Gold News

Europe's 21st Century Gold Standard vs. Warren Buffett's Martian

Gold Bullion could actually be put to good use in the Eurozone crisis today...

IMAGINE you owed the world €2 trillion, writes Adrian Ash at BullionVault, but you also sat on the world's 4th largest hoard of physical gold.

There must be some way Italy can use those reserves to ease its public debt. Right?

Well first off, the Banca d'Italia's gold hoard is only a drop in the bucket. Add its foreign currency holdings in fact, and the total equals a mere 7.8% of Italy's public debt. Rome owes a massive 123% of Italy's annual economic output, twice the upper limit set (and ignored) by the Euro nations. So besides leaving it naked in a distinctly possible post-Euro landscape, gutting its central-bank reserves would hardly solve the problem.

Second, those 2,451 tonnes of gold belong to the central bank, not the government. So does the €50.6bn in foreign exchange. And under the various Eurosystem treaties which Rome signed when it joined most of the rest of Western Europe in seeking low German interest rates without high German savings, that puts the reserves beyond the reach of government.

Witness the Banca d'Italia's forceful response, for instance, to Silvio Berlusconi's 2009 attempt to skim off a bit of gold to fund current spending when he was last prime minister. Get off our lawn, said the Banca – then run by today's pan-Eurozone central bank boss, Mario Draghi. Because Silvio's bunga-budgets aside, Eurozone states cannot use their central-bank reserves to finance government deficits. Which means, at first glance, that the region's huge Gold Bullion reserves – more than one ounce in every three held by official hands worldwide – are effectively dead.

"Gold gets dug out of the ground in Africa, or someplace," as Warren Buffett told Harvard students in 1988. "Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

But maybe Buffett, like his Martian, isn't thinking hard enough.

Don't whisper it too loudly, but two solutions are being bounced around which could see gold actually used by governments to ease the mess they have created. First, says the Council of Economic Experts in Germany, every Eurozone country with public debt of more than 60% of its annual GDP should put up assets – like gold, if not the Parthenon – to join a big "redemption fund". That fund would be secured by those assets, which members would then get back as they paid down their excess debt, over and above that 60% ceiling, over a period of 20 years.

With it so far? Berlin isn't. Chancellor Angela Merkel rejected this idea a year ago, perhaps because Germany – like France, the Netherlands and pretty much everyone else – would have to join the scheme. The Eurozone's biggest gold-owner as well as its biggest economy, Germany now has public debt equal to 83% of GDP. But the crisis hasn't improved since November 2011. And the redemption fund is a native German idea.

Second however, and because the Eurozone crisis is due to some nation's facing steeply higher borrowing costs than other member states, why not let them use their gold to raise cheaper finance in the market? That's what friends of Bullion Vault the World Gold Council propose.
Italy and Portugal for instance could issue new government debt part-backed by gold. Both have sizeable gold reserves compared to their immediate financing needs. Both could very likely get lower interest rates from private lenders if those lenders got the promise of a part-gold payment in the event of default. So both would be highly incentivized to avoid defaulting, thereby losing all or part of their gold reserves. And as the World Gold Council's director for government affairs, Natalie Dempster, put it to me last week, reducing their role in the problem – especially Italy's – would let the Eurozone focus its tax-funded resources on the other troubled states, most notably Greece and Spain.

Most crucially, this idea wouldn't require new money creation, since the debt would be raised from private lenders, rather than from the European Central Bank. So there would be no extra risk of inflation. Which to date has been the big stumbling for German agreement to all other schemes and solutions put forward.

Now, what coverage this idea has got so far has been mixed. The Financial Times was broadly positive in late summer; last week's coverage by the Wall Street Journal was less so. There's still the legal problem of using gold to help fund government debt. There's also the problem of leaving each Eurozone nation to sink or swim by itself, rather than splashing about together in the big happy pool of the German Experts' scheme.

But the idea of offering gold as collateral to get cheaper loans is common practice in Asia. It has revolutionized consumer credit in India for example, where private households own more Gold Bullion than even the Eurozone states added together. And as a positive study submitted to the European Parliament by University of Duisburg-Essen professor Ansgar Belke shows, using gold collateral to raise cheaper loans is hardly new to sovereign governments either.

"In the 1970s, for instance, Italy and Portugal employed their gold reserves as collateral to loans from the Bundesbank, the Bank for International Settlements (BIS) and other institutions like the Swiss National Bank. Italy, for instance, received a $2 billion bail-out from the Bundesbank in 1974 and put up its gold as collateral. More recently, in 1991, India applied its gold as collateral for a loan with the Bank of Japan and others. And in 2008, Sweden's Riksbank used its gold to raise some cash and provide additional liquidity to the Scandinavian banking system."

Yes, contrary to common wisdom and current Eurozone practice, governments can and have put gold to good use. And long after the demise of the classical Gold Standard seemed to mean Auric Goldfinger had beaten James Bond and (in the movie but not the book) effectively irradiated the world's official gold reserves, putting them beyond use. Nor do they need to sell and so lose it, as they did a decade ago – back when history had ended, and the risk of crisis seemed as remote as, say, a Greek Eurozone exit.

Part-backing debt with a chunk of gold has a much longer history than the 1970s too. Under the high Victorian Gold Standard, the Bank of England was allowed to issue banknotes over and above the actual gold-backing held in its vaults. Over the next 80 years – the zenith of international trade enabled by that London clearing house – the Bank of England's requirement was safely cut to just one ounce of gold for every 3 ounces' worth of paper Pounds Sterling. So two thirds of Great Britain's gold-backed money was unbacked, in short, with the "promise to pay" still stamped on all banknotes regardless.

To anyone watching from Mars, part-backing a debt issue today would look awfully similar.

Adrian Ash

Adrian Ash, BullionVault Gold News

Adrian Ash is director of research at BullionVault, the world-leading physical gold, silver and platinum market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, he was City correspondent for The Daily Reckoning from 2003 to 2008, and he has now been researching and writing daily analysis of precious metals and the wider financial markets for over 20 years. A frequent guest on BBC radio and television, Adrian is regularly quoted by the Financial Times, MarketWatch and many other respected news outlets, and his views from inside the bullion market have been sought by the Economist magazine, CNBC, Bloomberg, Germany's Handelsblatt and FAZ, plus Italy's Il Sole 24 Ore.

See the full archive of Adrian Ash articles on GoldNews.

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