I admit. My response to a recent interview is overdue. Last year, the Dutch financial newspaper Financieel Dagblad (FD) published an interview with Aerdt Houben, director of Financial Markets at the Dutch central bank, De Nederlandsche Bank (DNB), discussing that beautiful shiny precious metal we are so interested in: gold. Of course, there has been enough commotion about DNB and its gold reserves. DNB repatriated, for instance, in utmost secrecy over €4 billion euro worth of gold from New York to the Netherlands. Wat did Aerdt Houben of DNB say about investing in gold and what could we comment?
The first question goes straight to the point. “Many citizens buy gold themselves,” the interview begins. “To protect themselves against an Armageddon. A wise decision?”
Houben’s answer: “I would like to tell them: there is no need for you to do that: DNB will do it for you. Have faith in us. It is much more efficient if one organization holds the gold for everyone.”
This is beyond the point. We buy gold precisely to protect ourselves from central bank mismanagement. A central bank completely depends on the general acceptation of its liabilities. When no one accepts its liabilities, the central bank is powerless. Gold or no gold. Buying gold as a citizen means you are being, in a certain sense, your own central bank. Gold helps to protect you against mismanagement of the central bank.
By now, you might ask yourself: is it necessary to protect ourselves against the central bank?
Answering this question with a definitive “no”, as Houben does, would be foolish. History is full of central banks that completely fail. The perhaps most recent and relevant central bank failure is the case of the central bank of Iceland, which is the subject of a book of two of my esteemed colleagues, Philipp Bagus and David Howden (the book carries the title “Deep Freeze: Iceland’s Economic Collapse”).
The fall of the Icelandic central bank was in large part due to a combination of maturity and currency mismatching. The central bank’s liabilities were largely current (short-term) and not denominated in krona, but in dollars, euro’s and yen.
The FD journalists, however, do not mince words. They quickly add that people are worried about whether or not the gold is actually physically present. Houben responds:
- Have faith in us
- An audit “costs at least hundreds of thousands of euro´s”
Moreover, he says that “it would be a waste to use taxpayers´ money for a list with numbers.”
This is, of course, a straw man argument.
First, the operational costs of DNB are not directly financed by taxpayers´ money, but come out of the income generated by the assets that DNB holds on its balance sheet.
Second, it is to be seen if an audit would really cost hundreds of thousands of euro’s. The cost of an audit depends on the size of the assay sample and how long the assaying and audit will take. Perhaps DNB should talk to our auditor.
The interview becomes really interesting when the current DNB balance sheet is mentioned. The ECB buys corporate and governments bonds in huge quantities. As a result, DNB is increasingly exposed to losses, for instance when interest rates begin to rise and counterparties start to default. “Shouldn’t the size of our gold reserves be adjusted in light of that risk?”, is the question that ensues.
DNB has taken precautionary measures, says Houben. Moreover, the value of gold reserves will increase anyway, because that happens automatically in times of growing risks.” Houben calls this the “self-reinforcing mechanism” of gold.
Let´s do a quick and simple calculation. The problem is clear: DNB has enormous amounts of government and corporate bonds on its balance sheet. When interest rates rise or debts are not repaid (counterparty risk), DNB becomes insolvent without the slightest of doubts (insolvent means nothing else than having negative equity).
But, as Houben said, DNB has already taken this risk into account: a €500 million extra buffer and the self-reinforcing mechanism of gold.
DNB currently has over €210 billion euro of assets parked on its balance sheet.
When a 10-year bond with a 1% coupon yield is faced with an increase of market interest rates of 200 percentage points to 3%, the bond would sell for 17% less. 17% on €210 billion euro is almost €40 billion. A buffer of €500 million euro will not make the difference. Neither will a billion-euro buffer.
But we still have our gold reserves, says Houben. 612 tonnes to be exact. These 612 tonnes of gold currently possess a market value of about €22 billion euro.
That means that the gold price should triple to make up for the 17% loss.
An increase in interest rates from 1% to 3% is nothing out of the ordinary. The scenario outlined above is surprisingly realistic given past movements in bond yields. An increase of 200 basis points on a 10-year government bond is peanuts if we look at history. With a more extreme increase, DNB becomes completely insolvent and no billion-euro buffer or 612 tonnes in gold reserves will be able to solve that. No, not with a balance sheet with over €200 billion in assets, or €30,000 euro for every working Dutch citizen. Even with only a slight increase in interest rates, DNB ends up in a terrible mess.
Ironically enough, Houben said earlier in the interview the following: “When you have little equity and reserves, you are forced to beg the minister for money at the slightest setback.” Being solvent as a central bank is an all-important condition for Houben to operate independently. But the fact that DNB’s current reserves and its current equity pale in comparison to the risky asset side of the DNB balance sheet, should keep DNB up at night. But, apparently, it either did not get through to Houben that €210 billion euro is parked on the DNB balance sheet or he has an extremely good sense of a humor.
The solution could be easy: the government replaces all the government bonds on the balance sheet of DNB with one single giant government bond with an indefinite, zero coupon yield. But no one will ever succeed in turning a pile of shit into a cherry pie; at most you can disguise the bad smell for a while, but shit is shit, no matter how nice you dress it up. Therefore, calling this a “solution” is probably giving too much credit to the idea of turning the debt into a giant, all-encompassing zero coupon bond without a fixed duration.
In fact, the above has already happened in Guatemala. The Guatemalan central bank has a giant (relative, of course) bond on its balance sheet, which coincidentally belongs to the government and pays exactly 0 percent. A ghost debt.
What are the consequences? The central bank of Guatemala now incurs losses every year, which will be burdened in the future by the taxpayer. On the one side, the central bank pays interest on its liabilities, whereas on the other side, it earns nothing on its asset side. A big problem.
Simply canceling government debt works a bit different and is more extreme. Directly canceling debt (after all, the debt or bonds are issued by the government and owned by the central bank) is something of a different nature: by canceling the debt in one stroke, the central bank must bear the loss also in one single stroke. The net worth of the central bank is directly, in proportion to the total value of its bonds, impaired. Not a good prospect when you are trying to keep a central bank solvent.
The fact that DNB, as many other central banks, sold part of its gold holdings in the 1990s has been a grave error. In de 90’s, on the eve of the introduction of the euro, DNB sold a large part of its gold reserves. Only a third remained (the current 612 tonnes of gold). That gold does, at any rate, not suffice to make up for other losses on the balance sheet. That is my first critique.
My second critique is that, as central banks often do, the 90’s were the worst possible years to sell gold. Gold prices were ridiculously low.
Is it therefore still a good idea that DNB has sold its gold reserves? That remains to be seen. Whatever the answer might be, the idea that DNB invests in gold on behalf of us, so that you as a private investor do not have to do so, is plain wrong.
You should invest in gold. And you should invest in gold yourself and not leave your fate in the hands of a central bank, precisely to protect yourself against the whims and fancies of a central bank.
Cover image: © de Nederlandse Bank.