By Philip O'Connor*
When the US, Europe, and Japan print money the NZ dollar is debased.
This article shows how the Reserve Bank of New Zealand (RBNZ) can fight back by converting foreign exchange reserves into direct gold holdings.
New Zealand is among a short list of countries that do not hold gold to back its own currency. But New Zealand does have indirect holdings of other countries’ gold from holding these other countries’ currencies. As a result, every time these other countries bail out their banks, the amount of gold backing the New Zealand dollar decreases (debasement occurs).
It is estimated that the August 2011 indirect gold backing of the NZ dollar is about 7.7% or 1.6 milligrams of gold. It is also shown that through sales of foreign currency reserves for gold, NZ can get about 10 times the gold represented by their indirect gold holdings.
If half of the RBNZ’s foreign currency holdings are converted into gold, the NZ dollar gold-backing would increase to 42%. Having a sizable direct gold holding, the big 3 could continue to debase their currencies, and the New Zealand dollar will not be debased.
This article defers the reasons why gold never stopped being money to another article; however, four brief points will be made.
First, to those who say you cannot eat gold and therefore gold is not money: has anybody ever seen anyone with gold go hungry?
Second, gold has been used as money throughout almost all of the history of civilization.
Third, gold’s current prominent position on central banks’ balance sheets show that gold still backs world currencies.
Fourth, the tax asset backing world currencies is extremely weak at the moment. Since growth is low and government deficits and debt are high and rising in major countries, growth and taxes are not enough to strengthen the currencies.
In bad economic times the gold-backing of currencies becomes much more pertinent than in good economic times when the tax backing of currencies is significant.
Therefore, lets start by examining the gold backing of the RBNZ’s primary foreign currency reserve: the US dollar.
Gold backing of the US Dollar
Figure 1 shows the dollar value of the US’s gold holdings as a percent of the total balance sheet of the US Federal Reserve since 1915.
As a percentage of the strict definition of the US’s monetary base this figure is around 18%. However, the 18% figure excludes off-balance sheet obligations. The ordinary US banks produce derivative money that, nonetheless, is guaranteed by weak deposit insurance funds and is convertible into the base money. And the ordinary US banks derivative money is backed by bank loans and investments whose values have dropped sharply.
Michael S. Rozeff in an article at lewrockwell.com shows that with government guaranteed bank deposits, bad loans by banks add to the base money supply that gold is needed to back.
Amazingly, the US is still among the highest gold backed currencies because it has such a large gold stock and because its inflation rate has been moderate compared to most countries (King Dollar).
The Euro and Yen have even less gold backing. (See for example, Aftab Singh at marketoracle.co.uk, “If you debase the US dollar you debase them all”). The Euro gold backing is made worse by the European banks holding sovereign debts of the PIIGS which have a significant chance of turning into bad loans.
Will this low gold backing persist?
History shows that with a fixed rate of exchange between a currency and gold (“the gold-standard”), a gold run occurs when the gold-backing of the currency falls to around 20%. People rush to exchange the paper currency for actual gold before everyone else does.
Nixon’s decision to take the US off a fixed gold exchange rate in 1971 occurred once the US dollar got below 20% gold-backing.
Figure 1: US dollar gold backing (source: www.greshams-law.com)
Nixon floated the US dollar against gold, and since then there have been no runs into gold. However, currencies can still be converted into gold by selling the currency to buy gold in the gold market.
The effect of the floating gold exchange rate is that the currency’s gold-backing depends not just on the ounces of gold backing the currency but also on the price of gold.
Printing currency (currency debasement) can continue without a full-fledged run, because the floating gold exchange rate can restore the gold backing in dollar terms.
This is achieved by the price of gold rising. For example, if the US Federal Reserve doubles the amount of currency in circulation and the price of gold doubles (sound familiar, re 2008/09?), the US dollar gold-backing remains constant. However, the physical amount of gold backing each unit of the currency has declined and debasement has occurred.
New Zealand dollar debasement
The reason that US, Euro and Japan currency printing matters to New Zealand is that the foreign exchange which backs the New Zealand dollar, and was acquired through past labour, is being backed with fewer ounces of gold when these other countries print currency.
The (relatively) stable price range of the NZ dollar in terms of other fiat currencies hides the fact that New Zealand’s indirect gold backing is being steadily reduced.
There are other assets backing the New Zealand dollar but these will have to be raised through taxation and/or sacrificing other expenditure.
The NZ government sector is currently producing massive deficits and raising new debt against these other assets.
The shocking current rate of increase in total New Zealand government debt at 36% in the year to August 2011 shows that we cannot raise alternative reserves at the moment.
