Be your own Central Bank
Financial Times reported that there has been an indication by the EC, in the European Commission study of joint bonds, that gold may well be used as collateral for these bonds. In order to enhance the guarantees on the eurobonds, the draft says, governments could provide collateral, including “gold reserves which are largely in excess of needs in most EU countries”.
Further, last week the World Gold Council reported that Central Banks continued to increase their gold purchases in the last quarter, saying “activity among central banks continued to fulfil our expectations of further purchases in Q3. In fact, net buying accelerated notably during the quarter totalling 148.4 tonnes… We see this trend continuing in 2012.”
Whether using gold as collateral for bonds is a good idea, or whether central banks are hoarding gold for a return to the gold standard are questions for two different discussions. The main point I see is Central Banks are clearly directing their attentions towards gold. If Central Banks are realising the value of gold then why aren’t more retail investors?
European Central Bank Gold Reserves
The central banks of the Eurozone alone hold 10,792 tonnes of the yellow metal. This, according to the FT, accounts for 6.5% of the total ever mined. This gold is worth approximately $590bn, nothing compared to the debt overhang in the Eurozone but it is a significant amount compared gold reserves in recent years. According to the WGC report, gold sales by European Central Banks have dissipated “…as the period of intense economic and financial turbulence has emphasised the stability provided by gold to a central bank reserves.”
Central Banks’ investment into the gold market portrays a long term view. The last quarter, Q3, in which their net purchases have been increasing, has seen gold hit an all-time high of over $1900. This indicates that they are not only bullish on gold but their view of the yellow metal may not just be about its price but about its value, particularly as a safe haven.
Even the technocrats at the highest level in the machine which has driven us to this financial precipice on which we now find ourselves recognise gold as a safe haven. In 2009, the deputy director of market operations at the ECB stated.
“In a generalised crisis that leads to the repudiation of foreign debts or even the international isolation of a country… gold remains the ultimate and global means of payment that is still accepted and it is one of the reasons used by some central banks to justify gold holdings.”
Crisis leads rush to gold
This is exactly what we are seeing now. We are getting ever deeper into a generalised crisis and data shows that central banks are reacting to this and bolstering their gold holdings. This is seen no better than in the example of Hugo Chavez, President of Venezuela, who recently recalled 150-200 tonnes of Venezuela’s gold from the Bank of England. Using gold as a means of payment between countries is just a matter of time.
When it was suggested that Germany’s gold reserves be used to boost Eurozone bailout funds, the economy minister Philip Roesler stated Germany’s gold must remain untouchable. Was he perhaps alluding to the fact that the precious metal was too precious to play a role in this fiat mess and would be saved for the debut of a new monetary system?
The ECB’s director of market operations also commented back in 2009 that “there are four ideas behind those gold holdings. The economic security; the capacity to face unexpected needs; the question of confidence; and the risk diversification issue.”
As far as we can tell, those four criteria for holding gold are relevant not only for central banks but also retail investors, savers or anyone who cares about their securing their hard earned wealth.
The economic security
Gold has been chosen consistently time and time again because of its unique qualities and deserved reputation as a safe haven in times of economic uncertainty. Throughout history there are examples of people hoarding gold in times of economic and social crisis; one most commonly cited example is Jews fleeing Germany with bars of gold in the full knowledge that this would protect their wealth wherever they found refuge.
One example of gold’s role as a security against economic turbulence is its consistent purchasing power over the years. For example, according to James Turk’s research, the price of crude oil has essentially remained unchanged since 1945 when priced in gold grams, this is opposed to its price in US Dollars which has climbed beyond anyone’s expectations.
The capacity to face unexpected needs
The IMF state the presence of gold on their balance sheet holds a fundamental strength and they “should continue to hold a relatively large amount of gold among its assets, not only for prudential reasons, but also to meet unforeseen contingencies.”
