Ludwig von Mises Institute of Canada

With the media abuzz about German Bundesbank´s plan to repatriate its gold holdings held in foreign lands, officials at the Bank of Canada must be a little embarrassed. Not only does the BoC not have any gold holdings in foreign countries to ask for, it lacks any substantial gold holdings at all.

The Bank of Canada today holds less gold than at any other point in its 79 year history. The total reserve of just over 3 tons pales in comparison to the highest level recorded in its history – 1,023 tons in 1965. This means that there are about 0.003 ounces of gold sitting in reserve at the BoC for every Canadian, or just a little under $5.80 at today´s market prices.

Of course, one can easily ask what difference it makes. Like all fiat currencies, the Canadian dollar is nonredeemable. If you go to your bank and ask for something in exchange for a beautiful new twenty dollar bill the best you can hope for are two tens.

Even though it is nonredeemable, the gold in a central bank´s vaults serves two purposes.

First, as I discussed here and here, it is an asset that is steady in value and aids central banks in maintaining their operations. Central banks are not so different than private banks. Both hold assets and liabilities – in the BoC´s case, its assets include government of Canada bonds and its liabilities are comprised mostly of the currency outstanding. Central banks, much like private banks, don´t wish to go bankrupt. Partly this is to protect their independence. Central banks covet their independence from the governments that grant them their monopoly right to control the money supply. If the Bank of Canada entered insolvency tomorrow, there would be a bailout coming from Ottawa. And you better bet there will be increased political attention on the BoC´s operations as a result. I´m sure that central bankers at the BoC are not gluttons for the paperwork, overtime and other forms of pain this could entail.

Of course, the BoC could only enter insolvency if its assets lost value below its liabilities. (Its liabilities, being compromised mostly of currency, are fixed at par value, and as such cannot change in value.) A potential source of a loss of value on its assets could come from default – whether partial or full – on the assets it holds. The government of Canada is not the least fiscally responsible one in the world. Yet as I have outlined here, Canada ranks among the illustrious peer group of the United Kingdom and Portugal as the only other developed country to have debt-GDP levels above 90% for the government, household and corporate sectors. (Maybe this extreme indebtedness will help Mark Carney feel at home as he returns to the UK to take over the Bank of England´s helm.)

Holding gold erases the possibility that a central bank will have to turn to its government for help, along with the increased oversight that will come with it.

The second reason why gold in a central bank´s vault makes sense is that, well, something has to be there, and it might as well be gold. In order for a central bank to alter the money supply without causing undue disruptions to the economy, it must undertake a process called sterilization. This relatively simple procedure involves buying or selling an asset whenever the money supply is increased or decreased. If the central bank did not do this important step, it would be forced to give newly issued money directly to some parties, resulting in large wealth redistributions.

It is commonly argued that instead of holding gold in its vault and not earning interest on it, the central bank should just hold another risk-free asset in the form of government bonds. It will earn a little interest on these bond holdings, and thus be able to pay off some of its operating costs.

This strategy is indeed cost reducing for the Bank of Canada, with an important caveat. The government of Canada must make good on the bonds that the BoC holds. Increasingly it is becoming clear that the government is jeopardizing its financial stability by spending beyond its means and running deficits.

And this brings us to the core part of the argument. Her Majesty´s Government of Canada runs a deficit in part because it is cheap to do so. Interest rates on federal bonds are quite low. One reason why these interest rates are low is because the Bank of Canada stands ready to continue buying these debt issuances in a bid to hold on its own balance sheet as it increases the money supply. By pledging to purchase and hold on its balance sheet federal bonds, the BoC allows the government to take on a more precarious financial position than would otherwise be the case. The culmination of this process could be a loss on the BoC´s assets, if the government gets to the point of default.

Gold is not a barbarous relic for a central bank. The Bank of Canada, by shedding its gold reserves to the point where it holds less than Bolivia, Bangladesh, Cambodia or Macedonia, has placed itself in a difficult position. Refraining from buying federal debt now would cause interest rates to rise, and potentially endanger the government´s solvency. While this outlook is none too pleasing, the threat of insolvency would send a strong signal to Ottawa to get the government´s finances back on track. Threatening to recommence gold purchases to hold in its reserves at the expense of government bonds is an easy option available to the BoC. The federal government doesn´t have to listen to too many people, but in this case, the Bank of Canada has the ability to make the government an offer it can´t refuse.

David Howden is an assistant professor of economics at St. Louis University, at its Madrid Campus, and winner of the Mises Institute’s Douglas E. French Prize.

Tags: Bank of Canada, Gold Standard, Mark Carney