This is Erik Lenderman checking in.
This article is focused upon providing a brief Financial & Economic analysis of global markets in order to determine how these systems function. This will also review how the U.S. Government & Federal Reserve’s policies may impact a variety of asset prices.
The Origin of The Economy
Thousands of years ago, human beings most likely recognized that some individuals specialized in hunting, whereas others specialized in gathering. Through developing a primitive ‘Gift’ economy, the group would share their resources with each other in order to ensure sustenance for each member of the tribe. This most likely developed into a primitive barter system, where those groups learned that they could trade specified quantities of meat for the fruits and vegetables provided by those who gathered nuts and berries. The exchange of meat for nuts and berries would ensure that members of the group could survive and meet their body’s energy demands.
These small groups are believed to have next developed into larger and more sophisticated civilizations, which could exchange these sources of energy for more productive purposes — The creation of fabric, tools, protective armor, housing, entertainment, etc. However, the disproportionate value of one good or service in exchange for another represented an increasing challenge. Trading 1 bison in exchange for 1 suit of armor could become problematic, because the bison would decay, but the armor could endure for years. Therefore, these items may have been equally critical for survival, but the goods represented an asymmetrical storage of value.
Therefore, a more durable token would be required in order store value throughout time. This would enable a hunter to capture and sell many bison, store and accumulate coins, and exchange a reasonable sum for an equally durable good. Thus, a mutually agreeable durable token emerged throughout nearly all civilizations. These ranged from precious metals and minerals (‘hard’ money) to semi-precious or non-precious metals, which represented units of predetermined value (fiat currency).
The Projection of Value Upon Scarce Objects
Through relying upon Gold, Silver, Diamonds, Sapphires, Rubies, and other rare products of earth (‘hard’ money), tokens of value could not be counterfeited. These elements served as a natural vault onto which the psychological construct of ‘value’ could be projected. Throughout many civilizations across thousands of years, these items have held the psychological construct of ‘value’ and served as the bedrock of token-based trade.
The problems with these tokens quickly grew, where large transactions became vulnerable to attack along trade routes. Hauling billions of ‘dollars’ in value through these materials on ships or caravans could expose the transportation of wealth to the public. Ships could be lost at sea, and caravans could be assaulted — Transacting business became a risk.
The Development of the ‘Bank’ System
Therefore, many civilizations agreed that self designated groups could secure individual assets and issue certificates of deposit for token holders to withdraw their wealth from private vaults when ready — Thus the ‘bank’ was born. These certificates could also be transferred from one individual to another, thereby enabling the transfer of vast sums of precious metals through a single document. This practice, by extension, was mirrored within governments, which stored precious metals in their vaults and issued fiat currency to their citizens, which they could redeem for the equivalent value in precious metals.
The lending institutions and governments soon learned that they could generate profit through storing this wealth and loaning the monies to other individuals in exchange for the repayment of principle and interest on the loan. This interest would be used to pay for the cost of guarding the vaults plus a small profit. These institutions would naturally provide a portion of this profit to their account holders through sharing the interest payments. Therefore, everybody could profit from and participate in the benefits of the newly created financial services industry. Thus, the process of banking and generating interest on loans was born.
This process has been replicated throughout the world. However, this article will focus specifically upon the manner in which this developed within the U.S. Economy for simplicity.
The Role & Function of U.S. Treasury Notes (Bonds)
The U.S. Treasury Note (Government Bond) represents a ‘certificate of deposit’, which is provided to individuals to place their financial reserves within the U.S. Government’s bank vault. The government subsequently regards these deposits in the same manner as a private bank — Loans to the government, which will be repaid with interest.
The U.S. Treasury Note is regarded as stable, secure, and nearly impervious to default. This is because the U.S. Treasury Notes are backed by the confidence that it could repay Bond holders because the U.S. is capable of taxing the largest economy in the world as a source of revenue if needed. This typically confers a sense of security upon Bond holders, because they regard the risk of a U.S. default as low. Through comparing U.S. Treasury Notes with a startup, publicly traded companies, or a 3rd world government with frequent regime changes — The U.S. Treasury Bonds typically appear to be low-risk, guaranteed return investments.
Therefore, foreign nations, private corporations, and individual investors have sought to place their reserves with the U.S. Treasury in order to protect the value of their investments for decades. This behavior results in the U.S. Dollar serving as the ‘World Reserve Currency’, because those who invest their reserve capital naturally expect to be repaid in U.S. Dollars.
Storage of Value in U.S. Treasuries = Diversion of Liquidity from Markets
The U.S. Treasury Note’s perceived low risk and guaranteed rate of return results in the diversion of risk-averse capital toward the U.S. Government’s vault. The U.S. Treasury regards these ‘certificates of deposit’ as ‘loans’ to be repaid — Hence, many have observed that China is the largest holder of U.S. Treasuries (i.e. the U.S. ‘owes’ China money). Through these loans, the U.S. develops the capacity to spend money on Congressional appropriations as authorized by the President. Therefore, this capital is also not available to the investors until their ‘certificates of deposit’ mature (From several months to 1, 3, 5, 7 years, etc). The result of this is investors are temporarily unable to purchase goods and services with that capital. Hence — Liquidity is available to the U.S. Government, but not to the foreign nations, corporations, or individual investors (The broader economy).
