Urgent! Protect yourself now from the mad experiments of central bankers

Just a few short years ago, the idea that central banks in the Western world would one day be printing money to buy government bonds from the banks that held them was inconceivable.

But this might only be the first step. The financial press is now alive with mutterings that the next move could be for central banks to pay for government spending directly.

The idea is that the Bank of England (or the Federal Reserve) would just cancel all the government bonds they’ve bought already. So the government wouldn’t owe the money anymore.  

Let’s make our position clear just now – this way madness lies. We’ll explain why in a moment. But that won’t stop the world’s central bankers from giving it a shot.

That’s why you need to take steps to protect yourself now. Here’s how.

How to make money printing even more dangerous

Lord Adair Turner made a speech last week that many saw as being a closet job application for the Bank of England governor’s job. He argued that the Bank could take even more ‘unconventional’ steps to boost the economy.

Various journalists claimed that he secretly likes the idea of cancelling the government bonds that the Bank already holds. Turner said at the weekend that this isn’t what he was thinking of. But that hasn’t stopped it from being talked up enthusiastically.

So what’s the idea?

Currently, quantitative easing (QE) involves the Bank of England buying gilts (UK government debt) from gilt investors such as banks. The idea is to drive down interest rates and also have banks sitting on more spare cash. In turn, that should encourage people to borrow and banks to lend.

In practice, that’s not happening. Or at least, it’s not happening quickly enough for growth-obsessed politicians and policy-makers.

One academic explanation is that people know that in the future this government debt will have to be paid back, or sold back to the private sector. This will suck money back out of the economy. The private sector knows this, and so in the long run, QE doesn’t make much difference to their overall borrowing and spending decisions.

So why doesn’t the Bank of England just cancel the gilts? If it did this, the gilts would never have to be repaid or sold back. In effect, you’ve permanently increased the money supply. You’ve also removed this ‘overhang’ of bonds waiting to be paid off.

So in theory at least, the private sector would stop worrying about it, and start spending more. Given that the Bank now owns 25% of all outstanding government debt, this could have quite a big impact, notes Gavyn Davies in the FT Money Supply blog.

Inflation is a psychological problem

Anyone living outside the rarefied heights of academia or central bank policy-making can see what the problem is.

Central bankers have been at pains to argue that QE is not actually money-printing. Indeed, they and their supporters sneer at this idea as being a simplistic interpretation of what they’re doing.

Trouble is, if they cancel government debt, then it becomes very clear that money-printing is exactly what they’ve been doing. More importantly, it becomes very clear to everyone that this is exactly what the Bank is doing.

In the absence of a gold standard, the one restraint on government spending is the bond market. If governments get too reckless with their spending, then investors should stop lending to them, for fear of not being repaid. That’s what’s happened to Greece, for example.

Britain has been able to keep borrowing because we have a good record of repaying our debts. But we also have a government that talks a good game about cutting spending (even if the reality is somewhat less impressive). So QE is tolerated as a temporary measure designed to prevent the financial system from imploding.

But if the Bank of England writes off the debt altogether, that changes the game. If the government knows it can spend what it wants, and the Bank will just print money to fund it, then you are into Weimar Republic territory. And everyone will know it.

As my colleague Merryn Somerset Webb has constantly warned, the velocity of money is ultimately a psychological issue. Everything can look fine one day, but the next, you hit a tipping point where people fear the destruction of the currency more than anything else.

That’s when they start to swap the currency for whatever they can lay their hands on. And that’s when the currency’s value plunges and inflation takes off.

The real danger is that if central banks nakedly print money to fund government spending, then this psychological tipping point will be breached.

Why sterling investors should be especially vigilant

This sort of talk is why you should hold gold in your portfolio, particularly if you’re a British investor. After all, it looks as though if anyone is going to try this particular monetary experiment first, it’s the UK.

Even that manic money-printer Ben Bernanke might hesitate before blatantly monetising the deficit. I can see him gazing admiringly at the next Bank of England governor and thinking: “Rather you than me, pal.”

