On February 18, 2009, we wrote an article titled “When Paper Has No Value.” In that article, we highlighted West Germany’s $2 billion bailout of Italy in 1974 that was backed by the value of Italy’s gold holdings. Regarding the use of gold as collateral we said the following:
“No nation wants to actually resort to this feature first, 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. Unfortunately, desperate times call for desperate measures.”
We couldn’t help but notice that Moody’s credit rating for Italy was downgraded three notches on October 4, 2011 (found here). There are three primary reasons given for the downgrade of Italy’s debt:
(1) The material increase in long-term funding risks for euro area sovereigns with high levels of public debt, such as Italy, as a result of the sustained and non-cyclical erosion of confidence in the wholesale finance environment for euro sovereigns, due to the current sovereign debt crisis.
(2) The increased downside risks to economic growth due to macroeconomic structural weaknesses and a weakening global outlook.
(3) The implementation risks and time needed to achieve the government's fiscal consolidation targets to reverse the adverse trend observed in the public debt, due to economic and political uncertainties.
In Italian, the word slittare means to slide or to be postponed. This was the term that was used to describe Italy’s economic woes that led to the loan using gold as collateral in 1974. Depending on its usage, slittare encapsulates the problems faced by Italy today. The increase in long-term debt is the postponement of the inevitable and the increased downside risk to economic growth points to a further slide. The third issue mentioned by Moody’s, implementation risk, only adds to why the first and second reasons will only grow.
Like it was in 1974, Germany is currently in the position of having to buttress European nations as the “lender of last resort.” We’re wondering which nation will be the first to pledge their gold reserves as collateral in exchange for a loan to avoid collapse. It will be desperate times when a nation pledges their gold reserves for the purpose of a loan. However, when this does occur, it will set the ball in motion that will inexorably create a floor in the price of gold.