What backs the money in the present irredeemable paper system? Start by considering this brief anecdote. Joe buys some equipment from John, to be paid Net 30. We say that Joe owes John $10,000. Next month, Joe comes back and gives the money to John. Joe is out of debt, but has the debt been extinguished? No. The debt has been transferred. Now the Federal Reserve owes John the money. Surprised? Don’t be.
In a gold-based monetary system, every asset is ultimately backed by gold. This does not mean that every debtor (including banks) keeps the full amount of its liability in gold coin just lying around. Why would one bother to borrow if one did not need the money?
It means that every asset generates a gold income and every asset could be liquidated for gold, if necessary. If a debtor declares bankruptcy, the creditor may take losses. But he can rely on the gold income stream for each asset or if need be he can sell the asset for gold.
In a gold-based monetary system, money is gold and gold is money. Money cannot disappear; it does not go “poof”. Bad credit can be defaulted and must be written off. But money merely changes hands.
In a gold system, the promise of the gold coin is the only reason why anyone extends credit in the first place. Since 1913, there was a step-by-step evolution to our present irredeemable paper system. Now creditors are forced to accept the government’s scrip as payment in full. It continues to work (for the moment) partly because of inertia, but mostly because there is (still) good credit behind the dollar.
Let’s look deeper at what backs the money in the present irredeemable paper system. Start by considering this brief anecdote. Joe buys some equipment from John, to be paid Net 30. We say that Joe owes John $10,000. Next month, Joe comes back and gives the money to John. Joe is out of debt, but has the debt been extinguished?
No. The debt has been transferred. Now the Federal Reserve owes John the money. Surprised? Don’t be.
The dollar is the liability of the Fed.
The Fed, like every bank, must balance liabilities and assets. There is even a technical term for when they have liabilities without matching assets: “Bankrupt.” How does the Fed itself balance its liabilities?
The Treasury bond is the asset of the Fed.
Getting back to John, he deposits the money in the bank. The result is that the bank owes John the money, and the Fed owes the bank the money. The banks will typically buy Treasury bonds because they are “safe” and they pay a yield. In this case, the Treasury owes the bank the money.
Notice that whether the bank holds Treasury bonds directly, or whether it holds dollars that are the liability of the Fed backed by Treasury bonds as the asset, the Treasury bond ultimately backs the bank. And thus the Treasury bond ultimately back’s John’s asset, which is the deposit account.
The same principle holds true for other assets. A stock (equity) is valued based on the expected flow of dollars it will generate in the future. In addition, every company is obliged to hold dollars in a bank to cover payroll, pay suppliers, etc. Few companies could survive one minute past the default of their banks on these deposit accounts.
If this all seems perverse, that is because it is! The dollar is backed by the Treasury bond, and the Treasury bond is paid in dollars. It is circular, self-referential, and it is a Ponzi scheme.
Under gold, the metal itself is the risk-free asset. This is not a mere definition, but an observation about reality. Gold simply is. It is not a promise and therefore cannot default. But under paper, the Treasury bond is defined as the risk-free asset. Obviously, one cannot eliminate risk by defining it out of existence.
It is important to emphasize that if a party’s asset goes bad—especially with the leverage employed today—it will be forced to default on its liability. By the design of the system, its financial assets are someone else’s liabilities (and its other assets depend on the liabilities of the Treasury). The ultimate “someone else” is the Treasury in all cases. When they default, all financial assets will be wiped out. This means all debtors will default. This means all creditors will take total losses. Creditors include not only corporate employers, but savers, pensioners, annuitants, etc.
The next time someone blurts out that the dollar works just as well as gold (or better than gold!), an explanation of this should shut him up.
Keith Weiner is the founder DiamondWare, a VoIP software company, and is a PhD student at Antal Fekete’s New Austrian School of Economics in Munich. He is now a trader and market analyst in precious metals and commodities. He is also president of the Gold Standard Institute USA.
