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Money is Debt, Gold is Money

-- Posted Wednesday, 6 March 2013 | | Disqus

By Mark Motive and Alex Alibi of

“In numerous years following the [civil] war, the Federal Government ran a heavy surplus. [But] it could not pay off its debt, retire its securities, because to do so meant there would be no bonds to back the national bank notes. To pay off the debt was to destroy the money supply.”

John Kenneth Galbraith

In the investing world, you can take a 3 month view, a 3 year view or a 30 year view. One person looking at one asset class might have a different forecast depending on the time horizon he is considering. In this article, I will look at gold through a 30 year lens.

I believe that structural forces will support gold and other hard assets over the long term. While current forces may be bearish for gold in the intermediate term, there are a number of underlying currents that demand a strategic allocation to the metal (either bullion or via an ETF such as (GLD), (IAU) or (SGOL)). While the sophisticated gold investor is already familiar with these concepts, I think it is important to re-introduce them to a broader audience who may have zero allocation to gold, other precious metals (e.g. silver (SLV) or a basket (GLTR)) of hard assets in their portfolio.

The Origins of Money

Throughout history, money has always held an important position as a unit of accounting, a store of value and a means to pay taxes and facilitate transactions, thus creating massive efficiencies within an economy. Initially, transactions were directly conducted via barter, later, every imaginable item was used for money, like obsidian (volcanic glass), shells or cows. Later, money was directly issued by kings and governments without any debt. Today, nearly all money (except coins) is created by private central banks and loaned to the governments and charged with interest in exchange for government bonds, creating perpetually growing public debt.

Many historians suggest that fractional reserve banking and private money creation started when gold owners stored bullion within the vaults of goldsmiths for safe keeping. As proof of deposit, goldsmiths issued paper receipts – gold certificates – that could be redeemed in exchange for gold. Seeing an easier way to transact, when buying goods and services, gold owners would simply hand over gold receipts as forms of payment instead of redeeming for gold and delivering the metal.

Eventually, enough people were doing this that some enterprising goldsmiths, who noticed that the gold in their vaults was rarely reclaimed, started lending (with interest) more paper receipts than there were specific gold deposits. After making these loans, more paper was in circulation than gold in the vaults, resulting in an early example of expanding money supply and credit growth. Of course, any goldsmith that manufactured receipts far in excess of gold reserves risked a run on deposits and existing receipt holders may have experienced a loss of exchange value.

Money Creation Today

In the US today, many believe that the Federal Reserve is the primary source of money supply growth. Many also believe that the FED creates money and simply pumps it into the economy. This assumes the Fed has some sort of authority over how money is spent, but this is untrue. Monetary policy is the handmaiden of fiscal policy, but both are quite distinct.

Through open market operations, the Fed adds to the money supply by purchasing assets such as US Treasuries and mortgages. Effectively, each dollar injected this way is the mirror image of someone’s liability, giving rise to the concept that money is debt. In fact, Marriner Eccles, Governor of the Federal Reserve, stated on September 30th, 1941, before the House Committee Hearing on Banking and Currency that “[i]f there were no debt in our money system, there wouldn’t be any money”

Think about it this way: the massive fiscal response to the 2008/2009 recession and sluggish recovery has added trillions to the Federal debt. Much of this debt was indirectly financed by the Federal reserve (although they’d never admit it) via open market operations. So instead of simply printing and spending its own money, the US government has granted an independent entity (the Federal Reserve) the right to print and lend with interest to the government and its citizens. Some might see this as ‘checks and balances’, while others might argue that it grants unlimited power and profit to the banking cartel that controls the Federal Reserve. In the end, the US government has added $trillions to its debt and the US dollar has lost nearly all of its purchasing power since the instauration of the third Federal Reserve exactly 100 years ago.

The truth is that while the Federal Reserve can add new Federal Reserve Notes to the money supply, the biggest driver of money growth is the private banking sector via loans. And this is where it gets especially important for the gold investor.

The monetary system does not stand still – it operates on a treadmill of debt. The majority of money in the economy is created when private banks make loans. One might think that these loans are based on deposits, but the reality is that – much like the goldsmiths of days past – in a fractional reserve system far more loans are made than deposits on hand, on average 9 times more. Modern Money Mechanics, a publication by the Federal Reserve Bank of Chicago in 1968, states the following:

” For example, if reserves of 20 percent were required, deposits could expand only until they were five times as large as reserves … Under current regulations, the reserve requirement against most transaction accounts is 10 percent … Of course, they [the banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created … The deposit expansion factor for a given amount of new reserves is thus the reciprocal of the required reserve percentage (1/.10 = 10).”

They further illustrate this with the following diagram, showing the initial deposit and the cumulative expansion via additional loans.

Fractional Reserve Banking

Fig. 1: Cumulative expansion in deposits on basis of 10,000 of new reserves and reserve requirements of 10 percent, from: FED, 1968. Modern Money Mechanics – A Workbook on Bank Reserves and Deposit Expansion. Federal Reserve Bank of Chicago, Revised Edition, February 1994, p. 11

In essence, the banking system has the legal power to create money out of thin air

The Debt-Money Conundrum

Here’s the kicker: whether the money is created by the Fed or other private banks, the money must be paid back with interest. Because only the principal amount is loaned, only the principal amount exists in the first place. In aggregate, enough money doesn’t exist throughout the economy to pay both principal and interest on all debts, creating the need for credit-based growth to repay the interest, starting a vicious circle.

