Victor The Cleaner · @VictorCleaner
29th Nov 2014 from TwitLonger
The Mechanics of Currency Defence
Here are some schematic balance sheets in order to illustrate how (not) to defend your currency. The following is (roughly) the current consolidated balance sheet of the Eurosystem:
Assets
€300bn gold (300 million ounces at €1000 per ounce)
€200bn foreign exchange reserves
€1500bn financial assets
Liabilities/Capital
€1200bn monetary base (cash and bank reserves)
€400bn other liabilities
€300bn capital reserve
€100bn subscribed capital
As a goldbug you might be interested in the quantity of gold held per monetary base outstanding. As you can see from the numbers, this is 300 million ounces/€1200bn = 0.25 ounces per €1000. Not bad, is it? I bet many of you thought the Euro was "softer".
Scenario 1: Currency defence IMF/gold standard style
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"If you currency is under pressure, you ought to sell reserves and buy back your own currency."
Let's do it. We sell 100 million ounces of gold at €1000 per ounce and cancel the received euros, shrinking our balance sheet.
Assets
€200bn gold (200 million ounces at €1000/ounce)
€200bn foreign exchange reserves
€1500bn financial assets
Liabilities/Capital
€1100bn monetary base
€400 other liabilities
€300 capital reserve
€100 subscribed capital
So did this actually help? How much gold do we have per monetary base outstanding? We have 200 million ounces/€1100bn = 0.18 ounces per €1000. Ouch! We lost reserves, not only in absolute terms, but our currency is now backed by less (!) gold.
If you replace € by £ and "gold" by $, this is how Britain tried to defend sterling in 1992. The result is what's now known as "Black Wednesday". Probably George Soros had done the same maths as we just did above.
Scenario 2: Currency defence ECB/BIS style
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Here is how this is done properly: "Print your own currency and use it in order to purchase gold in the market"
Let's try it. We start with the balance sheet at the very top, and we purchase another 100 million ounces at €1000/ounce. Here is what we arrive at.
Assets
€400bn gold (400 million ounces at €1000/ounce)
€200bn foreign exchange reserves
€1500bn financial assets
Liabilities/Capital
€1300bn monetary base
€400bn other liabilities
€300bn capital reserve
€100bn subscribed capital
Now we have 400 million ounces/€1300bn = 0.308 ounces per €1000 monetary base. Yeah! Each unit of our currency is now backed by more gold than before, and this although we seemed to have "diluted" out balance sheet. Very nice! An additional advantage is that our central bank can never run out of its own money. No free lunch for George Soros here.
By the way, this is basically what Russia is doing these days, buying up part of the domestic gold production in rubles. Also, if there is a "yes" vote to the referendum in Switzerland tomorrow, and the Swiss National Bank wants to continue defending the €1.20 cap of the Swiss Franc, they would have to print Swiss Francs and purchase gold, at least for a part of the amount.
A couple of things to note:
1) If you think that in Scenario 2, the price of gold would remain constant, you'd be mistaken. Imagine the price increases to €1100/ounce. Then we would have
Assets
€440bn gold (400 million ounces at €1100/ounce)
€200bn foreign exchange reserves
€1500 financial assets
Liabilities/Capital
€1300 monetary base
€400bn other liabilities
€340bn capital reserve
€100bn subscribed capital
So there would be an additional €40bn of capital reserves. Nice to have in case some financial assets need to be written off.
2) On Twitter and at FOFOA's, Scenario 2 is often called GOMO (Gold Open Market Operations). James Mackintosh of the Financial Times dubbed it "QE Heavy".
3) What do you think is the strength of a central bank? The ability to *sell* gold, or the ability to *buy* gold?
4) Imagine the U.S. consider to obstruct the gold repatriation by the Netherlands, by Germany or by any other nation. What would you do if you were one of these European central banks? Of course, you would implement Scenario 2 as a kind of "nuclear" currency war. Jack Lew would call ViaMat before you can say "GLD puke".
5) It is very instructive to ask which central banks can use Scenario 2 and which cannot.
The dollar and the IMF, just as the gold exchange standard, operate according to Scenario 1. We note that the Federal Reserve does not own any gold (the U.S. Treasury Department does), and that there is no gold at market price on the Fed's balance sheet. The dollar will not be defended with gold, simply because it cannot. In fact, just when it was clear that the Euro would be launched, the U.S. gold was declared to be in "deep storage" as in "not to be used while the dollar in its old form is around".
The Euro, in contrast, is the first fiat currency engineered to be defended along the lines of Scenario 2. The ECB has sovereignty over exchange rate and reserve operations (in contrast to the Fed, the BoE and the BoJ). The gold reserves of their member central banks appear on the consolidated balance sheet of the Eurosystem at its market price. The institutional framework for Scenario 2 is in place.