When the director of the ECB referred to unexpected needs he used inflation as an example, an economic indicator everyone is beginning to show concerns about. This week Casey Research stated that The next logical step in this sovereign debt crisis is for us to see further signs of a loss of confidence in the currency. Such a currency crisis is usually measured by rising inflation that, in turn, leads to higher interest rates, which make the crisis worse.
Currently inflation across both the Eurozone and Great Britain is above their respective central bank target rates, and that’s even with the manipulated inflation tool which calculates a lower than actual rate. Inflation is a confiscation of wealth and is caused by an increase of the money supply.
The current system allows banks, not just central banks, to create money which in turn leads to inflation. The graph below beautifully illustrates the increase in the quantity of money circulating since Nixon closed the gold window in 1971, it is little wonder that the nominal price of the average car has soared from $3,542 in 1971 to almost $30,000 today according to Bud Conrad of Casey Research. Add to this the recent rounds of quantitative easing and bailout packages and it is easy to see how central banks and policy makers are losing control of inflation.
Buying gold bullion is a way of protecting your wealth. It has a virtually inelastic supply and therefore the issuer cannot negatively affect its value by creating more, unlike with our current paper system. Gold, as iterated above, is a finite resource and therefore the inflation of the supply is limited only by new discoveries of the metal, which by their nature, are finite.
The question of confidence
If Central Banks are buying more gold in order to diversify and secure their wealth this suggests even central and interested participants within today’s monetary paradigm are concerned about its potentially unstable footings. Ultimately, in times of crisis throughout history, individuals have returned to gold. These crises have been as a result of when fiat systems, un-backed paper systems such as the one we now operate, begin to collapse.
No fiat system has lasted more than 40 years; our current system has so far clung on for the longest time of them all, but this current fiat experiment has seen gold rise 500% in the last decade. If that isn’t people losing confidence in their paper money, returning to gold and driving up demand, then we don’t know what is.
The reason we have so readily accepted un-backed paper money is because of good faith. However, having watched the disjointedness caused by the collapse of Northern Rock and the implosion of the sub-prime crisis in the US, some are beginning to question whether the banks are able to return our money to us with the same good faith. At the moment British bank depositors will be compensated for amounts of £85,000 and below. But how long will they be able to sustain this? Who is acting as guarantor for the British government?
Is no one asking where they are getting this money from? Currently the government by providing this backstop to savings are simply increasing its potential balance sheet obligations. How far can this continue? Our government is close to walking in the footprints of Ireland, a nation which promised to backstop banks and savers, yet when push came to shove the bond market lost confidence with Ireland. Can our government back stop all of our savings? We would urge probably not.
The Risk Diversification Issue
Unsurprisingly this is often the most persuasive argument of them all. Very few people, understandably, can comprehend their banks going bust. And very few have their money in gold, representing only 1% of global financial assets. Currently central banks are in more than a sticky situation and even they appreciate the need to diversify from their credit based, inflation oozing paper system.
Unfortunately many retail investors are yet to allocate their capital on a similar basis. Studies have shown that portfolios, in both central banks and for retail investors, which do not hold gold experience higher volatility than those which do.
As many are aware the monetary system which holds our wealth hostage, is based on an unstable unit of account. Instability occurs for a plethora of reasons, from credit creation, fractional reserves, financial instruments and even the power of the central bank to manipulate the money supply. Gold has proved its worth by demonstrating its use as a safe haven in the long-term.
So there you have it, central banks are turning to gold. They have four main reasons for doing so. All of which we think come down to the same point. Gold is a historically sound, valuable and inherently stable asset. It is the indisputable store of value. It seems that central banks are becoming less trusting of government issued paper and wider political policy actions, and the future we are currently facing. Therefore, we might need to reconsider how we secure our own wealth.
As Jim Sinclair suggests, investors need to act like your own central bank.
Jan Skoyles is an economist at The Real Asset Company and contributes to other sites such as Renegade Economist. Jan’s interest in economics lead her to the Austrian school and the ideas of sound money and gold and silver. Read more of her articles.
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