Bernard Lietaer, who helped design the Euro and has written several books on monetary reform, explains the interest problem like this:

“When a bank provides you with a $100,000 mortgage, it creates only the principal, which you spend and which then circulates in the economy. The bank expects you to pay back $200,000 over the next 20 years, but it doesn’t create the second $100,000 – the interest. Instead, the bank sends you out into the tough world to battle against everybody else to bring back the second $100,000.”

The debt-money conundrum results in two conditions:

1. Systemic Competition. Like rats in a cage, current societal needs are meeting insufficient resources (natural and financial). In this case, unless money is continuously loaned into existence, the money required to repay all debts plus interest does not exist. This means that, unless new money is made available, if one person or company is able to repay their debts another is not. This raises the level of competition within society. Arguably, this has been a positive economic characteristic since the industrial revolution, however one must wonder what the world would be like if debt-fueled competition didn’t exist. Competition goes far beyond the healthy – many wars and other crimes can be traced to the competition for the resources required to maintain living standards, generate economic growth and thus indirectly repay debts. Money loaned into existence has created systemic competition.

Lietaer continues:

“The problem is that all money except coins now comes from banker-created loans, so the only way to get the interest owed on old loans is to take out new loans, continually inflating the money supply; either that, or some borrowers have to default. Lietaer concluded: [G]reed and competition are not a result of immutable human temperament . . . [G]reed and fear of scarcity are in fact being continuously created and amplified as a direct result of the kind of money we are using. . . . [W]e can produce more than enough food to feed everybody, and there is definitely enough work for everybody in the world, but there is clearly not enough money to pay for it all. The scarcity is in our national currencies. In fact, the job of central banks is to create and maintain that currency scarcity.

The direct consequence is that we have to fight with each other in order to survive.”

2. The Ultimate Ponzi-Scheme. If money was lent into existence on a single occasion only, lenders would take haircuts when some borrowers defaulted and, knowing this in advance, potentially would have never lent the money in the first place. Or lenders would have priced the defaults into interest rates and covenants, paradoxically making it even harder for all loans to be repaid with interest. The banking system simply would no longer exist in its current state.

In reality, new money supply begets new money supply. To reduce the number of defaults caused by the competition for money, the banking system must continually lend more money into existence. As new money and debt is introduced into the system, it helps money flow to past borrowers enabling them to pay the interest on their past debts. To adequately offset the number of bankruptcies in the system, money must continually be created. This is precisely why modern industrial economies have a implicit ‘normal’ inflation rate of 1-3%. But one should remember, that according to the rule of 70, an inflation rate as low as 1% still halves the value of one unit of currency every 70 years, With 2% inflation, this happens every 35 years [that's even official ECB policy], and 3% inflation needs only 23 years to reduce a money’s buying power by half. Money supply simply must expand for that kind of system to survive. Normally, that money is created by individual banks via loans; however, sometimes the lender of last resort (i.e. Federal Reserve) – as the only lender that can continually accept losses – steps in to offset private loan destruction in periods of extreme financial distress, such as the 2008/2009 crisis via substantial injections of newly created money.

The Growth Imperative

When inflation must be maintained at 1-3% for the system to stay solvent, many other areas of society are significantly affected. Companies must continuously raise prices, salaries must continuously increase, economies must continuously grow, populations must continuously increase, food supply must continuously rise, taxes must continuously rise and so on.

Over the long run, continuous monetary expansion leads to the destruction of the value of the dollar relative to assets with intrinsic value. While continuous monetary expansion can provide a tailwind to many businesses with pricing power, I think most investors are already set up to benefit from this through the equity portion of their portfolios (perhaps by using broad-based index ETFs such as (SPY), (DIA) or (QQQ) or through their various retirement programs). Where I think many investors are deficient is in a strategic allocation to gold and other precious metals.

Gold is Money

Many investors have a 3 month or 3 year view on gold, but few have a 30 year view. While I agree that intermediate forces could send the gold price down, I believe that structural monetary expansion means that all long-term investors should have some strategic weight to the yellow metal, which can serve as stable money while fiat currencies around it are devalued.

While equities (and other assets) can benefit from these same structural forces, gold has different risk-return characteristics and can help to diversify a portfolio. I am not saying that investors should dump half their portfolio into gold bars. What I am saying is that, as a stable currency, gold can help mitigate the effects of never-ending monetary expansion, and _most investors are significantly underweight.

Many investors might want to view Marc Faber‘s personal allocation (25% stocks, 25% bonds, 25% cash, 25% gold) as a starting point for determining their own allocation. Each investor will have his own target weight based on his time-horizon, risk tolerance and non-portfolio (e.g. real estate, career) exposure to the business cycle. In most portfolios, gold can provide factor exposure not obtained through traditional asset classes and may be a valuable tool in the preservation of long-term wealth in a world in which money is debt and gold is money.

Follow Plan B Economics on Twitter: @planbeconomics

-- Posted Wednesday, 6 March 2013 | Digg This Article | Source:

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