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While the
introduction of a trillion-dollar coin has been shrugged off as nonsense, there
are plenty of nonsensical concepts employed in our monetary system. Here we’ll shed
light on a few of them.
Governments - or
their central banks - can print a $100 bill. The value of such a piece of
paper is worth exactly as much as the supply and demand of a currency
dictates. Dollar bills are legal tender for payment of debt, but if someone
does not like that the $100 bill is not backed by anything, then anyone is
free to decline a $100 bill in exchange for services, and barter instead.
The problem arises
when the government decrees that something is worth a certain amount, unless
it becomes the basis of the government’s entire framework of reference,
as in a gold standard. In my humble opinion, no one, let alone a government
can precisely value anything. The value of goods, services, even debt, is in
the eye of the beholder, and varies based on supply and demand:
- Consumers buy goods or services
because they believe they are “good value;” in other words,
they only exchange money for goods in a deal where they see themselves
benefiting. Consumers should not blame companies for
“over-priced” goods or services; they should blame
themselves for paying such prices.
- The perception of what is good value
varies from person to person. What may be a must-have $80 a month cable
TV subscription, may be a waste to others. It also varies over time, as
some may deem a vacation well worth the money during good times, but
rather stay at homes when times are tough.
- When monopolies or governments impose
prices, distortions, such as supply disruptions can occur. Or
conversely, when the government keeps the price of fuel artificially
low, it can significantly erode the government’s ability to
provide other services, possibly even bankrupt it.
The market currently
prices platinum at over $1,600 a troy ounce. If the Treasury were to decree
that a specially minted coin is worth $1,000,000,000,000 instead, no rational
person would want to buy it. The argument is that the Federal Reserve could
be coerced into accepting it at face value, crediting the Treasury’s
account at the Fed with $1 trillion for it to spend. In our view, such a
move, if it were upheld in the courts, would:
- Highlight the not so well known fact
that the Federal Reserve (Fed) does not mark its holdings to market. The
lack of mark-to-market accounting leading up to the financial crisis is
a key reason why the financial system was brought to its knees in 2008.
A major loss at the Federal Reserve, such as writing down a $1 trillion
coin to $1,600 may not be too worrisome for those that know that even a
negative net worth won’t render a central bank inoperative.
However, losses at the Fed would deprive the Treasury of what has become
an annual transfer of almost $90 billion in “profits” (see MerkInsight Hidden
Treasury Risks?).
- Dilute the value of the dollar. If
the Treasury whips up an additional trillion to spend through trickery,
odds are that a trillion would no longer be worth what it used to be.
But wait, $1 trillion
is already not worth what it used to be, and a $1 trillion coin has not even
been minted. And I’m not talking about our grandparents: who had ever
heard of trillion dollar deficits before the financial crisis? The Federal
Reserve holds just under $3 trillion in assets, up by over $2 trillion since
early 2008. When the Federal Reserve engages in “quantitative
easing”, QE, QE1, QE2, QE3, QEn or however
one wants to call it, the Fed buys securities (mortgage-backed securities,
government bonds) from large banks, then credits such banks’ accounts
at the Fed. Such credit is done through the use of a keyboard, creating money
literally out of thin air. Even Fed Chair Bernanke refers to this process as
printing money, even if banks have not deployed most of the money they have
received to extend loans. However, the more money the Fed prints, the more
debt securities it buys, the greater its income; it’s that argument
that has allowed Bernanke to claim that his operations have been
“profitable,” neglecting to state that such money printing may
pose significant risks to the purchasing power of the dollar.
Note that we
don’t need the Fed. Amongst others:
- If the Treasury wants to issue debt,
it can do so without the Fed.
- If the Treasury wants to manage the
maturity of the outstanding government debt portfolio, it can do so
without the Fed’s Operation Twist.
Congress and the
Administration love the Fed because it is an off-balance sheet entity for the
government with special features; the Fed has ‘unlimited
resources’ (it can print its own money); and the Fed can have a
negative net worth without defaulting.
The way a trillion
dollar coin could work is if not just one, but all platinum coins of the same
fine ounce content (say one troy ounce) were decreed to be worth $1 trillion.
