Aside from issuing the nation's currency, formulating monetary policy and
implementing it though interest rate measures and managing the money supply, a
central bank is also a regulator of the nation's banking system, and as such it
can set the discount rate, the interest rate charged to commercial banks and
other depository institutions on loans they receive, in the case of the
United States, from their regional Federal Reserve Bank's lending facility -
the discount window.
The Federal Reserve banks offer three discount window programs to depository
institutions: primary credit, secondary credit, and seasonal credit, each with
its own interest rate. All discount window loans are fully secured.
A central bank also acts as a lender of last resort to commercial banks and
other financial institutions and even non-financial corporations during periods
of systemic financial stress. It aims at applying a monetary policy that will
stabilize the credit and money markets by providing needed liquidity to the
banking system and the credit markets in times of systemic financial distress.
To add liquidity to the gold market, many central banks provide gold to bullion
banks and commercial banks with proprietary gold trading desks. According to
the World Gold Council, bullion banks are investment banks that function as
wholesale suppliers dealing in large quantities of gold. All bullion banks are
members of the London Bullion Market Association.
Bullion banks differ from depositories in that bullion banks handle
transactions in gold and the depositories store and protect the actual bullion.
For example, the Federal Reserve Bank of New York stores and protects gold for
a number of central banks and foreign governments. The US Bullion Depository in
Fort Knox, Kentucky houses most of the gold bullion belonging to the United
States.
Significantly, central banks choose to release gold to market participating
institutions by leasing out gold for fees denominated in dollars instead of
selling gold outright for dollars. This is because central bankers know from
experience in recent decades that fiat currencies, led by the US dollar, had
been repeatedly devalued against gold by deliberate Federal Reserve policy.
Gold price and the debasement of fiat currency
This policy-induced debasement of fiat currency by central banks can be
expected to continue well into the foreseeable future until market confidence
in fiat currencies is exhausted, and a new international finance architecture
is formulated. Before that final crisis happens, central bankers would look for
another white knight in the form of a reincarnated Paul Volcker to slay the
inflation dragon with another blood-letting cure of sky-high short-term
interest rates, as he did in the 1980s.
However, within the pattern of protracted steady decline in the purchasing
power of fiat currencies over the long run, the price of gold can be highly
volatile at any one time for a range of obscure reasons. Peaking at $850 per
troy ounce on January 21, 1980, gold fell to $285 in February 1985 and
recovered to reach $800 in November 1987, all within a period of seven years.
Having failed to overtake its historical peak price for the second seven-year
period, gold fell back down to $357 in July 1989. It rose to a high of $417
seven years later in February 1996, only to fall back to $250 in July 1999.
Gold was $35 cheaper per ounce in 1999 that it was on 1985, 14 years before,
and $35 was the price set for an troy ounce of gold at Bretton Woods.
Notwithstanding common perception, the above indicates that gold is not a
totally reliable store of value even for the long run. The price of gold had
been and still can be detached from general inflation rate in the global
economy for extended periods. For example, from its peak of $850 per troy ounce
set in January 1980, the gold price was falling towards the end of the same
year when economic data and central bank policy would suggest that it should be
rising, with US inflation rate reaching 14.5%, bank prime rate at 20.5% as a
result of Fed chairman Volcker setting the Fed funds rate at 20% by December
1980, with the unemployment rate at 10.8%, and 30-year fixed rate mortgage at
18.5%.
Gold price unrelated directly to inflation rate
In 2008, the gold price kept rising when economic data would suggest that it
should be falling, with the US inflation rate falling from 5.6% abruptly to
1.07% by November, and the bank prime rate fell to 3.5% while the Fed funds
rate was lowered to 0-0.25% in December, with unemployment at 10.7% and 30-year
fixed rate mortgage at 6%. These figures were clear signs of a severe liquidity
trap, which John Maynard Keynes defined as a drastic fall in market confidence
giving rise to a liquidity preference that overrides otherwise normal stimulus
effects of low interest rates on the economy.
The peak gold price of $850 per troy ounce set in January 1980 was not breached
for 28 years, an extraordinary long period for a bear market for gold. It fell
to a historical low of $250 in July 1999 while inflation was rampant, after
which gold took off to reach a historical high of $1,421 on November 9, 2010,
an extraordinary rise of 569% in just 11 years, in a period of general
deflation.
Gold price volatility not driven by supply and demand
The volatile gold price pattern in the past three decades obviously was driven
by more than market supply and demand for the precious metal, or by the
persistent debasement of fiat currency. In fact, central bankers know that
central bank monetary policies and continuing central bank intervention in the
gold market had much to do with this wide volatility in the price of gold.
A secondary reason why central banks lease out gold is to earn interest and to
capture arbitrage profit from the differential between the dollar interest rate
and the gold lease rate. Central banks do this to lower the carrying cost in a
contangoed forward price curve, while at the same time capturing anticipated
gains in gold price.
Contango depicts a pricing situation in which futures prices get progressively
higher as maturities get progressively longer, creating negative spreads as
contracts go further out in time. The time-related price increases reflect
carrying costs, including storage, financing and insurance. Contango is a term
used in the futures market to describe an upward sloping forward curve (as in
the normal yield curve). Such a upward sloping forward curve is said to be "in
contango" (or sometimes "contangoed"). Formally, it is the situation where, and
the amount by which the price of a commodity for future delivery is higher than
the spot price, or a farther future delivery price higher than a nearer future
delivery.