I don’t know about you, but I’m not keen to have all of my savings in a currency whose central bank is thinking of boldly embracing the risk of hyperinflation.

The best way to defend against this sort of monetary catastrophe is to have some money in gold. As John Dizard notes in the Financial Times, as the policy debate moves more towards getting the “velocity of money circulation moving again… a hyperbolic, 1979-1980 style blowoff in the gold market is becoming much more likely.”

One sign of this change in tone, is that gold mining stocks have already started to outperform the gains in the metal, says Dizard. “In the third quarter, for example, the dollar price of gold rose by 10.9%, while the broad XAU index [that’s an index of gold miners] increased by 21.7%.”

However, as yet, the “broader public has not really been drawn into any gold mania, as it was in the late 1970s.” Nor have we seen “any flood of dubious junior mining stocks based on pieces of moose pasture in Northern Ontario or desert in Nevada.” That phase still lies ahead.

So hang on to your gold – that goes without saying. But you should also get a position in gold mining stocks if you haven’t already. We’ve just launched a new newsletter on precious metals miners – find out more about it direct from our expert, Simon Popple.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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21 Responses

  1. 15/10/2012, HL wrote

    John Stepek is always perceptive. This time, he has excelled himself.

    PMs and PM mining shares — everyone should stock up now.

  2. 15/10/2012, mark acklund wrote

    As has often been quoted, if the people really knew about the machinations and scheming of government and CB’s, rivers of blood would be flowing in our streets, only a matter of time …

  3. 15/10/2012, Banker wrote

    So house prices that are at most overvalued by 50% are a stupid bet, yet gold that increased five-fold and hass all the potential to roll back is a good bad? Should situation normalise in 3-5 years gold could well plunge back. Any value it offers as hedge against hyperinflation is already priced in several times over.

  4. 15/10/2012, Chris wrote

    @HL, couldn’t agree more. This is probably one of the best articles I have read in a while. The words flow off the page. @Mark, its frightening to think where this could go in the Southern Sates of Europe. @Banker, Don’t you mean houses are 50% “undervalued”? If as John says this is the route that lies ahead, I would think buying into property now would be agood idea as all physical assets would be inflated from the fresh liquidity and reduced risk on the banks & government balance sheets. Once the value of 1 unit of currency has been devalued so far, Gold and Silver will have to increase in value tenfold to align itself with the new economy. The wave of growth throughout the world as money floods the markets could be explosive. I would therefore think Commodities and Coomodity stocks would also be a good bet, i.e holding physical assets as well as Land, Food producers, corn, wheat etc etc; with a significant portion aligned to Gold I would suggest.

  5. 15/10/2012, COMMONSALT wrote

    One probably could not print enough money to represent the value of existing world assets and work in progress – not even for the created value in the last financial year.

    Money supply should never be a problem – finding someone to spend it properly, is our greatest challenge.

    commonsalt: http://www.salt.org.il/frame_econ.html

  6. 15/10/2012, Albert Einstein wrote

    Sounds unpleasant – civil unrest territory, as the game would well & truly be up if they can wipe off their own debts..

  7. 15/10/2012, jrj90620 wrote

    What makes you think the U.S. or U.K. are going to pay off their debts?There is no way they can tax enough to pay them.They will just keep rolling over the debt and the fiat currencies will continue devaluing.Don’t know when this nonsense will end.

  8. 15/10/2012, Kingbingo wrote

    I personally find it inconceivable that QE will ever be reversed. This is why I changed my view and bought a house. I now have gold, and a large 10 yr fixed rate mortgage.

    I also now have the Fed and and the BoE working as hard as they can to increase the value of my assets while decreasing the value of my debt. I think they will succeed in that.

  9. 15/10/2012, Boris MacDonut wrote

    #3 Banker .Well said.
    #8 Kingbingo. Totally correct. Central bankers are our friends saving us from the horror of deflation.

