Will the bomb go off, igniting the gold?
Some economists say debt-financed government stimulus was needed given the dire economic effects of the coronavirus crisis. Maybe so, maybe not (we think rising health care spending should be accompanied by spending cuts in other areas) – but one thing is certain. When the battle against Covid-19 is won (and it will be!), policy makers will have to detonate the debt bomb.
There are several ways to do this. The first is obvious and the least harmful in the long run. The government could reduce overspending, and hence budget deficits, by stabilizing the debt-to-GDP ratio. Unfortunately, this is the more politically difficult option, especially when Trump and the Democrats are talking about the need for more economic stimulus and increased infrastructure spending.
Second, the government could raise taxes to increase revenue, thereby closing the fiscal hole. Trump is unlikely to raise taxes, but if Biden wins, higher taxes for the wealthy are possible. Even if they would reduce public deficits, tax increases, especially in the aftermath of the recession, would be harmful for economic growth.
All of this means that policy makers will be tempted to reduce public debt either through higher inflation or through financial repression. Both ways support gold prices.
Let’s start with inflation. Gold is considered a hedge against inflation, so rising inflation – or simple inflation expectations – would increase the demand for gold and its price. Additionally, higher inflation means lower real interest rates – which would also make the yellow metal shine. So attempts to inflate debt would weaken the greenback, lower already ultra-low real bond yields, and support the price of gold.
The financial repression is perhaps less spectacular but also positive for the yellow metal. It works like this: the government caps the interest rates that financial institutions are allowed to pay. The idea is simple: through financial repression, the government can borrow cheaper than it otherwise could because people are simply not allowed to get better returns elsewhere. This method would not be unprecedented, as it was used to reduce high public debt after World War II.
Oh, by the way, the interest rate caps were below the rate of inflation, so creditors received negative returns in real terms. It goes without saying that gold should shine during financial repression. After all, the argument that gold earns no interest would be less compelling in a world where other assets offer low or even negative returns in real terms.
The yield curve control envisioned by the Fed would be this type of financial repression, as it would also aim to keep Treasury yields low enough to reduce the debt-to-GDP ratio over time. If implemented – so far the US central bank has not approved the idea – it would keep interest rates ultra low with all their negative consequences, such as: the prevalence of zombie firms and poor capital allocation, the search for yield and excessive risk. taken, the increase in private debt, etc.
In addition, ultra-low interest rates could lead to capital outflows, which would weaken the US dollar, while strengthening gold. Last but not least, the commitment to keep interest rates very low could force the Fed to let inflation soar, which would also support gold prices.
In summary, high public debt will be one of the most important legacies of the coronavirus crisis. Efforts to reduce it will become an important part of the political debate in the years to come, as policymakers will realize – sooner or later – that they are sitting on a ticking time bomb. It looks like financial repression will be the preferred method of reducing the high debt-to-GDP ratio, dominating investment prospects in the years to come. Precious metals investors holding gold should benefit from negative real interest rates.
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Arkadiusz Sieron, PhD
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