The Role of the U.S. Federal Reserve
The Federal Reserve was established in 1913 in order to serve as the Central Bank, which governs the monetary policy of the United States. This represents an institution that determines the interest rate for U.S. Treasury Notes. The function of the Federal Reserve is to (1) monitor inflation (prices) and unemployment,(2) provide currency to private lending institutions (banks) or the public (U.S. Treasury Notes), and (3) modulate the quantity of currency available to banks. The purpose of these policy mandates is to provide stability to the market and promote economic growth.
The Great Depression of 1929–1939 resulted in significant declines in stock market valuations, mass unemployment, and reduced global economic output (Gross Domestic Product — GDP). Therefore, John Maynard Keynes outlined a theory in which governments should intervene when economies enter into a recession or depression. Keynes’s principle theory was that when the free market moves from a ‘boom’ into a ‘bust’ cycle from which it does not recover, the government should be responsible for stimulating the economy. Keynes regarded government as responsible for correcting market failures, because it’s reserve of tax revenue and capacity to procure large emergency loans confers upon government the status of a public trust — The responsibility for protecting it’s citizens. Therefore, just as the government is typically responsible for providing military security from armed invaders or relief from natural disasters, Keynes believed the government should be sought to protect the public from economic failures.
This perspective provides for the possibility that the government’s policies could either produce a (1) Positive, (2) Neutral, or (3) Negative / Damaging impact when taking actions with it’s military, civilian, or financial agencies.
The Benefits of the Federal Reserve & Federal Deposit Insurance Corporation (FDIC)
The benefits of the Federal Reserve and FDIC include the capacity to provide liquidity in the event that the private banking system’s malinvestments result in the sudden loss of financial reserves.
The Federal Reserve and FDIC may provide liquidity to banks during a financial crises through (1) Reducing Interest Rates on U.S. Treasury Notes, (2) Increasing Money Supply, (3) purchasing toxic assets (i.e. insolvent companies or other assets). The objective of these policies are to promote the circulation of currency throughout the economy in order to ensure that trade continues.
Reducing Interest Rates & Stimulating Stock Purchases
First, through reducing Interest Rates, the Federal Reserve reduces the incentive for individuals to store their capital with the U.S. Government (The government pays less interest to investors in exchange for storing their capital with the treasury). Therefore, this encourages investors to allocate their resources to corporate investments in order to secure a higher potential rate of return (i.e. the stock market).
Through this process, publicly traded corporations provide shares of company ownership to investors in order to raise funds and invest in their company’s growth (i.e. Hiring workers and purchasing productive assets). This would theoretically ‘stimulate’ the economy through encouraging companies to hire workers, who subsequently purchase goods and services throughout the economy. Through encouraging investors to consider the stock market as a more effective route to produce returns, the Federal Reserve’s low interest rate policy is also responsible for increasing the price of stocks.
Note: Corporations may also leverage the increased capital that they raise from stock offerings through re-purchasing their own shares. This raises their share price without actually increasing hiring or the purchase of productive assets. This is of value to their stock holders, because the perceived value of their portfolios will increase. However, this behavior may not increase hiring or productive output, so the benefits of the ‘stimulus’ may be limited to stock valuations and not transferred to the broader economy.
FDIC Insurance & Increasing The Money Supply
The presence of a catastrophic malinvestment throughout the banking system could result in the profound loss of liquidity throughout the economy.
Typically, financial institutions are believed to strategically invest and recoup their loans with interest, which enables them to repay their account holders. However, large scale malinvestments may result in significant losses. Those banks, which find themselves with an excess of loans in default (toxic assets) may be unable to repay the principal or interest of their account holders. The large scale impact of multiple simultaneous bank failures could result in the inability of savings account holders to access their reserve funds. Meanwhile, businesses that require monthly credit in order to cover payroll expenses will no longer be able to secure loans from these financial institutions. Therefore, the economy could halt and cause further systemic financial failure.
Therefore, the FDIC may ensure that the process of spending, saving, and investment continues without interruption through insuring these accounts for up to a specified amount. The injection of emergency liquidity may be achieved through ‘purchasing’ the toxic financial assets, which could be financed through the equivalent of printing new money. This is designed to recapitalize companies, which the Federal Reserve regards as critical for the continuation of economic activity. Through transferring ownership of toxic assets from the private sector to the public sector, the government’s policy of ‘bailing out’ companies is regarded as a potentially stabilizing policy, but the costs are incurred by the tax payer (through increased taxes to finance the purchase) and those holding U.S. Dollars (through devaluing the dollar via inflation of the money supply).