  10. 15/10/2012, Critic Al Rick wrote

    If I have a problem I do something to eradicate the cause.

    I can’t see that such a ‘progression’ will do anything towards correcting the cause of the real problem i.e. a country living well beyond its means; on the contrary, it may well serve to exacerbate the problem.

    Do they even admit the country is living beyond its means? Do they even care? How much longer to the Fantasy Crunch?

  11. 16/10/2012, Market Observer wrote

    kingbingo: it doesn’t work like that. buying a property now won’t give you protection because the reckless money printing will give you hyperinflation, that will lead to a period of very high interest rates. you will see property prices crash while the long overdue correction finishes. prices will pick up from there and you may be able to see some sustainable growth. so buying now is jumping too early and will be regretted.

  12. 16/10/2012, The Watcher wrote

    It’s all about signals and muscle-flexing.
    The markets would crash the pound overnight if this happened, and although I also have serious doubts (long-term) about the prospect of QE being reversed or the national debt being paid off, default will only be done in conjunction with the imposition of martial law, curfews, etc. Give it another 8-10 years for that.

  13. 16/10/2012, Andy wrote

    #8 Kingbingo. Yes, you are right, until you mentioned the large mortgage. Yor’ll have to hope that your debt will be “eaten away” faster than the inevitable rising of your mortgage rate. Buying cash is a smart move (if you have enough), getting into debt less so.
    Also, let’s hope the population at large keep sleeping while you enrich yourself with unearned wealth.

  14. 16/10/2012, FourCandles wrote

    Andy, Kingbingo will not be affected by rising interest rates if his mortgage rate is fixed for 10 years. This seems like not a bad strategy to me.

  15. 17/10/2012, Pete wrote

    Kingbingo has done exactly the right thing by taking on debt but fixing the interest rate for 10years. When the BOE’s £375billion of QE starts to flood into the economy inflation will rip, and they will let it rip for fear of smothering any recovery. Kingbingo will be able to pay his mortgage with rapidly devaluing pounds. The suckers, who lent the money at a fixed rate, will be scalped.

  16. 17/10/2012, Market Watcher wrote

    FourCandles: of course he will be affected if mortgage rate rises, because property prices are only supported by extreme low interest rate at the moment, prices will fall down the cliff when rate rises.

  17. 17/10/2012, Pete wrote

    Buying for cash is a dumb move. You are investing in an asset (house) that is already over priced. Sure the Nominal Price of houses will go up but when you adjust for inflation you will find, in the future, that your cash investment will have lost value. Much better to invest someone else’s money in a house and pay them back with monopoly money. Meanwhile invest your own money in something real for instance gold.

  18. 18/10/2012, JimW wrote

    At last someone has actually mentioned what I’ve been wondering about for months now.

    Although I was thinking about debt being slowly written off, similar to Greece debt although we would be doing it to ourselves.

    I suspect if C.banks do cancel debt then it would be subtle. Wait for an emergency or possibly a war then expect a law enabling a major write off of gov.debt. Hopefully USA & Japan will start the ball rolling, that’s if they haven’t started quietly doing so.

    Isn’t life interesting.

  19. 20/10/2012, Massivebogey wrote

    But who is going to protect us against John Stepek?

  20. 21/10/2012, jack wrote

    Your not talking about a financal investment.

    If this happens, your talking about world war 3!!!!

  21. 13/11/2012, Iain wrote

    Interesting but ‘academic’ article from John. The fact is that he does not know what would happen if the UK wrote off £375b of debt that Britain owes itseslf. His article although entirely reasonable is a plead for morebanking rigour linked to gold. We tried that via a return to the gold standard in 1928 and that did not get us very far. What I cannot understand is that in previous articles it has been pointed out that we can get out of this mess by either growing our way out or reneging on debt — incidentally advocated for Greece. I doubt that a financial armageddon awaits us if the BoE cancelled that QE debt. The clock would be reset to zero.

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