It would be the re-introduction of a gold, well, platinum standard, as it
would link the value of a precious metal to the value of the currency. The
government would quite likely want to punish any speculators that are
front-running the idea of valuing platinum at $1 trillion, possibly even
outlawing private ownership. But it would put the value into context and
anyone could buy a substitute. Pricing of all goods and services would adjust
to reflect the new value of $1 trillion for a troy ounce of platinum. In
plain English, such a move would substantially move up the price level.
We deem the
re-introduction of a precious metals standard to be rather unlikely,
precisely because it takes away the power of Congress to spend: it could only
spend money if it got hold of more platinum. Unless, of course, Congress realizes
that it may get away with not backing all of the currency with platinum or
resets the price of a platinum coin yet again. Soon enough, the
“platinum window” would be closed again, just as Richard Nixon
closed the gold window in 1971. Let’s call it a coincidence Nixon would
have turned 100 years old this year, just as the Federal Reserve is
celebrating its 100th anniversary.
While most agree that
a $1 trillion platinum coin is a silly idea, few think that a $100 bill is
also absurd. There are indeed key differences:
- $100 bills are all one and the same.
Well, almost. In some developing countries, newer bills are worth more
than older ones (because of counterfeit bills in circulation).
- A platinum coin has intrinsic value:
its fine ounce content of platinum. In contrast, the $100 bill is worth
the paper it is printed on.
To be precise, a $100
bill is a Federal Reserve Note:
- The holder of a $100 bill may deposit
such bill into his or her account.
- The bank can deposit the $100 bill at
the Fed. In turn, the Fed will credit the bank with $100 in checking
account.
- The bank can withdraw the deposit of
$100 from the Fed.
- The bank account holder can withdraw
$100 from the bank yet again.
Importantly, the $100
is always an obligation: an obligation of the bank, the government (through
FDIC insurance in case of default of the bank) and the Fed (currency in
circulation appears on the liability side of the Fed’s balance sheet).
Most currency is not issued in paper, but in electronic form. Banks receiving
a $100 electronic credit can, through the rules of fractional reserve
banking, lend out a multiple of such deposits. Because of this, currency
always carries counter-party risk. By regulation, if the counter-party is the
Federal Reserve or the Treasury, it is considered to be risk-free. But
it’s still a debt security. Moreover, the rating agency Standard &
Poor’s does not consider US debt risk-free, having downgraded it
because of the dysfunctional political process in addressing the long-term
sustainability of U.S. deficits.
In contrast, a coin
in itself does not have counter-party risk. It’s a coin with intrinsic
value. If a government decreed a value onto that coin, there’s a risk
that such decree may change or be undermined.
Precious metals coins
may be considered barbarous relics, but at least they do not carry
counterparty risk. Indeed, we like the fact that gold in particular has
comparatively little industrial application, making it a pure play on
monetary policy.
So what is an investor
to do? In our opinion, investors must gauge for themselves what something is
worth, rather than rely on a government. That applies to the dollar as much
as it does to a platinum coin or any security. Notably, forget about the
notion that something is risk-free. Those trusting their governments to
preserve the purchasing power of their savings will be the losers. Those
throwing out the risk free component in their asset allocation models may
well come out with fewer bruises.
And while the gold
standard has some admirable features, democracies tend to favor spending over
balancing books. Over the past 100 years, we have moved further and further
away from the gold standard. While a collapse of the fiat monetary system
might temporarily get us back on a gold standard, don’t trust a
government to take care of you. In practice, this means that investors need
to create their personal frame of reference as to how to deploy investments;
rational investors are unlikely to mint a personal $1 trillion coin, realizing
that no one would pay $1 trillion for it. It also means there is no single
safe haven during times of crisis. The fact that precious metals have no
counter-party risk is an attractive feature, but don’t kid yourself: if
your daily expenses are in U.S. dollar, the value of your purchasing power
will fluctuate. Investors must be able to sleep at night with their
investments; if not, consider reducing your exposure.
Is volatility with
regard to the U.S. dollar an argument against owning
precious metals? No, but one needs to be keenly aware of the risks of any
investment, including perceived safe havens. To manage the risk to the U.S.
Dollar, investors may also want to consider actively managing dollar risk.
Please join our Webinar this Tuesday, January 15, 2013, that
focuses on our outlook for the dollar, gold and currencies for 2013. Please
also sign up for our
newsletter to
be informed as we discuss global dynamics and their impact on gold and
currencies.
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