Profits deal means euro will not be backed by gold

A by-product of the deal to distribute the profits of the European Central Bank is that the euro will be an almost entirely paper-backed currency. While eurozone central banks are big holders of gold, with stocks worth 130bn euro, almost none of this will be "earmarked" to back the note issue.

The reason for this is a political compromise over the distribution of the ECB profits. After the Maastricht Treaty was signed it became clear that there would be big relative shifts in the distribution of the seigniorage income after the new currency was introduced. The Maastrict Treaty specified that participating central banks would receive shares of euro seigniorage according to their capital shares in the ECB. These shares are determined partly by each countries share of European GDP and partly by their share of European population. Some central banks, especially the Bundesbank, lost out badly. The popularity of Deutsche Mark notes within Germany and Eastern Europe meant that the Bundesbank (and the German Treasury) have always received a large seiniorage income. Over the last few years Deutsche marks have made up around 35% of existing European paper currency. The German share of ECB capital though is much less (24.5%), and hence Germany stood to lose a sizeable proportion of its traditional seigniorage income.

However, in a difficult political compromise announced on 6 December, these large transfers have been avoided. Transfers are to be phased in over five years, so that the profit share out envisaged in the Treaty - which would have been so tough on Germany - does not fully come into effect until 2008.

So what does this have to do with gold? In order to calculate the amount of seigniorage ("monetary income" in ECB jargon) central banks have to "earmark" assets which back the note issue. It is the income on these assets which is defined as monetary income, and which then gets pooled and shared out according to the capital key.

But this creates a potential problem - if central banks are free to choose which assets to earmark (and hence which income streams are pooled) there will be an incentive for them to "earmark" as many low-yielding assets as possible (such as gold) and keep high-yielding assets for themselves.

To avoid this, the ECB has set rules on what assets, and in particular how much gold, can be earmarked to back the note issue. Under the agreement, NCB's can only earmark gold in proportion to their capital share. Effectively this means that the central bank which holds the least gold determines how much gold is earmarked to back the note issue "the limit is driven by that NCB which holds relatively the smallest amounts of gold" said an ECB spokesman.

Since the central bank of Ireland has only negligible gold holdings this means that no NCB can earmark a significant amount of gold, meaning, in the words of an ECB expert, that, "very little" gold will be earmarked as the counterpart asset to the euro liability, the euro note issue. If any of the participating central banks were to sell all their holdings, then this rule would mean that it would be hard to claim that gold was in any sense backing the euro. On the other hand, it should be noted that the ECB and participating central banks are still bound by the Washington agreement on gold which limits their sales and lending of gold, and the ECB will continue to hold 15% of its external reserves in gold.