Why central banks lease gold to the market
Focusing on gold leasing fees is a diversion from the fundamental reason why
central banks lease out gold. Central bankers know from experience that even as
the price of gold rises, the monetary profit gold owners make from holding gold
does not necessarily add up to net gains after inflation. Gold owners are
merely hedging to reduce, but not avoid fully, monetary losses from the
inevitable debasement of fiat currencies caused by escalating loose central
bank monetary policies.
Gold leasing does allow central banks to earn rental income with the gold they
hold to cover some holding expenses. But more importantly, gold leasing by
central banks provides gold-backed liquidity to gold-related financial markets.
In a fundamental manner, adding gold liquidity slows the rise in the price of
gold which in effects slows the debasement of fiat currencies caused by
deliberate central bank monetary easing policies.
When a government issues fiat money that is legal tender for payment of taxes
(the publics debt to the government) and private debts, it is in essence
issuing interest-free sovereign credit to the bearer of its currency, which is
"legal tender for all debts, public and private" - a declaration that appears
on all US dollar bills - which are Federal Reserve notes.
Tax liabilities until paid to the government are debts to the government owed
by members of the public within its jurisdiction. The government charges no
interest for its sovereign credit in the form of fiat money it issues, unless
new fiat money is issued to quantitatively increase the existing money supply
to reduce through inflation the purchasing power of the money in circulation.
Thus mild inflation, up to 3% annually, is a benign way the government charges
interest for holding its fiat money in the form of sovereign credit
certificates. In that sense, the mild debasement of fiat money orchestrated by
the central bank is an inherent structural characteristic of sovereign
credit. In addition to other positive economic effects, mild inflation
increases tax revenue from fixed progressive tax rates, through bracket creep.
Milton Friedman's monetarist conclusion that a steady expansion of the money
supply at 3% annual rate is the optimum rate that balances inflation and
economic growth is a confirmation of this fact.
The issuing of fiat money as sovereign credit certificates should not be
confused with government fiscal spending of fiat money already in circulation
in the form of sovereign credit certificates already issued. Only the Federal
Reserve, as a central bank, can issue fiat money. The dollar is a Federal
Reserve note, not a bank note. The word "bank" does not appear in any dollar
bill. The US Treasury cannot and does not issue money. It receives money by way
tax revenue denominated in dollars issued by the Federal Reserve.
Fiat money in the form of sovereign credit certificates issued by the central
bank is accepted by members of the public because, by law, fiat money can be
used by the bearer to discharge tax liabilities to government. Payment of taxes
with fiat currency is in essence the canceling of tax liability with sovereign
credit earned by the taxpayer. The debasement of fiat currency is caused by
central bank new issuance, but not by government deficits if such deficits are
repaid with higher future tax revenue in the form of sovereign credit
certificates (fiat money issued by the central bank) already in circulation.
Fiscal deficits are only inflationary if a government pays for them with newly
issued fiat money from the central that enlarges the money supply without
expanding the economy.
History and politics of US central banking
In the United States, central banking was not born until 1913 with the
establishment of the Federal Reserve System.
The first national bank in the US was the Bank of the United States (BUS),
founded in 1791 and operated for 20 years, until 1811. A second Bank of the
United States (BUS2) was founded in 1816 and operated also for 20 years until
1836.
The first national bank, modeled after British experience, was established by
Federalists as part of a nation-building system proposed by Alexander Hamilton,
the first secretary of the Treasury, who realized that the new nation could not
grow and prosper without a sound financial system anchored by a national bank.
Jefferson's opposition to the establishment of a national bank was key to his
overall opposition to the entire Hamiltonian program of strong central
government and elite financial leadership. Jefferson felt that a national bank
would give excessive power over the national economy and unfair opportunities
for large certain profits to a small group of elite private investors mostly
from the New England states. The constitutionality of the bank invoked the
dispute between Jefferson's "strict construction" of the words of the
constitution and Hamilton's doctrine of "implied power" of the federal
government.
Hamilton's idea of national credit was not merely to favor the rich, albeit
that it did so in practice, but to protect the infant industries in a young
nation by opposing Adam Smith's laissez-faire doctrine promoted by advocates of
19th-century British globalization for the advancement of British national
interests. This is why Hamilton's program is an apt model for all young
economies finally emerging from the yoke of Western imperialism two centuries
later, and in particular for opposing US neo-liberal globalization of past
decades.
The creation of a national bank was one of the three measures of the
Hamiltonian program to strengthen the new nation through a strong federal
government, the others being (2) an excise duty on whiskey to extend federal
authority to the back country of the vast nation and to compel rural settlers
to engage in productive enterprise by making subsistence farming uneconomic;
and (3) federal aid to manufacturing through protective tariff and direct
subsidies.
To Hamilton, a central government without sovereign financial power, which had
to rely on private banks to finance national programs approved by a
democratically elected congress, would be truly undemocratic and to rely on
foreign banks to finance national programs would be unpatriotic, if not
treasonous.
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