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May 31, 2010

The Metamorphosis (with apologies to Franz Kafka)

One morning, as Monty was waking up from anxious dreams, he discovered that in his bed he had been changed into a monstrous gold bug.

One of my abiding fascinations has been with the concept of money. What exactly is money, anyway? Why is gold deemed to be valuable? How is the "value" of money set? Who or what determines what a service or good costs?

These turn out to be vastly complicated questions that have spawned legions of philosophers, statisticians, and economists over the millennia to figure them out. That we continue to have financial crises shows that these philosophers and economists still don't understand the subject as well as they'd like to.

I'm not going to go into any kind of detail here on the nature and purpose of money. Many thick, impenetrable books have been written by people far smarter than I about the subject. There have even been some short, readable books written about it: Economics In One Lesson by Henry Hazlitt is a good one. My purpose is more to start in medias res, so to speak, and figure out what "money" is right now to citizens of the United States of America (and other western nations).

If you have some paper money and some change, lay them out in front of you: the paper money on one side, the coins on the other. If you have credit cards, put them in the third pile. Your checkbook (and debit card, if you have one) goes in the fourth pile. If you have hard currency (gold or silver coins), put them in yet another pile. If you own bonds (Treasuries or T-Bills), put them in yet another pile. Stock certficates: another pile. These various piles each represent distinct kinds of "money" that the average citizen makes use of. Yet they are very different.

Let's start with the paper currency. US paper currency is in the form of Federal Reserve Notes (part of a broader class of Bank Notes), and are "legal tender" for all debts, public and private (just like it says on the front of the bill). US currency, like nearly all paper currency in the world today, is fiat currency: that is, it's value is not backed by a hard asset like gold or silver. It's notional worth rests on the "full faith and credit" of the US Government. Its value "floats" according to the economic picture at any given time.

At various times in US history, the US Dollar has been backed by gold and/or silver reserves. For a long time, a US Dollar was directly convertible into gold -- you could give a banker a ten-dollar bill, and he was obliged to give you ten dollars worth of gold. This regime of gold-convertability was a foundation of the post-World War II "Bretton Woods" financial system, and was the main driver behind the resurgence of the world economy after the war. It's also the main reason the US Dollar became the de facto world reserve currency (a status it still enjoys). For a few decades, the US dollar became, for all intents and purposes, synonymous with gold.

In 1971, Richard Nixon, in a move that came to be known as the "Nixon Shock", abolished the convertability of dollars to gold and later abolished the gold-standard entirely. The US dollar thus became a purely fiat currency (fiat from the Latin, meaning "let it be so"). This move was to prevent a run on America's gold reserves by foreign banks, and to allow for the inflation of the money supply to pay for war expenses and ballooning federal entitlement spending. As a result, the United States entered a period of very high inflation combined with low economic growth that didn't end until the early 1980's.

Your paper money has no intrinsic value. It is not backed by any goods or assets beyond the "full faith and credit" of the government. It is, at base, a zero-percent bearer bond, or promissory note.

Let's move on to the pile of coins. If you had made this pile with coins minted prior to World War II, you might with justice call the silver-colored coins "silver" and the copper coins "copper", but that is no longer true. Genuine silver, gold, and copper coins are called specie coins because they intrinsic as well as declared value. Modern US coinage is composed mainly of base metals whose bullion value is far below the declared value (by design). There are exceptions: the US Mint does produce legal-tender coins of pure silver (Silver Eagles) and gold (Gold Eagles). However, these coins are intended for numismatic (coin collecting) and bullion purposes, not as currency (since the value of the metal far exceeds the declared value of the coin). Your pennies, nickels, dimes, quarters, and half-dollars are also fiat currencies in that their declared value is far higher than their bullion value.

Now for the gold and silver pile. If you have any pure gold or silver, you own "hard money". Hard money is not fiat money; it has innate value. The delcared value on my American Silver Eagle coins is $1US, but the bullion value of a 1 oz. coin (as of this writing) is around $19US. A 1oz Gold Eagle coin has a face-value of $50US, but a bullion value of around $1300US (as of this writing). The relative value of precious metals -- gold, silver, platinum, and palladium -- is set by the international market, not by governments.

Gold is basically eternal: it doesn't rot or degrade or become corrupted. It is comparatively rare. It is easily worked, and is esthetically very pleasing. This is why humans have from prehistoric times used gold as a form of wealth. It is a very durable value-store. Other precious metals have similar characteristics. Many people prefer this kind of wealth to fiat currencies because of this kind of durability: empires rise and fall, fiat monetary systems come and go, but gold and silver remain. Their prices may fluctuate up and down, but they have never gone to zero (unlike every fiat currency in the history of the world).

Let's move on to the checkbook (and debit card, if you have one). Much of an average American's money never exists in physical form at all (i.e., probably 70% of your yearly income is never in the form of bank-notes or coins or hard assets like gold or silver). Your "money" exists in the form of digital bits in a bank computer system. Your "money" is in turn part of a larger pile of bank "assets" that also do not exist in terms of actual money. When you write a check against your bank account, you are basically issuing a promissory note: a lein against your account, redeemable by the owner of the note. The bank agrees to honor your note, payable in cash or equivalent. But even the owner of the note rarely redeems the note in the form of cash; the redemption is usually electronic, and involves simply decrementing one electronic account (yours) and incrementing another (the redeemer of the note). Very few transactions of this kind actually involve physical money at any point in the chain.

