How Relevant is the Swiss Referendum to the Gold Price?

Regular readers will already know the answer to this question, while readers not familiar with our previous discussions of this particular topic should take a look at a recent post by Mish that does an excellent job of explaining the issue in the context of the gold demand potentially exercised by the SNB if the referendum succeeds.

To quickly summarize: gold is quite different from industrial commodities and therefore cannot be analyzed like an industrial commodity. This is in spite of the fact that renowned gold institutes like the World Gold Council (WGC) and numerous other “experts” are doing just that. For instance, the WGC publishes annual statistics on mine and scrap supply, central bank supply/demand, jewelry and industrial demand, and from this “infers” investment demand.

Superficially this exercise may appear to make sense, but in reality it doesn’t. Contrary to e.g. copper or oil, gold is not “used up” – most of the gold ever mined still exists above ground, in various more or less usable forms. As a result, gold is the commodity with the largest stock-to-flow ratio. This is a major reason why gold is so useful as money – its supply is relatively stable (it increases only by about 1.4% per year, and the trend is falling) and a very large amount of it is available. There is therefore no point in e.g. trying to divine the effect of a 10% change in annual mine supply on the gold price. All we can say about such a change is that it will almost certainly have no effect whatsoever (since it would only amount to 0.14% of the total supply).

Gold must be analyzed like a currency. Its price in terms of fiat monies is affected by the expectations of market participants about the future evolution of a range of macro-economic data and events, such as real interest rates, credit spreads, the steepness of the yield curve, the desire to increase savings, the growth rate of the fiat money supply, confidence in the economy, expectations regarding the growth of government debt and how it will be funded, and perhaps most importantly, the degree of faith in the monetary authorities.

If one thinks about gold in terms of supply and demand, the important point to keep in mind is that the total supply is essentially all the gold ever mined. Since supply and demand are always in balance, the total demand (including its most important component, namely reservation demand) is just as great. Thus, when the WGC reports that “investment demand” was 600 or 800 tons, it is simply proving that it doesn’t really know how the gold market works. The vast bulk of gold demand is in fact investment, or monetary demand.

For a detailed explanation as to how the gold price is formed and what the role of reservation demand in this process is, readers can review Robert Blumen’s timeless article “What Determines the Price of Gold”, which we have published back in 2011.

With that out of the way, we agree of course with Mish that the 300 tons of gold that the SNB would be forced to buy per year if the referendum succeeds should have a minimal direct impact on the gold market. In fact, the SNB could probably buy this much in a single trading day without raising too many eyebrows. In London alone some 700 to 900 tons of gold trade every single working day. One of the world’s major gold trading centers is in fact right where the SNB is located: in Zürich, Switzerland.

However, the decision may actually matter to the gold price in the short term for another reason: it may have an effect on market psychology. India’s purchase of 200 tons from the IMF for instance did have a short term impact on market psychology. The reason is that once a central bank enters the market as a sizable buyer, market participants will consider the possibility that other central banks may be tempted to follow its lead. Given the fact that central banks are the most deep-pocketed buyers on the planet by virtue of their almost unlimited fiat money creation powers, they tend to inspire the appropriate fantasies.

 
Gold refined in Switzerland.

Hamstringing Central Bankers

As is well known by now, the SNB, the Swiss government and parliament, the Swiss Council, in short, essentially the entire political-bureaucratic establishment of Switzerland, is dead set against the gold referendum.

We previously mentioned that it is not quite clear to us why this is the case, since the need to hold a minimum of 20% of the SNB’s reserves in the form of gold (up from a current level of approx. 7.5%) will in no way keep the SNB from creating more central bank credit and money ex nihilo. So we were a bit mystified as to why the SNB kept insisting that its vaunted “flexibility” would be unduly restricted (this is beside the fact that we believe that restricting the flexibility of central bankers would be a good rather than a bad thing).

Recently we have taken a closer look at the central bank’s line of argument against the gold referendum to see if we have perhaps missed something. Here it is, in the words of the SNB’s public relations minions:

“The so-called gold initiative demands that the SNB hold at least 20% of its assets in gold, that it be prohibited from selling gold and that all gold reserves be physically stored in Switzerland itself.

The SNB does not generally comment on any political initiatives. However, the gold initiative has a very direct impact on the SNB’s capacity to act.

