Central Bank Losses Make Them Buy Record Amounts of Gold

Central Bank Losses Make Them Buy Record Amounts of Gold
(Pla2na/Shutterstock)
Daniel Lacalle
1/2/2023
Updated:
1/19/2023
0:00
Commentary
In 2022, central banks will have purchased the largest amount of gold in recent history. According to the World Gold Council, central bank purchases of gold have reached a level not seen since 1967.

The world’s central banks bought 673 metric tons in the first three quarters of 2022, and in the third quarter, the figure was almost 400 metric tons. This is interesting because the flow from central banks since 2020 had been eminently net sales.

Why are global central banks adding gold to their reserves? There may be different factors.

Most central banks’ largest percentage of reserves are U.S. dollars, which usually come in the form of U.S. Treasury bonds. It would make sense for some of the central banks, especially China’s, to decide to depend less on the dollar.

China’s high foreign exchange reserves are a key source of stability for the People’s Bank of China. The high amount of U.S. dollars ($3.1 trillion) may have been a key stabilizing factor in 2022, but it could be too much if the next 10 years bring a wave of money devaluation that has never happened before.

Central banks have been talking about the idea of issuing a digital currency, which would completely change the way money works today. By issuing a digital currency directly into a citizen’s account at the central bank, the financial institution would have full access to savers’ information and, more importantly, would be able to accelerate the transmission mechanism of monetary policy by eliminating the channels that prevent higher inflation from happening: the banking channel and the backstop of credit demand.

What has kept inflation from going up much more is that the way monetary policy is passed on is always slowed down by the demand for credit in the banking system. This has obviously led to a huge rise in the prices of financial assets and still caused prices to go through the roof when the growth in the money supply was used to pay for government spending and subsidies.

If central banks start issuing digital currencies, the level of purchasing power destruction of currencies seen in the past 50 years will be exceedingly small compared with what can occur with unbridled central bank control.

In such an environment, gold’s status as a reserve of value would be unequaled.

There are more reasons to buy gold.

Liquidity was cryptocurrency’s Achilles’ heel. A few rate hikes by the Fed quickly disproved the idea that digital currencies could only go up in value. Cryptocurrencies didn’t combat monetary expansion; rather, they were one of its effects. Gold was now one of the few remaining true reserves of value.

The performance of gold in U.S. dollars may have disappointed investors in 2022, even though it was flat, but in a year of broad financial asset declines, gold rose in euros, pounds, yen, and the majority of emerging currencies.

Central banks need gold because they may be preparing for an unprecedented period of monetary devastation.

The Financial Times claims that central banks are already suffering significant losses as a result of the falling value of the bonds they hold on their balance sheets. By the end of the second quarter of 2022, the Federal Reserve had lost $720 billion while the Bank of England had lost $241 billion. The European Central Bank is currently having its finances reviewed, and it’s predicted that it will also incur significant losses.

The European Central Bank, the U.S. Federal Reserve, the Bank of England, the Swiss National Bank, and the Australian central bank all “now face potential losses of more than $1 trillion collectively, as once-profitable bonds turn into liabilities,” according to Politico.

If a central bank experiences a loss, it can fill the gap by using any available reserves from prior years or by requesting help from other central banks. Similar to a commercial bank, it may experience significant difficulties; nevertheless, a central bank has the option of turning to governments as a last resort. This implies that the hole will be paid for by taxpayers, and the costs are astronomical.

The wave of monetary destruction that could result from a new record in global debt, enormous losses in the central bank’s assets, and the issuance of digital currencies finds only one true safe haven with centuries of proven status as a reserve of value: Gold. This is because central banks are aware that governments aren’t cutting deficit spending.

These numbers highlight the enormous issue brought on by the recent overuse of quantitative easing. Because they were unaware of the reality of issuer solvency, central banks switched from purchasing low-risk assets at attractive prices to purchasing any sovereign bond at any price.

Why do central banks increase their gold purchases just as losses appear on their balance sheets? To increase their reserve level, lessen losses, and foresee how newly created digital currencies may affect inflation. Since buying European or North American sovereign bonds doesn’t lower the risk of losing money if inflation stays high, it’s very likely that the only real option is to buy more gold.

The central banks of industrialized nations will make an effort to shrink their balance sheets in order to fight inflation, but they will also discover that the assets they own are continuing to depreciate in value. A central bank that’s losing money can’t immediately expand its balance sheet or buy more sovereign bonds. A liquidity trap has been set. Quantitative easing and low interest rates are necessary for higher asset values, but further liquidity and financial restraint may prolong inflationary pressures, which would then increase pressure on asset prices.

The idea that printing money wouldn’t lead to inflation served as the foundation for the monetary mirage. The evidence to the contrary now demonstrates that central banks are faced with a serious challenge: they’re unable to sustain multiple expansion and asset price inflation, lower consumer prices, and fund government deficit spending at the same time.

So, why gold? Because a new paradigm in policy will unavoidably emerge as a result of the disastrous economic and monetary effects of years of excessive easing, and neither our real earnings nor our deposit savings benefit from that. Unfortunately, central banks have been forced by governments to choose financial repression when given the option of sound money.

The only reason central banks buy gold is to protect their balance sheets from their own monetary destruction programs; they have no choice but to do so.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
Daniel Lacalle, PhD, is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”