Now for the credit cards. A credit card is actually an instrument whereby you issue debt at a given rate of interest to the lending bank. The bank agrees to buy your debt, and you agree to make periodic payments on that debt (at some predetermined rate of interest plus principal). Your debt is a liability on your ledger and an asset to that of the bank, but it doesn't represent any real money at all: it's the promise of future money to be paid over time. Debt is senstive to overall economic conditions. High interest rate environments punish debtos but reward savers and investors; low interest rates reward debtors but punish savers and investors. Extremes of either kind are very bad, but it's hard to maintain a "happy medium". Credit debt tends to be a very bad kind of debt if done to excess, because over time the interest payments can actually exceed the borrowed principal; indeed, simply making the interest payments on loans can drive some people into bankruptcy. A little credit is not a bad thing; in fact, it's essential. But too much is a road to ruin because it eats up too much future income and retards growth.

If you own bonds (whether government-issued or corporate-issued), you basically own debt: someone else charging something on their "credit card". Your "bond" is a promissory note: a promise to repay a loan at a given rate of interest. When your bond reaches maturity -- which can be as short as a month or as long as thirty years -- you will receive the principal amount plus the negotiated interest rate. The interest rate of a given bond reflects the riskiness of the underlying loan.

Government bonds of various kinds are assumed to have very low risk, and thus tend to have fairly low interest rates: between zero and 5 percent, usually, depending on the kind of bond. Government bonds -- municipal bonds ("munis"), long-term federal government bonds ("long bonds") or short-term bonds ("T-bills") -- are considered very safe investments by both individuals and foreign governments. Much of America's expenses are funded by sales of bonds.

Corporate bonds tend to be riskier than government-issued debt and thus carry higher rates of interest (though some corporate debt is considered nearly as "safe" as government debt). If you are invested in a bond-based mutual fund, as many 401(k)-type plans are), then you are probably invested in the bonds of many Fortune 500 companies. Companies also issue "commercial paper", which is very short-maturity debt that is used to fund day-to-day activities. Banks and other companies are usually the purchasers of this kind of debt. (And a failure to sell commercial paper can rapidly kill a large company, as this is a major funding source.)

Let's move on to your stock certificates. If bonds are basically debt, then stocks represent equity. A stock certificate, or share, is basically a very small portion of a company's total assets (physical plant, assets, liabilities, everything). When you buy stock in a given company, you are making a bet that the company will grow or at least maintain its state. When the company grows, so does the value of your stock; if the company shrinks, so does the value of your stock. Some stock also pays dividends -- if a company makes a profit, the board or owner may decide to distribute that profit to shareholders in the form of additional stock or even cash. (A dividend is to a stock what an interest payment is to a bond, roughly speaking, except that a dividend is not assured.) Stocks tend to be more speculative than bonds -- earnings and profits are not assured. Interest on a bond is guaranteed, but a stock may go up or down depending on market conditions. A stock may appreciate by double or triple, but it may also go to zero. Thus equities are considered far riskier assets than bonds.

For average people, the above instruments represent their "money". Yet very little of an average person's wealth exists as paper currency or coins. And a very small percentage of Americans actually hold assets in "hard" money: gold, silver, or specie. An average American's wealth, at any given time, rests almost entirely on a shared trust between the citizen, the banks, and the government. We trust our banks to issue currency and redeem promissory notes; we trust the government to maintain the value of the national currency. The banks and the government trust us to live within our means and to pay off our debts.

At base, though, all trust resides in the ability of the government to maintain stability of the economy. The past several months has strained this trust-relationship to the breaking point. Everyone, from individual citizens to the government itself, has spent far beyond its means. The world is awash in debt, with an dwindling market of buyers willing to purchase that debt at rates the borrowers can afford. The fiscally prudent -- the savers and investors -- have been brutally manhandled by zero-percent interest rates and constant "gaming" of financial markets by large banks and soverign governments. There is going to be a huge pressure on the Federal Government in coming years to pay off these debts with new money rather than by imposing austerity on the citizens -- in other words, by printing money. Inflation.

In the low-trust environment which seems to be looming, many people -- including Yours Truly -- are beginning to wonder if it would be wise to impose some discipline on the world economy. One of the ways of doing this is to "short" fiat currency and go "long" on hard money like gold, silver, and other precious metals, or on commodities. I'm not an alarmist -- not yet, anyway -- but I have begun to build a little cache of precious metals. And I don't mean in terms of "gold certificates" or shares in a gold ETF, either: I mean real, actual metal.

I'm seeing a nation and a world full of people who seem to believe that monstrous debts can be run up indefinitely with no day of reckoning. It's possible that they are right...but I suspect not. In keeping with my "hope for the best, prepare for the worst" theory of the world, I'm buying some gold and silver. Not a lot. I'm not dumping all my investments into bullion. But I have become concerned enough to put a significant amount of my assets into money that the federal government has no control over.

It was a wake-up call for me, to realize how little of my money was actual money. I'm being forced to trust people (the government, the banks) whom I consider to be fundamentally incompetent and rather stupid for my own wellbeing. That doesn't sit well.

*NOTE: I am not by any means a financial expert, so if I have made a mistake in the essay above, I'd appreciate it if the brainy Morons would put me some knowledge.

Links on what money is, and how we got where we are:
Bretton Woods
"The Nixon Shock"
Fiat Money
Hard Currency
Commodity Money
Legal Tender
Governments and Money

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posted by Monty at 01:19 PM

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