© 2012 by Keith Weiner
It seems to me as I read this that at some point in time there had to be an original “reference” of value. I can see how in a barter economy that over time the value of things (labor, crops, animals, water) would become to be known and could be used as the reference for exchange, but how did gold (and to the lesser extent silver) which was nothing more than a shiny metal every attain it’s original value? As I understand it large mining discoveries in history were thought to be associated with bad inflation. I can certainly appreciate that Gold isn’t create-able like a digital entry is, but how would we square our economy using Gold as the medium of exchange if a new technology were invented that required large amounts of the stuff to be included in its use (think handheld devices using Gold interconnects or something).
Chance: as people began to barter they encountered a problem known as the “coincidence of wants”. What happens if you make leather moccasins and you want to trade for some eggs, but the egg guy does not need leather moccasins?
It turns out that some goods are more marketable than others. You can trade something like moccasins which are less marketable, perhaps not for the good you want but for something that is more marketable. For example, salt. Then trade the salt for the eggs.
Over time, people were able to figure out which good was the most marketable. This good then became even more marketable due to its demand for indirect trade.
“It turns out that some goods are more marketable than others”
True, but you still haven’t explained why. Here is an interesting quote from Sandeep Jaitley from just the other day.
Sandeep would seem to be saying, that you just can’t get enough silver or gold, that the demand for silver & gold approaches infinity. As you well know Keith, money is what extinguishes all debt, thus money is the one thing you cannot have enough of, since there is no limit to human desire & to have what you desire, you must pay for it, otherwise it’s called theft. You incur a debt that must be extinguished. If only you have enough money, there is no limit to the debt you can incur.
So what gives gold & silver constant marginal utility? I’d have thought it obvious to any serious student of gold. It is constant, inert, forever – you could even say infinite. Its quality does not change over time. Silver less so, but a much closer second to gold than anything else. Only the infinite quality of gold (& silver) can have infinite demand. You cannot infinitely demand fish, which will rot before you ever get around to eating it all. It even goes tough & tasteless when thawed after freezing, that is, its quality declines.
Gold & silver’s constant marginal utility has nothing whatsoever to do with its quantity, which you also well know, is enormous. It would not matter a jot if significant quantities of gold suddenly appeared, in fact just that occurred during the gold rushes of the 19th century.
The quality of gold also squares nicely with the Real Bills doctrine, which I know you well know. Real bills are quality monetary substitutes, as good as gold. Only gold (& silver) redemption can keep the monetary substitutes ‘money good’, otherwise we see a serious decline in their quality, regardless of their quantity – & I know you don’t believe in the quantity theory of credit Keith.
Keith, do you think that the USA will resort to gold/silver again? I love the idea of a stable currency, but doesn’t that obviate the need for 75% of the banking cartel?
If you had to guess, when will we see the death nell of the US Dollar?
I have learned from some of Keith Weiner’s writings but I really don’t understand what he is saying here. The article starts out with the question, “What backs the money in the present irredeemable paper system?” But his example is not talking about physical paper money. He is talking about electronic money that Joe pays to John and that now John has the electronic money in his account and it isn’t in Joe’s account any longer.
Yes, irredeemable physical paper currency is a liability on the Federal Reserve Bank’s balance sheet. They never have to pay it off in gold. They never have to pay it off at all. The liability may remain forever. Currency is a small part of all the money out there.
Credit money, that is to say money created by commercial bank lending, isn’t backed by the FED at all. It isn’t even on the FED’s balance sheet. All the money out there isn’t on the FED’s balance sheet as a liability. And the FED doesn’t have all that money backed by Treasuries. M2 money stock alone is $10 trillion dollars at the moment. The FED’s balance sheet less than $4 trillion.
Abuseable money is backed by confidence in the money, which means it isn’t backed by anything physical or even a financial instrument from the Treasury department. Much of the assets of the FED are toxic mortgage backed securities, not Treasuries.