The initiators see a high level of gold reserves as a guarantee for currency stability. They fear that the Swiss franc will decline in value and that price stability will be threatened if a large proportion of the balance sheet does not consist of gold holdings. They are also concerned that the SNB’s gold reserves held abroad are not secure and will not be accessible in critical situations.

Some objectives the initiators put forward are shared by the SNB, such as maintaining currency and price stability and ensuring both the SNB’s capacity to act and its independence. However, the measures proposed to this effect are not suitable; in fact, they are even counterproductive.”

So what is actually the problem? It turns out that what the SNB regards as the biggest problem is the second part of the sentence highlighted above, namely, “that it be prohibited from selling gold”. Hold on to your hat for what comes next.

“The SNB has the statutory mandate to ensure price stability, while taking due account of

economic developments. The monetary policy operations that must be carried out in fulfillment of this mandate have a direct impact on the SNB’s balance sheet. In order for the SNB to fulfill its mandate at all times, its capacity to act in monetary policy matters must not be compromised by rigid rules on the composition of its balance sheet, which would be the case with the required 20% minimum share of gold and the ban on the sale of gold. It was precisely the latest crisis that demonstrated how important it is for the SNB to have the flexibility to expand its balance sheet, if needed. In future, the SNB will also need this flexibility to reduce the balance sheet again, if necessary. The demands of the initiative would considerably curtail this flexibility.

Were the initiative to be accepted, the SNB would – in the current environment – have to

make large-scale gold purchases to meet the required 20% minimum share of gold. It would not be allowed to sell this gold at a later point, even if it had to reduce its balance sheet again in order to maintain price stability. In a worst-case scenario, the assets side of the SNB’s balance sheet would, over time, be largely comprised of unsellable gold.

Managing the interest rate level and the money supply would only be possible via the liabilities side of the balance sheet; in practice by issuing the SNB’s own interest-bearing debt certificates (SNB Bills). This would have serious financial consequences: On the assets side, the SNB would neither have any interest income nor could it realize any profits on gold due to the ban on sales. On the liabilities side, it might have to pay high interest on debt certificates.The SNB could therefore find itself in a situation in which it could only finance its current expenses by means of money creation.”

In other words, the SNB predicts that it could in theory become entirely superfluous one day – namely in case that it should actually reduce the size of its balance sheet (which would be an event almost on the order of the miracle at Cana). In that case its assets could potentially begin consist solely of “unsellable gold”, and the Swiss Franc would de facto be a fully gold-backed currency again. The monetary bureaucrats might as well go home then, which from the point of view of the average Swiss citizen would actually be a highly desirable outcome (we believe so, anyway).

Given the typical Keynesian deflation paranoia besetting the SNB’s policy-making body, the chance of this putative “balance sheet contraction” happening in our lifetimes is of course pretty much zero, as this would imply an enormous contraction of the Swiss money supply, i.e., genuine deflation. The same guys who have blown up Switzerland’s money supply by more than 100% since 2008 and keep yammering about the “danger of deflation” every time they issue a monetary policy assessment are seriously trying to convince their audience that they want to contract their balance sheet again one day? Well…

Muhuahahahaha.

(Image via modernluxe.wordpress.com)

Switzerland’s money supply aggregates. The SNB’s policy rate is similar to the Fed’s at 0-25 basis points (i.e., zilch – the effective interbank rate stands at 0.004%). The money supply, specifically the narrow monetary aggregate M1 (currency and demand deposit money – roughly equivalent to TMS-1) has more than doubled since 2008, and yet the SNB continues to insist that Switzerland is threatened by deflation. It is interesting in this context that the biggest jump in y/y money supply growth of approx 45% occurred in 2008-2009 when the deflation panic was at its peak.

Switzerland’s monetary base. Swiss base money has grown in explosive fashion as the SNB has purchased foreign currency by the truckload to defend its minimum exchange rate peg. Bank reserves on deposit with the SNB currently amount to 2190% of required minimum reserves.

Conclusion:

There is an extremely remote possibility (best expressed as an infinitesimal, i.e., a number greater than zero, but smaller than any positive real number… colloquially known as a “fat chance”) that the SNB’s balance sheet and the Swiss money supply could one day be voluntarily reduced again. If the gold referendum succeeds, the Swiss Franc might then end up as a fully gold-backed currency again, as it once used to be (not too long ago in fact). Contrary to the SNB we don’t think this would be a particularly tragic development.

Charts by: SNB