Europe Economics Executive Brief

Gold as Collateral for Eurozone Sovereign Debt

The World Gold Council (WGC) has commissioned Europe Economics to provide a politicoeconomic assessment of its proposal for the use of gold as collateral for Eurozone sovereign debt, especially the debt of Italy and Portugal. InthisexecutivebriefweshallsummarisetheWGCsproposal,consideringitsmeritsrelativeto other ECB schemes such as the Outright Monetary Transactions (OMT) programme. We do not consider other alternatives such as certain countries leaving the euro or the exchange of Member State debt for Eurobonds.

The WGC Proposal

The WGC proposal is that Eurozone Member States with significant gold holding relative to their medium-term financing requirements should consider, as an option, offering gold as collateral for sovereign debt issuance. We see in the figure below that such a scheme is potentially relevant for Italy and Portugal, as these countries have gold reserves of in excess of 20 per cent of their financing requirements over the next two years, but not for other widelydiscussed distressed Eurozone sovereigns. Financing requirement and reserves1

Note: 2-year financing requirement includes the refinancing needs of each country and forecasted public deficits 1. Gold and FX reserves as per World Gold Council Q3 2011 data, price of gold taken to be $1,604/oz.; 2yr financing requirements are full year 2013-14 2. Bond yields as on 17 July 2012 Source: Bloomberg, World Gold Council

Which Gold?
The gold under consideration is not held by the ECB to manage the euro. Neither is it the collective property of the Eurozone. The gold relevant to the WGC proposal is held by the national central banks (NCBs) of Italy and Portugal in their own right. The governments of Italy and Portugal, as the recipients of all or virtually all profit distributions of their NCBs, are the beneficiaries of this gold e.g. if it were to be sold, the money made would overwhelmingly go to the governments of Italy and Portugal, not to the collective resources of the ECB or Eurosystem. There are many potential routes by which this gold could be transferred from the NCBs to their governments e.g. perhaps the Bank of Portugal could pay a dividend to the Portuguese governmentintheformofgold,ortheItaliangovernmentcouldbuygoldfromtheBancadItaliaat the prevailing market price, with the profits being paid immediately to the Italian government. A further possibility is that the NCBs could use the gold themselves, to back Portuguese and Italian government bond issuance. However. whatever the precise mechanism, the transfer of this gold would need to be authorised by the ECB.

Concreteness, simplicity, and credibility

Money (e.g. euros) newly created to purchase sovereign debt is abstract numbers on a computer screen. By contrast, gold is concrete. Gold bars might sit in a warehouse or vault. Creditors could go to see them. The mechanisms by which monetary interventions are intended to ease the raising of sovereign debt involve complex chains of causality, in which there are many potential unintended consequences to be mitigated and the high risk of the main strategy not working as intended. By contrast, using gold as collateral is simple, direct, and clear. Monetary actions raise considerable issues of credibility. When do they stop? Will they be reversed at an unexpected moment, or not be reversed when it is promised that they would be? The concreteness and simplicity of the use of gold as collateral makes it more credible. Physical gold bars could be transferred to a third party location (e.g. in London). The Italian or Portuguese governments would get them back when their debts were redeemed and would not get them back if they defaulted. It is difficult to see how a policy could be more credible.

Drawbacks of Direct Monetary Financing of Eurozone governments

Under the OMT (as with other schemes such as the LTRO or SMP) the ECB uses its balance sheet to indirectly reduce the costs to Eurozone Member State governments of financing their debts. This is not the stated intention of the ECB in doing this. But no-one doubts that it is the effect. The EU Treaty forbids the ECB from financing Member State governments for two very good reasons: (a) Such financing involves a form of fiscal transfer between Member States conducted covertly under the auspices of monetary policy. (b) Such financing is potentially highly inflationary.

We shall consider these in turn, each time seeing why the WGC proposal does not suffer from the same difficulty.