Even worse, NZ is relying more on foreigners to fund its deficits and official government overseas debt rose 97% in the year to June (the most recent published data point). The recent downgrade of NZ government debt by the ratings agency reflects the fact that the value of NZ’s other net assets (assets minus debt) is declining fast.
Adding to these problems, the value of the RBNZ’s foreign currency assets is being debased by other countries’ money printing. New Zealand is being forced to take action now, before these other countries print away the ounces of gold backing the NZ currency.
NZ Dollar’s gold-backing
Figure 2 shows the approximate gold backing of the New Zealand dollar in terms of NZ dollars (left hand axis) and in terms of milligrams of gold (right hand axis). The graph assumes all foreign currency is held in US dollars. This is a best-case scenario because the US dollar has a relatively large gold-backing and because it ignores that most of the RBNZ’s foreign currency assets are not direct holdings of foreign currency but stand in-line with many other assets for conversion into the foreign currency base.
The RBNZ undertook a wise course of action to increase foreign currency assets to back the NZ dollar starting in 2005. This is the cause of the increase in the New Zealand dollar’s indirect gold-backing beginning in 2005.
Notice how the US dollar debasement in the 2008 financial crises dramatically reduced the New Zealand dollar’s gold backing in dollar terms and in terms of milligrams of gold.
Since 2009, the increases in US money supply has caused an increase in the price of gold and the milligrams of gold backing the NZ dollar have been whittled away. In fact, despite the RBNZ increasing net foreign currency assets by $14 billion since January 2005, the NZ dollar’s physical (indirect) gold-backing has actually declined from 1.8 to 1.6 milligrams of gold per NZ dollar.
Figure 2: RBNZ net foreign assets* US gold holdings/US Fed liabilities/RBNZ NZ liabilities (source: World Gold Council, RBNZ, Fred St Louis Federal Reserve)
Conversion of 50% of RBNZ’s foreign currency reserves into direct gold holdings
For the case of this conceptual experiment I use a round number gold-backing of 10% which reflects an estimate of the off-balance sheet obligations of the US Federal Reserve (and also the lower gold-backing of the RBNZ’s other foreign currency assets).
This means that for every US dollar that the RBNZ sells for gold, the RBNZ exchanges $0.10 of indirect gold for $1 of direct gold. This is not an illusion. Because the world is willing to let the US gold backing be only 10%, New Zealand can arbitrage the difference and get gold at 10% of its cost in terms of gold that it gives up when it gives up foreign exchange.
Taking the RBNZ’s net foreign currency reserves and dividing by their total liabilities, at August 2011, the RBNZ has an indirect gold backing of just 7.7% in dollar terms or 1.6 milligrams of actual gold per dollar.
Half of the RBNZ’s foreign currency assets (representing a 3.86% indirect gold-backing) can be exchanged for gold itself, and the gold backing of the New Zealand dollar would rise to 42%.
The remaining half of the foreign exchange assets contributes 3.86% indirect gold-backing and the directly held gold 38.6%.
The actual amount of gold is about 160 tonnes and would be about 40 grams per person.
Interestingly, this amount is very similar to NZ’s 1925 direct gold holdings. According to the World Gold Council, in 1925, New Zealand held 56.73 tonnes or 1.8 million troy ounces, about 40 grams per person. This represents more than the USA’s current per capita gold holdings. The optimal amount of gold may not be exactly 50% of foreign reserves, but this experiment is useful starting analysis. (Perhaps some reserves could be silver.)
The chance of a worldwide run into gold
Obviously, it made more sense to do the exchange for gold when the US dollar gold backing first went below 20% just before the turn of the millennium. The gold price was around $300 and NZ would have gotten about 5 times more gold than today. But waiting further may be even more costly.
With the interconnectedness of the global financial arrangement that operates on credits all built on a sliver of gold, there exists the possibility that the whole financial system will see a crisis/panic that causes a run into gold.
Other countries have noticed that the major world currencies have low gold-backing, and China, Russia, South Korea, Thailand, India, and others are embarking on the path of acquiring more direct gold holdings. Recently, Venezuela actually took delivery of its gold, taking it out of the Western banking system.
However, New Zealand has one huge advantage: NZ is small and can achieve this transformation relatively easily. China which has been accumulating gold for over 10 years is still a long way from converting their foreign reserves to gold, but its efforts which include buying all local gold supply (it helps being the largest world producer), creating gold and silver exchanges, and introducing gold ATMs are intensifying – but they are too large to make a sudden leap into gold for the gold price would go nuclear. And if they did, New Zealand would be the last in line at the gold window and left holding an empty fiat bag.
