Polleit wrote a very good article about the possible implications of the passage of the Swiss gold referendum.
The referendum on the Swiss Gold Initiative will take place on November 30.1 The Initiative demands the following: (1) The Swiss National Bank (SNB) shall be prohibited from selling any of its gold reserves; (2) the SNB’s gold reserves must be stored in Switzerland; and (3) the SNB must keep at least 20 percent of its assets in gold (i.e., the “20-percent rule”).
The balance sheet of the SNB currently amounts to 522.3bn CHF (Swiss francs), with its gold holdings and claims from gold transactions amounting to 39.4bn CHF. The share of gold of the SNB’s assets is therefore about 7.5 percent — substantially lower than what the Initiative calls for.
If the referendum is successful, that is, if the Initiative is adopted, the SNB will have to increase its gold holdings relative to its total assets. This can be done in two ways:
- If the balance sheet of the SNB remains as swollen as it currently is (due to purchases of foreign currency made in recent years), the SNB would have to buy additional gold worth the equivalent of around 65bn CHF.
- The SNB could shrink its balance sheet (to the level it had at the end of 2007) by selling foreign exchange reserves until gold reserves amount to at least 20 percent of the SNB’s assets. This, however, appears to be unlikely and won’t be considered any further here.2
Let us assume that the SNB has to buy additional gold — and that this would require a fairly sizable amount of money. An important question is: how can the gold purchases be financed? And what are the consequences?
Financing the Gold Purchases
The SNB may finance its gold purchases by exchanging its foreign currency reserves — which are largely held in euros, but also in US dollars, Japanese yen and British Pounds — against gold. Three effects would follow from this:
- Buying gold in exchange of foreign reserves would leave the Swiss domestic money supply unchanged; it would not be inflationary as it does not affect the Swiss quantity of money.
- The currencies sold by the SNB to buy gold would presumably tend to devalue against the Swiss franc; we will look closer into this aspect below.
- SNB gold purchases would presumably tend to raise the gold price; of course, this effect cannot be quantified with any precision in advance.
Restricting Money Creation
Once it complies with the 20-percent rule, the SNB can still increase the domestic quantity of money: namely by buying gold and/or warehouse gold from private persons (Swiss or foreign) against issuing newly created Swiss francs.3
That said, the Initiative would not put Switzerland on a gold standard, under which the SNB has to, for instance, redeem Swiss francs in gold. Nevertheless, the Initiative would certainly have some very positive implications.
First and foremost, the 20-percent rule would make the SNB policy of money expansion more difficult. For increasing the quantity of money, the SNB would have to buy gold equivalent to 20 percent of the Swiss franc amount issued.
The expansion of the Swiss franc would not only be linked to physical gold — that is the ultimate means of payment, which is in short supply. Moreover, such transactions would be “visible” and could be more easily sanctioned by the Swiss public.
Furthermore, the 20-percent rule would force banks to adopt a much more cautious business approach. Fractional reserve banking, for instance, would be much less attractive and possible, as banks could no longer expect the SNB to bail them out by printing up new money.
Last but not least, the Initiative would make the Swiss franc less inflationary, especially so as it discourages greatly commercial banks’ money creation out of thin air — which is also the central cause for boom-and-bust cycles.‘