The OMT Involves a Fiscal Transfer Absent Democratic Accountability

When the government spends money, it buys real things peoples time, concrete for roads, medicines for hospitals, etc. That real value must come from somewhere. If a central bank finances government spending, the real value arises because there is a real-terms transfer from users of the currency to the government spending. A simple driver (though not the only possibility) for such a transfer is thatthereisinflation.Wecanrefertothisasaninflationtax. Within a sole-country currency area (e.g. the UK) an inflation tax to fund government spending would be applied to broadly the same set of people (the British, users of the pound) as the recipients of government spending (the British). But within the Eurozone, the inflation tax is applied to Germans, Belgians, Finns and so on whilst the beneficiaries are, say, Italians or Spaniards. Monetary financing of government spending within the Eurozone involves a fiscal transfer between Member States, without any process of democratic accountability or straightforward limit. TheLobsterProblemandtheVassalProblem As well as central-bank-mediated fiscal transfers occurring absent democratic accountability, there are the usual problems that would apply to such transfers even if they were democratically approved. In particular, if someone else is paying your debts, you are likely to be less disciplined in controlling them. We can make this point more concrete by considering the familiar problem of splitting the bill at a restaurant. When we each pay for our own dinner at a restaurant, we decide what we want to eat, bearing in mind the cost to us of our choices. Similarly, when the government of an individual member state of the Eurozone pays interest on its own debts, it decides how much to spend and borrow (and how much to bear the political costs involved in reforming labour markets and other parts of the economy in ways that promote growth), bearing in mind the cost to it of its choices. But when diners split the food bill in a restaurant, or the governments of the Eurozone split the interest cost

bill in a debt union, those incentives change. Instead of bearing in mind how our choices impact on our own costs, we consider how our choices impact on the total cost across all diners or governments. That will tend to mean that we eat/spend-and-borrow more, because others bear the costs. How significant an issue is this? That question was addressed in a well known academic study in the Economic Journal in 2004 "The inefficiency of splitting the bill", by Gneezy, Haruvy and Yafe. These authors conducted experiments with diners (strangers to one another), some of whom paid individually whilst others split the bill. Those that split the bill spent about 36 percent more than those that paid individually. Splitting the bill with strangers adds more than one third to the cost of lunch. In the context of the Eurozone crisis we can refer to this as the Lobster problem if other countries pay your debts, everyone will order the lobster. Tomitigatethelobsterproblem,lendersseektoimposestrictconditionality.Inotherwordsthey insist on oversight of the spending and borrowing decisions of distressed sovereigns. Conditionality is, for example, a feature of the OMT (though it is unclear how credible it is many commentators doubt whether, in practice, the ECB would stop purchasing the sovereign debt of, say, Spain were it to miss its deficit targets, given that the ECB has not done so in respect of Greece). Conditionality is not unusual or unnatural in respect of single loans. Any company that has sought a temporary bank loan will be familiar with the need to provide a business plan and report to the bank on progress against it. But strict conditionality seems unlikely to be sustainable for long in respect of sovereign states. If, for example, Italy were required to submit its budgets for approval by Germans for a decade, it would be reduced to the status of an economic vassal. It would not be its own population making the key decisions, to which democracy normally applies, regarding how much taxes should be and whether money should be spent on this or that priority. Instead, such matters would be determined by foreign bureaucrats. We can refer to this as the Vassal problem if you submit to conditionality over the long-term, you become a vassal state.

The WGC Proposal Involves No Fiscal Transfer

Monetary purchases, by the ECB, of government debt of an individual Member State constitute a quasi-fiscal transfer, because assets held in common over the Eurozone as a whole (the scarcity value of the currency) are used for the benefit of an individual Member State. But NCB-owned gold is an asset owned by an individual Member State. For example, sales of that gold at a profit can result in profit distribution back to the shareholders of the NCB. So the use of these assets would not involve a quasi-fiscal transfer between states but, rather, the use of the assets of a state for the interests of that state. Because there is no fiscal transfer, there is no Lobster problem countries retain responsibility for their own spending and debts, and so have strong incentives to control their spending and engage in structural reforms to raise their growth rates enough to service their debts and hence no Vassal problem no transfer means no need for conditionality and no surrender of sovereignty.

Monetary Financing is Inflationary

Purchases of governmentdebtbythecentralbankincreasethecentralbanksbalancesheetand thus the monetary base. Increasing the money stock can be highly inflationary. TheECBsterilisesitspurchasesofsovereigndebtunderoperationssuchastheOMT.Inother words, it takes precisely as much money out of the system elsewhere as it injects in via sovereign bonds (typically by selling one-week bills thus taking in euros in exchange for those bills, those euros there leaving circulation). It is a matter of dispute how effectively the ECB in fact sterilizes such operations(the ECBs one-week bills can be deposited as collateral with the ECB, unlike most other securities, and are essentially as good as cash), and there is also the question of whether short-term sterilisation can address longer-term effects (e.g. if monetary base increases are suddenly multiplied up). But a more intractable problem is the simpler one that once governments start being able to have their spending financed by central bank money, past experience suggests that they find it difficult to stop, and inflation (even hyper-inflation) is the nearly inevitable long-term result.

