ECB Gold: Accident Or Strategy?

When the euro was launched, the European Central Bank (ECB) held approximately 15% of its assets in gold. That ratio has remained reasonably stable, giving rise to a variety of chatter, including suggestions that it may displace the U.S. dollar. We pursue the question on whether the ECB’s gold holdings are an accident or strategy.

Let’s look at the numbers. Below is a chart depicting the percentage of gold relative to the ECB’s total assets. As one can see, the percentage has remained reasonably stable despite a significant growth in total assets.

Out Of Thin Air
Total assets of a central bank may be considered a proxy for the amount of money that has been “printed”; it’s a crude measure as it does not reflect physical money; nor does it reflect money in circulation; neither does it reflect sterilization activities that also show a rise in assets. Still, a central bank balance sheet is often referred to as a printing press as money is literally created out of thin air (by the stroke of a keyboard) when assets are purchased. Federal Reserve Chairman Bernanke has referred to such fiat money as 'the printing press'. We like to think of it as super-money, as central-bank purchases provide cash to the banking system, allowing it to lend a multiple of the money that has been “printed”. While banks have been reluctant to lend (the velocity of money has been low), the analogy we like to give is that if you give a baby a gun you're asking for trouble. That said, let’s look at total assets at the ECB:

The interpretation shows that while money can be printed, wealth cannot be created out of thin air: as money is printed, gold has appreciated versus the euro. So, while inflation has not shown up in indicators such as the Consumer Price Index, monetary easing is rightfully reflected in the price of gold.

Diving a little deeper to determine how much of this is strategy versus accident, let’s look at the gold holdings at the ECB once more:

Holdings Have Been Stable
The ECB marks its gold holdings to market, i.e. uses market prices for gold. The ECB was selling gold from the inception of the euro until the onset of the financial crisis. Since then, the ECB’s gold holdings have remained stable. To understand the motivation, one needs to note that when one refers to ECB gold holdings, one is actually talking about Euro-area gold holdings. While the ECB holds some of the metal, most gold is held by the respective central banks (this is not a discussion of where such gold is physically located):

Seventeen Nations, Seventeen Agendas
It's relevant to note that each nation in the euro zone pursues its own agenda with regard to its gold holdings. Germany has resisted political pressure from within to sell gold, as Bundesbank (Buba) profits would need to be transferred to the government. Indeed, the hawkish Buba has indicated that it would be considered selling gold to help finance the government’s deficit. Italy, as one can see, has not sold any gold. Conversely, as a percentage of its holdings, the Netherlands had been eager to sell gold up until the financial crisis. Portugal, too, was an aggressive seller. As one can see, gold sales are not particularly related to the financial health of a euro zone nation, but more to the cultural attitude in the respective nations toward gold.

U.S. Holdings
Let’s cross the Atlantic to see whether the ECB’s gold strategy is undermining the U.S. dollar. The Fed’s gold stock is valued at $44.22 per fine troy ounce. For purposes of the chart below, we adjust the Fed’s gold holdings to market prices:

Note that the chart above starts in 2006, so as to focus on the period of the financial crisis. The Fed has been more aggressive than the ECB in printing money. As such, the percentage of gold in relation to total holdings has declined at the Fed in a more pronounced fashion. There is clearly no perfect relationship between the size of the balance sheet and the price of gold, as other factors also influence the supply and demand of gold. However, increasing the supply of fiat money (dollar, euros) may decrease its value when measured in real assets, such as gold. We have in the past referred to the Fed as the champ in printing money (as measured by the percentage balance sheet growth since August 2008), although the Bank of England has, of late, taken over that title.

ECB's Measured Approach
From what we see, central banks have been scared into holding gold since the onset of the crisis. Beyond that, we don’t see an active strategy at the ECB to keep its gold reserves at 15% of total assets. Instead, the ECB’s comparatively measured approach has simply lead to a reasonably stable percentage of gold reserves. Of course that was before ECB President Draghi said on July 26 that he'll do “whatever it takes to preserve the euro.” (an interpretation of that may be that more money printing is on the way). For now, the cultural differences in responding to the financial crisis -- Europe: think austerity; US: think growth -- suggest that the euro should outperform the U.S. dollar over the long term, assuming the not-so-negligible scenario of a more severe fallout from the euro zone debt crisis won’t materialize.

It may help to keep in mind that, historically, inflation has been the response to a deflationary shock. If market forces were left to themselves, we believe the credit bust of 2008 would have caused a major deflationary shock. It’s the reaction of policy makers that fights market forces that may lead to inflation. Letely, Bernanke has brushed off such pessimism. As the charts above show, however, gold has been a sensitive -- and sensible I might add -- indicator to the trigger-friendliness of our central bankers.

Axel Merk
President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds

This report was prepared by Merk Investments LLC, and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice.