Get Ready For More Central Bank Sorcery

In March and April, the covid crisis sparked an unprecedented policy response from governments and central banks — first monetary, and then fiscal.  As the magnitude and scope of these interventions became clear, the likely longer-term consequences for gold also became clear.  Further events have only served to reinforce this view. 

The stock market remains — and will remain, for the foreseeable future, in spite of its volatility — the real long-term growth engine of an investment portfolio.  However, the case for gold as a bulwark against future inflation, monetary debasement, over-indebted government, negative-yielding bonds, and political turmoil only gets stronger.  Contrary to the common opinion of many misguided investment professionals, we have always considered gold an indispensable tool, and not a “barbarous relic.” 

Gold is a vote of skepticism in the competence of financial and political authorities.  In the short term, those authorities can manipulate the gold market; and under extreme duress, as in the 1930s, they can attempt to crush it altogether. 

Another skeptical vote now exists: cryptocurrencies.  Although gold has risen substantially in 2019 and 2020, cryptocurrencies such as bitcoin have spent the last few years languishing after their most recent massive spike at the end of 2017.  More recently, bitcoin has again been receiving speculators’ attention, recently coming close to the $12,000 level — for largely the same reason that gold has.

Just as the authorities resent gold and have an interest in suppressing it, investors and speculators can be sure that they also resent cryptocurrencies.  For those who are unfamiliar with cryptocurrencies, they are, in essence, virtual currencies that exist without any central authority to administer them, with a supply that is strictly algorithmically limited.  Transactions occur without any financial intermediaries.  In principle, they present the prospect of a free-market currency that cannot be manipulated by any central bank.  (The full picture is considerably more complicated, of course, and crypto speculators should educate themselves thoroughly before trading these instruments.)

While this promise of cryptos as “government-proof money” or “digital gold” is interesting and has galvanized a whole generation of young traders and tech enthusiasts, the same promise is enticing to central bankers for entirely different reasons.  Anyone interested in cryptocurrencies should understand the uses that these authorities are imagining for cryptos and digital currencies in general.

Central banks and central governments envision repurposing digital currencies to aid them in their push towards a cashless economy.  A cashless economy is preferable to them for many reasons.  Electronic transactions can be thoroughly monitored — and if they are passing through a central hub, they can be controlled.  Purely electronic financial transaction systems present political and monetary authorities with a host of tantalizing tools for fighting crime and detecting fraud.  Most of the world’s central banks are now in the process of researching the rollout of a digital version of their national currency.  Some of these projects are far advanced — for example, China’s and Sweden’s.  The covid crisis, and its associated germophobia, is reducing public resistance to such ideas.

However, these government-sponsored “e-currencies” are fundamentally different from decentralized, cryptographically based digital currencies such as bitcoin.  The authorities likely hope that they will satisfy the demand for digital currencies by the public and the financial system, while supplanting the cryptocurrencies that they cannot control.  The end game would be to marginalize — or even to criminalize — the use of truly decentralized cryptos.

A recent article in The Economist proffered some of the usual arguments in favor of cashless transactions and government-sponsored and administered digital currencies.  For example, in an economy that is organically moving towards cashlessness, government-sponsored digital currencies could be more stable during a crisis; or they could prevent the appearance of monopolistic digital currencies controlled by one or another of the tech giants (surely a veiled reference to Facebook’s Libra project [NASDAQ:  FB]).  The authors go on to note:

“CBDCs [central bank digital currencies] also give central banks more control.  They could allow for transactions to be easily tracked, perhaps making them more alluring to China’s authorities…Where things get really interesting from a theoretical perspective are the implications for monetary policy. CBDCs may make it easier to implement negative interest rates.  Unlike old-fashioned cash, digital fiat can be programmed.  For now, rates cannot go too negative, because savers can always demand cash, which by definition offers an interest rate of zero.  But if digital cash is programmed to have a negative interest rate, people would have fewer fallbacks and central banks more flexibility.”

That casual mention of central banks “programming” their digital currencies to enact negative interest rates recalls one of the most outlandish monetary proposals of the 20^th century: Silvio Gesell’s idea of money with an “expiration date.”  If you don’t spend it, you lose it.  It would be the same effect as central bank engineered inflation — but completely direct and controllable, and with fewer escape hatches.

CBDCs could also be used to implement a “universal income,” or other redistribution mechanisms.

Of course, this is all still just a twinkle in the eyes of the financial authorities.  But investors should not maintain any illusions that such ideas are not being researched.  Very likely, this is the shape that “digital currencies” will take in the future — and not the decentralized and somewhat Utopian dream of the pro-crypto libertarians.

Once centrally administered digital currencies were in place, it would be easy to implement controls to hinder the interaction of genuinely decentralized cryptos with the official financial system.  And since those genuine cryptos still cannot process transactions anywhere near fast enough to serve as a medium of exchange, their sole use-case — the store of wealth — would be significantly challenged.

Investment implications:  The crypto space is being reinvigorated by some of the same forces that have been helping gold higher: the desire for access to a store of wealth that can’t be debased by central bank policy or central government profligacy.  The bigger picture, though, is that around the world, central banks are studying how to implement their own digital currencies.  Ultimately, this is simply another manifestation of the perennial desire of central authorities for deeper control.  It is unclear whether genuinely decentralized and private cryptocurrencies will be able to coexist with government digital currencies, or if they will be marginalized.  Speculators who are interested in cryptos from a longer-term perspective would do well to consider these trends.  We reiterate that cryptos are unlikely to dethrone gold from its position as the ultimate hedge against debasement and profligacy.