Risks of holding gold
The risk of holding direct gold reserves is that the price of gold falls.
The supply of gold is relatively known with mining increments adding to the amount already above ground. Demand reflects expectations about a wide variety of factors but demand mainly reflects expectations about future currency debasement.
Some argue that the total amount of credit in the worldwide economy affects the price of gold, and in a crisis, current demand could become supply as wholesale liquidations of all assets including gold occur.
This wholesale liquidation of all assets including gold appeared to be the case in 2008, although the effect on the gold price was temporary.
In addition, countries that are accumulating gold are using price dips to wisely build their direct gold holdings.
But if the world’s central banks change their behaviour and stop debasing their currencies as in 1980, the price of gold will fall. And in that case, having 50% of reserves in foreign currencies mitigates the impact of a fall in the price of gold.
Benefits of holding gold
So the risk of direct gold-holdings is that central banks change their behaviour leading to a fall in the gold price. But what if the world’s central banks continue their current behaviour and follow their stated policy objectives?
In that case, having direct gold-holdings stops the debasement of the NZ dollar when other countries debase their own currencies.
Europe is proposing bailout packages of Greece (and an unknown number of other Euro countries). The Fed continuing to increase its money supply and rumours of QE3 abound. Japan likewise has excuses for printing money.
The danger of the RBNZ waiting to convert into direct gold holdings is that as the big 3 keep printing the gold price is forced higher to keep the gold backing above run levels and the weight of gold that New Zealand gets by a partial conversion of foreign exchange assets into direct gold declines.
Diversification motivation for the RBNZ to add direct gold holdings
Even without the worldwide run into gold intensifying, gold can offer the RBNZ some benefits. In fact, an article by the RBNZ’s Kelly Eckhold in the 2010 September RBNZ Bulletin analysed different foreign exchange assets including gold and concluded that “gold also proved to be a resilient risk diversifier”.
It is important to keep some foreign exchange assets for transactions purposes and to support the NZ dollar in a crisis.
But with the current allocation of 100% in foreign currencies, the RBNZ is undiversified.
The RBNZ is essentially betting that the fiat powers do not debase their currencies further, or at least more than that reflected by the current gold price. Given the current state of worldwide economic news and the action of world central banks since 2008 (and most central bank behaviour throughout history), that seems a rather brave bet.
Perhaps it has not occurred to the RBNZ that their foreign currency reserves are being debased in terms of gold.
Diversification into direct gold holdings is less risky than the current RBNZ allocation of zero direct gold holdings. Holding gold directly as well as foreign currency assets will give less volatile outcomes over the entire possible range of outcomes in the future.
Other arguments against direct gold holdings
A perverse argument against direct gold holdings is that it will create a strong NZ dollar.
But, for any economic entity, once cash flows start to decline and the debt rating starts to get downgraded, creditors start to look more closely at the company’s assets to assess market values and liquidation values.
In bad economic times, it is extremely difficult to see any benefits of having a weak NZ dollar, and more importantly, a weak NZ dollar caused by other countries printing money.
It seems to be crazy to continue in the current system and experience real losses in the value of the NZ dollar (in milligrams of gold), when these loses have no benefit whatsoever to NZ citizens.
Is it reasonable to incur a loss of wealth in NZ to help save Deutsche Bank, Goldman Sachs and their likes for making wrong highly leveraged bets at the financial 'casino'?
Individuals can also trade currency for gold
Individuals can do the same transaction as the RBNZ by exchanging NZ dollars with little gold backing for gold itself, but many people are scared by articles in the financial press that instead talk of gold being in a bubble.
Gold did decline dramatically to below $300 after a brief peak of prices above $600 an ounce in 1980. However, it is extremely important to compare today’s low US dollar gold-backing to the approximately 100% gold-backing in 1980.
You could say that gold was in a bubble in 1980 as expectations were that the gold debasement of the US dollar that started at $35/ounce would continue. Instead, the US Federal Reserve temporarily stopped the debasement by dramatically increasing interest rates (remember the 20%+ mortgage rates?)
Today to get back to a safe gold backing necessary to prevent the chance of a run into gold, the US Federal Reserve could halve its money supply. This would entail a major change of behaviour as minor annual contractions in US money supply are rare and have only occurred in the 1920s and in 1937.
The other alternative is that the US dollar price of gold doubles.
Philip O'Connor is a senior lecturer in Finance at the Department of Accounting and Finance of the University of Auckland. You can contact him here » firstname.lastname@example.org