This ensures that the general public continues to have access to their reserves of fiat currency during the short-run, but this may also destabilize other sectors of the economy (i.e. Increased taxation and increased inflation).
The Problems with the Federal Reserve & FDIC
The injection of liquidity into the financial system through printing money could damage the public currency. The process of inflation describes the tendency for the monetary supply to increase, which correlates with increasing prices. Through printing excess supplies of fiat currency, the public may interpret the currency as losing value with each additional ‘dollar’ in circulation. This is due to the psychological bias in humans, whereby abundant resources are regarded as less valuable, because they are less costly to attain.
For example, H2O is highly valuable across all cultures, because human beings will die if they do not drink within 3–4 days. However, the cost of H2O in the 1st World is typically very low (nearly ‘free’), because the resource is abundant. The resource is not ‘scarce’ so, the price is low. Meanwhile, clean H2O is more scarce in 3rd world countries, and some groups must walk 5–10 miles each day in order to reach the nearest stream and haul a bucket back to their village. The ‘cost’ (time, energy, and calories) to secure access to H20 is high. Therefore, although the need for water is universally constant across each civilization, the ‘cost’ varies in accordance with it’s scarcity, so the price will correlate with it’s scarcity.
Consequently, governments that print an excess of money risk creating high levels of ‘inflation’, wherein the abundance of the fiat currency causes a drop in the costliness of securing access to each unit. Therefore, the goods and services, which are relatively inelastic in demand (i.e. food, water, and shelter), will appear to rise in relation to the fiat currency. The classic example of post World War I Germany printing money to pay for it’s debts resulted in the citizens carrying cart-loads of fiat currency to purchase a loaf of bread. The abundance of currency resulted in a loss of it’s perceived value, so the cost of bread (in German fiat) rose to astronomical levels. This precipitated a second World War.
The printing of money to absorb toxic assets may provide a short-run benefit to the economy, but the long-run problems include potentially damaging the value of the currency.
The Damage to Money Supply & Rise of Hard Asset Prices
This damage to the nation’s fiat currency naturally produces a benefit to those who hold ‘hard’ money such as Gold, Silver, Diamonds, etc. The decline in the value of the fiat currency occurs in relation to objects, which retain their perceived sense of value. Therefore, these asset prices may begin to rise in proportion to the degree in which the fiat currency declines. However, those assets, which are used in industry may be more volatile, because industrial consumption drives demand. For example, Gold tends to hold a more stable psychological projection of value relative to Silver, because the latter is used more heavily for industrial applications — Economic recessions result in reduced consumption of Silver. Therefore, those who hold Gold assets may observe a relatively stable increase in their price relative to the value of the U.S. Dollar.
There are, of course, some ways in which the U.S. could retain the strength of the Dollar relative to Gold. This includes confiscating the Gold of it’s citizens and requiring an exchange for a government-determined fiat price. This first occurred during 1933 through Franklin D. Roosevelt’s Executive Order 6102. This Executive Order mandated that all citizens provide their Gold in exchange for fiat currency, which ensured that the U.S. Government’s fiat was backed by the long-standing ‘hard’ money.
The U.S. Government could also engage in purchasing gold from the global market and link the value of USD to a designated quantity of Gold. This would enable it’s citizens to retain their personal reserves while reducing the leverage of foreign nations in replacing the USD as a reserve currency. Through accumulating Gold, the U.S. could increase the stability of it’s currency and discourage the inflation of asset prices relative to it’s fiat.
The Problem with the Gold Standard & Liquidity Traps
This, of course, could result in a ‘liquidity trap’, whereby the storage of Gold and it’s link to a fiat currency could reveal that the total quantity of fiat currency cannot be readily modified in the event that fiscal stimulus is required. Therefore, if each member of the nation saved rather than investing or spending their capital, the economy could slow. This could result in rising unemployment and reduced new business growth, thereby increasing the tendency for citizens to save their money — This could precipitate a recession or depression. The problem of excess savings was observed in Japan‘s ‘Lost Decade’ during the 1990s, which contributed to declining economic productivity. This occurred without the nation’s participation in a ‘Gold Standard’, but this serves as an effective example of how a liquidity trap is formed.
The potential of returning to a ‘Gold Standard’ therefore also includes risks, because the Federal Reserve would be possessed of less ‘room to maneuver’ in the event that a liquidity trap was present during the onset of a systemic bank failure due to malinvestment. The Federal Reserve would be unable to mine sufficient Gold so as to replace lost investments, and savers could find themselves having stored their reserves with a defunct banking institution.
Those large, medium, and small investors are advised to monitor the Federal Reserve’s policies, U.S. Treasury interest rates, and the fiat monetary supply relative value to ‘hard’ money. These variables may serve as an effective ‘base-line’ for monitoring and interpreting the value of fiat currency in relation to the historically stable psychological price projections, which are placed upon precious metals.
Erik A. Lenderman