And much of the assets that banks hold are not Treasuries. They are loans, mortgage backed securities, credit card securitizations, commodities and stocks which are often day traded.
Sorry Keith, I won’t be using this explanation to people who tell me the dollar works just as good as gold. There are better ways to explain a gold standard.
“Credit money, that is to say money created by commercial bank lending, isn’t backed by the FED at all”
Yes it is. 2007-08 proved that, if proof was needed.
Gold and silver traditionally, but now platinum and other rare metals, have value only because they are inert (do not degrade over time) and they are scarce in a relative sense. They are used as money directly or indirectly because it is harder to counterfeit them by the various governments, which are always trying to find ways to make more money to buy votes. Gold and silver are simply what we use to keep the politicians as honest as we can which is not easy. Over time we forget the reasons and they take advantage of that with fiat currency and that always leads to a major collapse and we start over. In my opinion it’s just that simple.
JR: what’s your point, are you trying to tell everyone what my views are? I don’t believe that constant marginal utility means anything is infinite (and I don’t prefer the term “demand” for a variety of reasons). Gold has very high stocks but obviously they are not infinite. Yes, I’ve said many times that the linear quantity theory of money has no redeeming merit. By the way, Real Bills don’t work at all if they are not paid in gold. Today, we have factors, specialized businesses that provide liquidity to companies based on receivables. But receivables do not circulate.
Pat: I would not use the word “resort”, it would be like asking someone who is currently forced to drink dirty water from a pond if he will someday resort to clean water! I think it is inevitable (see my book review posted yesterday also). I think the US dollar has 3-7 years left it in, depending on how the eurocrisis resolves itself.
Rigorous: I did not say that commercial bank credit is on the Fed’s balance sheet. Obviously, it is a liability on a commercial bank’s balance sheet. And the commercial bank has what on the asset side? What will happen to their liabilities when their asset evaporates?
David: Platinum and the other high-priced metals have very low inventories. Their stocks to flows ratio is measured in months. This is the proof that they are not money. Their price depends entirely on industrial demand for things like catalytic converters for cars.
Keith I agree — I only said that they had value like diamonds and works of art. As you correctly state only gold and silver can actually work as money today.
Treasury bonds are backed by the full faith and credit of the U.S. Government.
Because of this backing many people believe that debt is as good as cash.
Bruce Webb at Angry Bear made this statement: Treasuries Bonds are better than cash for they pay interest.
I find this to be somewhat ludicrous, in the context we were discissing: redemption of the Treasuries’ interest, and eventually principal, from the SS trust fund until exhaustion.
Redeeming the interest and principal requires either new general revenues (if a surplus) or increased debt held by the public (if a deficit).
In other words, believers of Webb’s perspective, think not only debt equals cash, but Treasury debt is better than cash.
My contention is that if bonds can simply be liquidated for cash, for they are pre-funded and left intact, they are more valuable than bonds which have only “faith” backing them.
There is even a name for these believers: the Trust Fund Perspective.
Adherents of this viewpoint believe Medicare Part D is fully funded!
Don Levit
[...] 16, 2012 By Colin Lokey Leave a CommentThis short piece is inspired by and is a brief summary of a longer article that appeared on DailyCapitalist by Kieth [...]
Dear Keith,
I always look forward to reading and enjoy your articles. I put you in the same class as Rothbard and Hazlitt whom I highly respect.
Best Regards and keep up the good work…
So now when people disagree with the Institute they are cashiered?
http://globaleconomicanalysis.blogspot.com/2012/08/economist-fired-for-expressing-opinions.html
Keith Weiner, is that your real name or just an AKA?
Are you really, Phillip Barton or not?
Does the Institute have two presidents?
Keith Weiner, are you the President of GSI??
http://news.goldseek.com/GoldSeek/1346160660.php
Mr Weiner, is indeed a President…
However, the GSI is catering to inflation itself, by having three, yes three Presidents!!