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1000 gram gold bars on American flag

Fort Knox follow-up: Why does the U.S. government keep gold reserves?

John-Rothans

Written by Philip Diehl

Apr 28, 2014
Gold bars purportedly stored in Fort Knox

Gold bars purportedly stored in Fort Knox

My recent post on Fort Knox and Coin Week article about Fort Knox generated quite a few questions. I'll answer a couple of the most interesting questions here on the blog.

Q: Since we are no longer on the gold standard and like you said, Fort Knox houses such a small percentage of the world's gold why do we keep any gold at all?

President Richard Nixon took us off the gold standard in 1971 but I think there are two reasons the U.S. keeps its gold.

Support for the world economy

First, any sign the U.S. was considering selling its gold would wreak havoc in the marketplace. Prices would collapse and gold investors and speculators would be devastated. The reserves of central banks around the globe would decline sharply and the solvency of so-called bullion banks would be threatened. These banks are the same too-big-to-fail banks we bailed out during the 2008-2009 financial crisis and we’d face the prospect of letting them fail or bailing them out again.

2013 World Gold Reserves. Courtesy MoneyWeek.

2013 World Gold Reserves. Courtesy MoneyWeek.

Since the U.S. holds “only” 2.5% of the world’s gold, you might think this assessment is hyperbolic. Not so. A year ago, when reports swept the market that Cyprus might be forced to sell its gold reserves to deal with its debt crisis, world gold prices plummeted. U.S. gold reserves are 330 times larger than Cyprus’ reserves.

The politics of gold

I think politics is another reason we hold onto the gold. The politics of gold is complicated, highly emotional and very partisan. There's no compelling reason to empty the vaults at Fort Knox and selling the gold would ignite a political firestorm. Better to let sleeping dogs lie.

Credible Currency

This raises another question: Why do other nations hold gold in their reserves? Again, there are two primary reasons.

One reason is to protect the credibility of their currencies. Although the world long ago abandoned the gold standard, the metal still maintains virtually universal confidence. So if confidence in a nation's political or economic stability is shaken, gold stands as a backstop buttressing trust in its creditworthiness.

For example, Germany's decision last year to repatriate a portion of its gold reserves was driven, in part, by German public concern about the state of the euro. These concerns reached a peak as the European Union struggled with its debt crisis and confidence in the euro eroded. Bringing a portion of the country’s gold back from France and the U.S. provided Germans some security that if the value of the euro collapsed, the German central bank would have substantial gold reserves in its vaults.

A second reason central banks hold gold is to balance their portfolios. For example, Asian central banks hold enormous reserves in dollar-denominated assets. If the dollar falls in value, the value of their reserves falls in tandem. Better to diversify by spreading their reserves among other assets. Gold has been central bankers' asset-of-choice as an alternative to the dollar and today, when the dollar falls, gold usually rises.

A bull run for gold

This is one reason I think gold will enter another bull run. As I said, Asian reserves are huge, the vast majority of which are held in dollars. They have strong incentives to diversify their portfolios and gold is really their only alternative. This shift by Asian central banks from dollars to gold is already occurring. It will continue and is likely to accelerate if or when the dollar begins a sustained fall.

But the central banks are likely to proceed carefully over many years in order to avoid huge sums of dollar-denominated assets hitting the market at once, causing a tailspin in the value of their reserves. This move out of dollars into gold will drive gold prices higher for years to come as gold demand rises and as the value of the dollar falls. I think this shift will be gradual, but if for some reason, the Asian banks were to move more aggressively, the effect on gold prices would be immediate and dramatic.

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