A Thought for the Next Relapse: Europe and Gold

An analytical piece by Stephen Fidler of The Wall Street Journal’s “Brussels Beat” on October 18th raised the prospect of the use of gold as collateral for sovereign debts, something that sounds like a big step toward re-monetization. One story does not make for a policy shift, but it is good that such ideas have returned to the mainstream of discussion after a long and unhealthy exile.

Fidler was in turn inspired by two papers, one a policy note prepared for the European Parliament, by Ansgar Belke, and commissioned by the World Gold Council. The other paper, also commissioned by the WGC, was a “Europe Economics Executive Brief” written by Andrew Lilico. And yes, as Fidler acknowledges, the WGC is hardly a disinterested party.  Still, unless we are to decide that ad hominem disqualifications are now good things, (not a decision that will help anyone in search of alpha), we ought to take a look at this new fermentation about the old precious metal.

Portugal and Italy

Either Portugal or Italy could kick off the collateralization, on Fidler’s hypothesis. Each country has significant supplies of the stuff. Portugal has 383 metric tons, equaling 90 percent of its foreign reserves. Italy has close to 2.5 thousand metric tons, or 72 percent of its foreign reserve. Also, Portugal and Italy both need the ability to continue to sell bonds.

Further, the gold reserves of both Portugal and Italy are more than 20 percent of their respective financing requirements over the next two years.

At the moment, the euro-debt crisis is in one of its periods of remission, as measured for example by the €18 billion that Italy raised in its last bond sale, so no such action is imminent. But nobody seems to regard the remission as a solution, and this is an intriguing thought to store away ahead of the next relapse.

Northern Resentment

After all, the latest remission came about courtesy of the European Central Bank’s plan of Outright Monetary Transactions (OMT), a more overtly inflationary successor to the Securities Market Program (SMP), both bond purchasing campaigns.  These campaigns remain extremely controversial within Europe; in large part because the citizens of the northern countries are convinced they involve the shift of risks northward.  As Belke writes, “a gold-based solution is much less inflation-prone and does not reduce incentives for the reform of beneficiary countries.”

The price of gold is now standing, so to speak, on a roof. Back in 2000, gold was selling for $333 an ounce. This price crept up slowly over the following years, reaching $650 in July 2007. By that point, markets had been spooked (quite rationally). A boom largely built on the flip-ability of U.S. homes, and the ingenuity of the designers of derivatives, was reaching its inevitable end. Sales price for new homes sold in the U.S. had clearly peaked and derivatives based on the premise that prices could go up forever were, then, plainly overvalued. No one could yet be sure of what other consequences these facts might have, but the markets were turning.

So it was that in mid-2007 the price of gold began an historic four-year rally, and passed $1,880 in September 2011.

Is the World Ready?

Prices haven’t continued upward since then, but they haven’t come down from that roof, either. Thus, at close of trading on Friday, October 19, 2012, gold sold at about $1,740. This was off its peak of 13 months before, but still well over 500 percent of its value at the turn of the century.

So: is the developed world ready to re-monetize gold? Nineteen forty-four was the last time such a thing happened, and it had taken a terrible war to bring that about. The resulting system, the Bretton Woods fixed rates based ultimately on gold, worked quite well: for a time.

Now we find ourselves again within a world of mutually competing fiat currencies, and there is reason to fear that it will end, and not end well. It seems both a plausible and a cheering speculation, then, that the value of gold may yet serve to strengthen the credit of two of the southern-tier European nations, and this in turn will be a turning point in the re-monetization of gold worldwide.

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