Gold is back in the news, big time, and not just because the price may be on the verge of another upswing or that Peter Munk is turning Barrick, the world's biggest gold company, into a CEO meat grinder. It's because Germany, it appears, wants to make gold the effective currency of the euro zone before the region plunges to the bottom of the seas like a concrete U-boat.
The weakest euro zone countries are tapped out financially and economically. But a few of them are brimming with gold reserves. Take Italy, the euro zone's third-largest economy. The Italians love gold and it's stashed everywhere, in their central bank and in their jewellery and safe deposit boxes. (I once saw a religious-festival parade of children in a mountain town, with each child groaning under the weight of heavy gold necklaces and other baubles). At last count, the central bank had 2,451 tonnes of gold, valued at close to €100-billion ($128-billion). That's not a fortune compared to Italy's €1.9-trillion national debt, but it's not bad when Rome is raiding the pantry to pay its ever-rising debt.
Germany's idea is coyly named the European Redemption Pact and it is nothing if not creative. While details are scant, here is roughly how this gilded baby would work. Countries with debts greater than 60 per cent of gross domestic product – the (ignored) limit under the European Union's Maastricht Treaty – would transfer those debts into a redemption fund, which would be covered by joint bonds. The scheme has been called "euro bonds lite."
Here's the catch. Countries using the scheme (most would, including Germany, because of generally high debt-to-GDP ratios) would have to cover 20 per cent of their debt with collateral, payable in gold or currency reserves. Default on the payments and you lose your gold. The "sinking" fund would retire the debt over 20 years.
Italy set the precedent in the 1970s, when it was in the midst of one of its blandly regular financing crises and resorted to a gold-backed loan. The loan was quickly paid off, because there was so much political pressure to do so. If the finance minister had forfeited the Italian family jewellery, the entire government would have been embarrassed and humiliated, then turfed from office.
There's a lot to like about the European Redemption Pact, politically and economically, and a lot not to like if you're worried that this German-inspired fund is the mother of all potential loot grabs.
On the positive side, the gold bricks are piled up like Lego in central bank vaults. They are unpledged and devaluation-proof, meaning the gold-backed loans would be ultra-cheap – probably 1 per cent. Politically, a gold-backed loan is defensible, in the sense that it's cheap. The alternative is trying to flog sovereign bonds at crippling yields – 5 to 7 per cent. That, in turn would mean ratcheting up the austerity programs in an attempt to restore enough investor confidence to bring yields down.
The downside, of course, is potential default, which would mean transferring a huge chunk of a country's hardest, most gorgeous assets – and hence economic power – out of the country. You would have to presume, however, that any country would be ultra careful to make sure it gets the gold back, as Italy did.
The political consequences of the European Redemption Pact are one thing; what the gold-backed loans say about the common currency is quite another. The underlying message is not pretty. Germany, the supervisor of the pact and presumed inheritor of the gold if the loans are not repaid, seems to be saying: We don't trust the euro as it is; it's too weak, so give us a stronger gold-backed euro. Doubts about the health of the euro only increased on Friday, with more reports that Spain would formally seek a European bailout for its gutted banks as early as this weekend.
If the ailing European countries accept the gold deal, it would strengthen the euro. If they were to reject the deal, it would hurt the euro. Why? Because rejection, in effect, would state that they can't muster the fiscal discipline to ensure they get their gold back.
The European Redemption Pact is a psychological biggie. If it were to happen, it would say that gold is a key central bank reserve and that it can be an effective crisis management tool.
Two questions. If Europe goes for the gold-backed deal in an effort to save its sorry butt, what does this say about the credibility, or lack thereof, of fiat currencies around the world? And would it save the euro from extinction? Desperate times require desperate measures. We can all agree the euro is a pig. A pig stuffed with gold is an entirely different beast.