COMMENTARY — Holding gold

Although the European Central Bank (ECB) will not come into formal existence until Jan. 1, 1999, its governing council will need to make a large number of decisions prior to this time, and one of these will concern the amount of foreign reserve assets to be pooled by member central banks at the ECB. This can, in the first instance, be as much as 50 billion euro, or US$54 billion, but the more interesting question concerns the composition of the pool: should it consist entirely of foreign exchange assets, or should gold also be included?

First, as a totally untried and untested central bank, there will be considerable advantages in the ECB for holding gold. While not everyone shares this view, there are strong and intellectually robust arguments in its favor.

Second, the European Monetary Union (EMU) will be a major step in the evolution of the international monetary system. It will have been meticulously planned, but in the early years it is bound to face a number of perhaps unexpected challenges.

One very important — indeed, necessary — condition assuring the longevity of the new monetary arrangements will be acceptance by the people in potentially 15 European states that monetary affairs will operate to ensure an environment of low inflation and overall financial stability. This process has been reinforced by the general move by European governments (as required by the Maastricht Treaty for those countries participating in EMU) to give their central banks formal independence.

Third, all 15 potential members of the ECB currently hold gold, in some cases significant amounts. For example, France holds almost 45% of its total reserves in gold (valued at market prices), whereas both Italy and Germany hold more than 25%. The reserve profile of the typical European central bank thus encompasses — and has long encompassed — gold as well as foreign exchange.

The new ECB will be the successor to national central banks. In order to inspire confidence and trust at the outset, it will be expected to behave and look like the bodies it supersedes. The structure of the ECB’s reserve pool is, however, equally important in demonstrating that it has not only the quantum of resources it might need to ride out unexpected shocks in the early days, but also the right mix.

Fourth, gold, as has long been remarked, has the important virtue of being no one’s liability. It is an asset independent of the monetary policy, inflation record or vulnerability to exchange controls and/or asset freezes that can afflict holdings of foreign exchange.

Fifth, even though a central bank cannot, of course, use gold directly in older to intervene in the foreign exchange markets, it is liquid in times of need; it is universally acceptable as a means of payment; and it can provide a ready form of collateral against the need to borrow.

Sixth, the new tripolar international monetary system, with the dollar, euro and yen at its base, will take time to bed down. It is impossible to say what shocks may hit it during the formative years. In the face of uncertainty, there is considerable virtue in holding an asset such as gold.

It is said that the return that can be earned on it is inferior to that on other financial assets. That may, of course, be true in certain periods, but it need not be true in others, especially in an era of low inflation.

If an opportunity cost of holding gold does exist, it can be seen as an insurance premium — a price deliberately paid to guard against a highly improbable but (if it occurs) a highly damaging event. Such an event might be war, an unexpected resurgence of inflation.

The exact amount of gold to be held by the ECB is clearly a matter for debate. Individual countries already take different views on this (and it is important to remember that national central banks will continue to hold that portion of their existing reserves which has not been pooled at the ECB).

However, there are undoubtedly very strong reasons why gold should form a part of the ECB’s reserve portfolio. In the face of such a high degree of uncertainty, Europe’s central bankers should not pass up any opportunity to build confidence in the new currency from the outset. Gold provides that opportunity.

— The author is a spokesman for the Public Policy Center of the World Gold Council.