What Fiscal Dominance Means for Gold

When looking at government finance, there are two main areas of policy: fiscal policy and monetary policy. Fiscal policy encompasses federal spending, the federal budget, the appropriations process, and the means by which Congress funds government actions. Monetary policy encompasses the actions of the Federal Reserve in providing currency to the financial system.

Ever since the 1950 Treasury-Fed Accord, the Fed and the Treasury have remained nominally independent of each other. The Fed was no longer required to keep interest rates low, and could manage interest rate policy and monetary issues without Treasury interference, while the Treasury managed federal finances without resorting to help from the Fed.

Whenever a Treasury Secretary would testify in front of Congress and field a question about monetary policy, he would quickly refer it to the Fed. And anytime a Fed Chairman was asked a question about budget deficits and federal spending, he would quickly deflect that to Treasury, which is responsible for fiscal policy.

But that relationship between the two agencies is breaking down, with the Fed in danger of once again becoming an arm of Treasury, enabling runaway government spending. That’s dangerous to investors, or at least to investors who haven’t taken steps to protect their assets by investing in gold.

What Is Fiscal Dominance?

Fiscal dominance is what happens when the fiscal authority (Treasury) starts spending so much money that the central bank is forced to step in and monetize that debt. In essence, there is so much spending that the central bank is forced to abandon whatever mandate it has (low inflation, full employment, etc.) in order to fund government operations.

This happens when the fiscal authority spends so much that it has to issue debt to fund that spending in such large quantities that markets couldn’t possibly absorb it all at once at prevailing rates of interest. If the amounts of debt issued are so large that they exceed market demand and markets can’t absorb them, it would result in a tremendous fall in bond prices and therefore a rise in interest rates, thus burdening the government with additional interest expense and threatening whatever interest rate policy the central bank is pursuing.

The solution then is for the central bank to abandon its mandates and purchase the newly issued debt in order to keep markets from being overwhelmed and to keep interest rates stable. The danger in this, however, is that once the central bank has shown itself willing to step in, the fiscal authority can abuse that willingness and resort to ever more debt-fueled spending, expecting the central bank to step in. Thus the fiscal authority’s actions come to dominate the monetary authority’s actions.

The Effects of Fiscal Dominance

Those purchases by the central bank require money to be created out of thin air. The Fed isn’t directly purchasing new debt from the Treasury. Rather, primary dealers purchase Treasury debt at auctions, then the Fed purchases that debt from the primary dealers. Sometimes that process can take as little as 30 minutes.

The money the Fed uses to purchase that debt from primary dealers is created from nothing. It’s an electronic ledger just created from scratch, and that electronic money is sent to the primary dealers in exchange for the Treasury debt. Those primary dealers can then either store that newly-created money at the Fed in the form of reserves, or they can use that money within the financial system, such as by lending it out.

In this way, this monetization of debt becomes directly inflationary, as it increases the supply of money within the financial system even though there was no increased demand for money. And if too many rounds of monetization are undertaken, it could even become hyperinflationary.

The amount of debt the Federal Reserve has had to monetize this year has been astronomical. Thanks to COVID-related stimulus spending, the federal debt held by the public skyrocketed from $17.2 trillion in the first quarter of 2020 to $20.5 trillion in the second quarter of 2020, an increase of nearly 20%.

There was no way that debt markets would have been able to absorb such a massive debt issuance in such a short period of time, so the Federal Reserve stepped in to absorb much of that, increasing its balance sheet by $3 trillion. We’re seeing the effects of that today, as stock markets rebounded from their lows to push toward all-time highs, and out-of-work consumers are putting their unemployment checks to use by continuing to make purchases.

Prices that should have been falling in an economy that shrank by 33% in the second quarter, and in which over 50 million people lost their jobs at one point or another, are instead spiking, punishing those who worked hard to save and invest. We’re living in a bizarro world in which everything we expect to happen isn’t, and everything we think shouldn’t happen is. The only question is how long this will go on, how long the economy will remain skewed by all this easy money.

The federal government seems intent on spending even more trillions of dollars on COVID stimulus this year, further driving up the federal debt. And the Fed will likely have to step in again, monetizing debt and creating more money ex nihilo.

Fiscal Dominance and Gold

As fiscal dominance threatens to create a monetary policy of permanent easing, the risk of hyperinflation will continue to grow. At the very least, prices could continue to rise as more money floods the economy. That will erode the purchasing power of the dollar and reduce the standard of living of Americans whose salaries fail to increase to match those price rises.

As the dollar weakens, one investment asset will remain as a shining beacon among the flood of new money: gold. During times of inflation and hyperinflation, gold has protected investors’ wealth against monetary inflation and currency devaluation. If fiscal dominance takes hold, and the Fed continues to inflate the money supply, gold should continue to rise in value. Some analysts are predicting a rise in the gold price to $3,500 an ounce before it’s all over, and that’s not outside the realm of possibility.

If you’re worried about the performance of your investments and looking to protect your wealth, have you thought about safeguarding your assets with gold? With stock markets possibly on the cusp of a major correction, now’s the time to buy gold, before stock markets tank and gold takes off. So contact Goldco today to find out how you can protect and defend your wealth with gold.