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The time will come when governments of the world realize, by force in some cases, that more value and confidence can be gained from using gold (GLD) as collateral as the last resort bailout mechanism rather than paper or digital money. However, gold as collateral is very much the financial equivalent of a nuclear option.

No nation wants to actually resort to gold as collateral for a bailout because as one nation dips its toes in the water, all subsequent nations will follow in its path at ever higher gold prices. It is only the last nation in the pool, with sizable gold reserves, that benefits the most from using gold as collateral. The first nation in the pool becomes the sacrificial lamb. However, gold investors need to be prepared for the unexpected when gold is used as collateral for a bailout.

As an example, in 1974 the official rate of gold was at $42.22 an ounce. However, the free market price of gold reached $180 an ounce. The free market price of gold increased the borrowing power of bankrupt Italy, which had 2,500 tonnes of gold, from $3.7 billion to $15.8 billion. On September 1, 1974, West Germany lent Italy enough money to stave off complete collapse using the free market price of Italy's gold holdings as collateral.

The most interesting part in this deal was that West Germany never collected on the gold. It was accepted on faith that if the loan could not be repaid then the gold would be shipped to West Germany. Almost overnight, the gold in Italy suddenly became someone else's liability. However, as long as Italy was able to make their payments on the bailout then there would be no question of whether or not they would ship the gold in the event of default. This gave every incentive for both West Germany and Italy to hope for the rise in the price of gold.

What was the market reaction to the maneuvers in the bailout of Italy by West Germany with the backing of gold? In the period from September 2, 1974 to December 30, 1974, the price of gold rose +23.93%. However, in the period from December 30, 1974 to August 25, 1976, the price of gold declined -46.99%. At the same time (Sept '74-Dec '74), the Dow Jones Industrial Average (DIA) declined -9.05%. In the period from December 1974 to August 1976, the Dow increased +60.93%.

From a long-term perspective, buying either gold or stocks on September 2, 1974 to 1980, gold increased in value just over 4 times while the Dow increased +31%. Of course, holding both until the present yielded equally contrasting results. Gold rose slightly more than eight times while the Dow increased 19 times.

We often hear chatter about how governments would rather not have gold compete with their currency or that gold has no master. Then why are central banks filled with the stuff? The case of Italy in 1974 provides a perfect example of the reason why.

Gold acts as the last resort to combat the global competitive protectionist policies of coordinated rate reductions and domestic stimulus packages that we're seeing today. When a nation is on the brink and there is talk of a loan agreement based on the value of gold then, and only then, can we be assured of the turn in the tide for stocks and the price of gold. However, the turn in the market may not be what most investors would expect.

We believe that when it is announced that gold is used as collateral to bail out another country (it is coming), there will be an initial euphoria among goldphiles quickly followed by a "sell the news" effect. Thereafter, it will dawn on investors that there is a limit to what gold can actually do to save a government's finances. This will take the shine off of gold as it did from 1974 to 1976 to the tune of -46.99%. If a similar capitulation is experienced in the gold market, we wouldn't be surprised of a copycat run-up in the price of gold from 1976 to 1980.

Sources:

  • Lee, John. "German-Italian Deal ignores U.S. Policy." New York Times. September 2, 1974. p. 21.
  • Hofmann, Paul. "Bonn to give Rome a $2 Billion Loan in Financial Crisis." New York Times. September 1, 1974. p. 1.
  • Russell, Richard. Dow Theory Letters. June 26, 1974. Letter 601. p. 4.
Source: Central Bank Gold: For When Paper Has No Value

Additional disclosure: Holders of physical gold and silver.