German Gold, the Fed, and the Island of Yap

The “audit the Fed” crowd is rather obsessed with the idea that the Federal Reserve is an evil institution that’s lying to us all and debasing our currency.  What would have been dismissed as a fringe conspiracy theory a few years ago has become an increasingly mainstream idea, thanks in no small part to Ron Paul’s very public calls for increased scrutiny of the country’s central bank. Now, it looks like even Germany may be getting on the “audit the Fed” bandwagon. FT Alphaville has the breakdown from Eurointelligence (emphasis theirs):

The Bundesbank duly counted and weighed all the 82857 gold bars stored in Frankfurt, some 1100 tons. MPs were even allowed in the cellar to see if the gold is still there. In an ultimate act of desperation, the Bundesbank is even considering to let journalists inside the vaults. The problem is only that the gold held outside Germany has not been audited. There are no official figures, but Suddeutsche estimates about 1500 tonnes are held by the Fed, and about 800 tonnes by the central banks of England and France. The total value is some €133bn. The court of auditors has now demanded regular audits of Germany’s foreign gold reserves. The last audits from New York were from 1979/1980. The Bundesbank has since been let into the vault, but not allowed to open the boxes in which the bars are stored, something that has obviously stokes suspicions.

But the question of whether or not the gold is really there (or if it’s just painted tungsten, which has also been suggested) is a much thornier one than at first it may appear. It may seem logical to want to confirm the reserves, but it’s a move that has little upside, and plenty of risk. John Carney over at CNBC explains:

…There is nothing to be gained by inspecting the gold. If it is all there and pure, there is no difference from an undiscovered absence. But if the gold isn’t there, well, calamity could follow as trust in the central bank gold depositories evaporated instantly.

In this case, the lie might be preferable to the truth. As long as all of the central banks of the world pretend that their gold stocks are real, there’s no problem. But as soon as the truth of a conspiracy emerged, the whole system would tumble. Now, to be very clear, we don’t actually believe that the world’s gold reserves are an elaborate ruse… but the possibility certainly leads to some interesting thought experiments. For instance, Carney points out:

The compartments [in the Federal Reserve vault] do not have labels reading “Germany’s gold” and so on. They are instead numbered, and only a few people at the Fed know what numbers correspond to which country. The Fed says it does this to protect the privacy of the depositors. But this also makes actual inspection less reliable. There’s no way for Germany to know that the gold it is being shown is Germany’s, as opposed to some other depositor’s. In an extreme case—which I have no reason to believe is true—miscreants at the Fed could just show everyone who came to visit the same pile of gold.

All of this brings to mind the island of Yap – which despite its name is not an invention of Dr. Seuss, but an actual place where, lacking for precious metals, they instead used giant stones for money. Because the stones were so heavy, when they were “traded” they stayed right where they were; the population just agreed that ownership had been transferred. According to tradition, one of these stones was once lost in the ocean, but the people of Yap continued using that stone as money, allowing it to change ownership even though no one had seen the stone in over 100 years.

Much like the sunken stone at the island of Yap, the Bundesbank can still use their gold receipts for collateral, trade them for foreign currency, etc. Even if the gold isn’t there, as long as everyone pretends like it is, it’s still just as useful as real gold. As Milton Friedman famously noted, physical gold rarely changes hands… instead, people exchange gold receipts. In other words, “physical” gold reserves can behave as a fiat currency just as much as any paper note…. and confirming the existence (or lack) of their gold might turn out to be a terrible move for the German government. Carney sums it up perfectly:

But I like to imagine that the Fed officials would bring the Germans to the door of a compartment labeled, say, No. 322, and then pose the question: “Are you absolutely sure you want to see what’s in here?”

Talk about Pandora’s Box.