generators for the government.

But a government supporting a central bank is also increasingly interested in how that bank is run. Increased oversight of the monetary authority might be welcomed by some, but it also opens Pandora's box: perhaps with the increased oversight the government will also start influencing the central bank's operating mandates, or even its daily operations.

Gold purchases by central banks are completely rational responses given this independence dilemma. With the solvency of some large governments being increasingly questioned each day, investors and central banks alike are also questioning the value of their debts. Greece just gave private holders of its debt a 50 percent haircut; could the same for governments and other organizations be far off? The solvency of a growing list of countries gets longer by the week — Ireland, Portugal, Italy, Spain — not even the United States is immune to this possibility, as its own debt crisis illustrates.

Holding gold does not eliminate the possibility of negative equity for the central bank (indeed, it might even increase the odds). But given the recent past it makes for an attractive option. As countries demonstrate their difficulties in getting their debts and deficits in order and thus improving their solvency outlooks, the value of their debt becomes questionable as well.

While holding any real asset serves no direct use for a central bank, it does act as an insurance policy of sorts. The solvency of a central bank holding government debt is subordinate to the solvency of the countries whose debt it holds. For a central bank worried about the value of its assets, diversification of its assets into gold makes for a rational alternative.

David Howden is a PhD candidate at the Universidad Rey Juan Carlos, in Madrid, and winner of the Mises Institute's Douglas E. French Prize. Send him mail. See his article archives. Comment on the blog.

© 2011 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in