The use of NCB Gold is not Monetary Financing and is not Inflationary
The euro area is not on a gold standard and hence gold is not a monetary asset, either absolutely (in that gold is the medium of exchange) or implicitly (in that gold backs the medium of exchange). It is true that some gold and foreign reserves are required for the orderly management of the currency. The gold so required resides with the ECB, and is not the gold to which the WGC proposal applies. The WGC proposal applies strictly to the gold not deemed required for the management of the euro and thus left with the NCBs of Portugal and Italy. A monetary asset has value only in use as money as a medium of exchange, as a store of value for future exchange, and as a unit of account (a measure of price in contracts). A real asset has value in its own right it has uses other than as money. In the euro area, gold is a real asset, not a monetary asset. Furthermore, unlike a monetary asset, gold is available only in restricted amounts. The ECB could, in principle (if not constrained by law, Treaty, custom and politics), produce unlimited quantities of new euros to purchase additional sovereign bonds. But the amount of gold available as collateral for Italian and Portuguese sovereign debt is the amount held by the NCBs of Italy and Portugal and any additional gold their governments purchase. The fact that amounts are constrained is an important disciplining factor (a pro) but also places a de facto time limit on the period of collateralised bond issuance (a point to which we shall return below). As a real asset, the use of gold as collateral is not inflationary any more than would be the use of historic buildings or military equipment or islands or any other of the forms of collateral that have been proposed for distressed sovereigns.

NCB Gold can Address the Key Potential Market Failures

The OMT is defended by the ECB as motivated by a market failure (as were the SMP and LTRO before it). Specifically, the OMT is intended to remove or reduce the yield risk associated with the risk of outright euro collapse a risk feared to be self-feeding, creating a market failure in the form of a high-euro-breakup-risk equilibrium. The presence of outright euro collapse risk creates incentives for investors to selling Italian bonds and purchase German bonds, to exploit the likelihood that a post-euro Italian currency would depreciate versus a post-euro German currency. Low Italian bond prices mean high Italian yields, which in turn create the spectre of Italy being unable to fund itself at any price (being unable to raise debt), creating a liquidity crisis that might increase the risk of a political crisis leading to the break-up of the euro validating the initial concern. By intervening to remove the element of high Italian yields that reflects such risk, the ECB hopes to reduce the risk. The use of gold as collateral for Italian debt could address this same market failure, in two ways: i. Reducing liquidity risk. With gold available to use as collateral, Italian liquidity risk would be materially reduced. In the event that Italy faced difficulties raising unsecured debt, it could issue gold-backed debt until purchasers of unsecured debt returned. Given its large holdings of gold, if necessary and in extremis it could maintain gold-backed-only issuance for perhaps two years. More probably it could maintain a combination of some unsecured and some gold-backed issuance for a much longer period. Reducing depreciation incentives. Under the hypothetical scenario of a total euro collapse, with gold as collateral, incentives for Italy to devalue post-euro would be significantly reduced if the collateral comfort were expressed in gold terms, since devaluation would result in an increase in the percentage collateral comfort provided by a given amount of gold (for a given gold price).

ii.

Conclusion
We have seen that there is considerable Italian and Portuguese gold available in National Central Banks that could be used as collateral for new sovereign debt issuance. Unlike monetary financing of sovereign debt, under schemes such as the OMT, the use of gold as collateral would not create fiscal transfers between Eurozone members or long-term inflation risk. It could address the same market failure issues at which current ECB policies are directed, but do so without the drawbacks that have made those policies controversial.

Europe Economics, October 2012

Europe Economics is an independent economics consultancy, specialising in the application of economics to public policy and business issues. For general enquiries contact: Alexandros Iakovidis at Europe Economics, Chancery House, 53-64 Chancery Lane, London WC2A 1QU. Tel: (+44) (0) 20 7831 4717 Fax: (+44) (0) 20 7831 4515 email: enquiries@europe-economics.com