[Skybird]

Frankfurter Allgemeine Zeitung:
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Many central banks are buying gold again. This bodes ill.

The world's central banks bought a net 1136 tons of gold last year. According to the World Gold Council, the last time European central banks purchased gold on a large scale was in 1967. At the time, the devaluation of the British pound and deficits in the U.S. balance of payments heralded the end of the international monetary system, dubbed "Bretton Woods" after a small town in the mountains of New Hampshire. Is the sharp increase in official gold purchases now again a portent that an international order is breaking down?

The Bretton Woods system was based on the fact that national currencies were tied to the value of gold via the dollar. This tie was severed when, in 1971, U.S. President Richard Nixon abandoned the promise made to other countries since 1934 to exchange $35 for a troy ounce of gold. That was the end of the gold standard, which had governed the world economy since about 1880. Put simply, from now on the value of money was no longer backed by central banks' gold reserves, but solely by the central bankers' promise to keep the value of money stable.

The end of the international gold standard also meant a move away from fixed exchange rates. In Europe, a precursor to monetary union developed to prevent large exchange rate fluctuations. The rest of the world moved in principle to flexible exchange rates, in which some countries intervened sometimes more, sometimes less.

The change in the monetary policy framework after the collapse of Bretton Woods had a decisive impact on the need for gold and for reserve assets as a whole. The move to flexible exchange rates called into question the level of total foreign exchange reserves because, at least in principle, there was now no need to defend exchange rates. And because central banks no longer guaranteed gold cover, gold reserves actually became superfluous.

But the central banks did not want to keep their hands off gold. In memory of the economist Fritz Machlup, one can justify this with the theory that bears the cumbersome name "Mrs. Machlup's Wardrobe Theory of Foreign Reserves." According to this theory, Mrs. Machlup is not concerned with having enough clothes to wear. Her sole concern is that new clothes are always being added. By analogy, Machlup suspected central bankers of having a penchant for having more and more. He saw foreign exchange reserves as more of a desire than a necessity.

With or without Mrs. Machlup, it took about two decades after the fall of the gold standard for central banks to start divesting themselves of their gold bullion. This coincided with the fall of the Iron Curtain and the end of the East-West conflict. It seems reasonable to assume that gold was given special importance as a currency hedge or emergency reserve during the Cold War.

However, this beautiful theory is disturbed by the fact that the central banks of Canada, Australia and Belgium, which were among the first to sell gold, were truly not in the forefront of the Cold War.

Shortly before the turn of the millennium, economists Michael Bordo and Barry Eichengreen classified the gold reserves of central banks as a barbaric relic of the past and did not see a bright future for them. They found some evidence in their historical research that pointed to less rather than more gold in reserves. Less inflation, flexible exchange rates and fewer capital controls were associated with fewer gold reserves in the study. Tradition and inertia working in favor of gold would lose weight, Bordo and Eichengreen speculated.

They were right about that - until the financial crisis of 2008/9. Since then, central banks as a whole began to stockpile gold bullion again. Today, central bankers' gold reserves are once again higher than at the turn of the millennium. Eichengreen already asks with co-authors in a new study just published whether gold is no longer a barbaric relic after all. A clear answer they remain guilty.

The increase in gold reserves since the financial crisis has been fed by two developments. Central banks in the countries of North America and Western Europe, which the International Monetary Fund classifies as "progressive," largely stopped selling gold after the financial crisis. Developing and emerging economies, however, bought significantly more.

Eichengreen and his co-authors find evidence that developing and emerging economies in particular respond to greater economic policy uncertainty by holding more gold reserves. "Progressive" countries are more likely to respond to geopolitical risks, but this effect is less pronounced.

The largest gold buyers include Russia, China, Turkey and India. Russia, a gold producer, is of particular importance. China, for example, bought a lot of gold, but kept gold's share of its foreign reserves below 5 percent. Russia, on the other hand, has drastically increased the share of gold in its reserves to more than 20 percent since the global financial crisis.

This is likely explained by the fact that Russia has been subject to economic and financial sanctions imposed by the West since its occupation of Crimea in 2014. In any case, Eichengreen and his colleagues show a fairly close correlation between sanctions and gold reserves in their study. Developing and emerging countries that are subject to sanctions by America, the European Union, the United Kingdom and Japan react by increasing their gold reserves. In this way, they are trying to avoid the financial blockade of foreign exchange reserves. As early as 2021, Russia announced that it had now brought its gold reserves home in their entirety and that no more bars were stored abroad.

Against this background, the large gold purchases by central banks last year look like a gloomy omen. Already in Bordo and Eichengreen, we read that before World War I, Germany and quite a number of other countries began to exchange their foreign exchange reserves for gold.


Serena Arslanalp, Barry Eichengreen, and Chima Simpson-Bell (2023): Gold as International Reserves: A Barbarous Relic No More? IMF Working Paper WP/23/14.Michael D. Bordo, Barry Eichengreen (1998): The Rise and Fall of a Barbarous Relic: The Role of Gold in the International Monetary System. NBER Working Paper No. 6436.Fritz Machlup (1966): The Need for Monetary Reserves. Reprints in International Finance No. 5, Princeton University.
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