Money And Collateral
Roasted Barley Is No Substitute For Coffee!
In previous posts, I’ve discussed the workings of a gold standard and how that contrasts to today’s fiat currency system. The role of gold in the monetary system continues to be a frequent topic in political discourse, and recently there has been renewed talk regarding what to do with the American government’s stockpile of gold, a leftover from the days when the world still had a semblance of a gold standard.
The US government’s stock of gold currently sits at over 8000 metric tonnes. This is largely a relic of the pre-1971 era when the US dollar was redeemable for gold, at least for a limited number of parties, at a fixed rate. Until 1973, that rate was set at $42 per ounce. Of course, US dollar bank notes can no longer be redeemed for any of this gold. The gold sits in a storage vault, not earning any interest, marked to the federal government’s balance sheet at the 1973 value. That’s around $11 billion. Since 1973, of course, the dollar price of that gold has risen considerably. At the time of this writing, it sits at $4300 per ounce. Valuing the gold stock at current market prices would see the total value rise to well over $1 trillion. This escalation in the dollar price has led some to suggest that the government ought to do something with this capital gain. They have suggested that the gold stock ought to be “monetized”.
A Financial Post article from almost a year ago illustrates the basics of the framework for monetization:
“The speculation centres around the idea that the U.S. Treasury could re-peg its gold holdings at a higher level, a move that would generate quick cash for a government eager to run more efficiently. In summary: The U.S. government should revalue its gold reserves from the US$42-an-ounce set in 1973 to current prices, allowing the Treasury Department to monetize the sudden balance-sheet boost of about US$750 billion, thereby reducing the need to issue bonds.”1
When I first heard of this proposal a question immediately popped into my head: if revaluing the gold stock can essentially create “found money” which can then facilitate even more borrowing, why hasn’t this already been done? It’s as if an individual inherited a valuable property years ago but never bothered to either use it to generate income or sell it for a capital gain, the proceeds of which they might happily consume. But while the idea of “monetization” seems to offer an “easy out” for at least some of the Treasury’s budget problems, this analogy fails to accurately describe the status of the Treasury’s gold stock.
The main reason that no one ever revalued gold is straightforward enough: creditors to the US government already implicitly value the gold on the government’s balance sheet at current market value. Making this value explicit at this point amounts to a bookkeeping change and nothing more. It would have no effect on the US government’s financial situation, much less on the fiat monetary system itself.
If an individual inherited a property worth $100,000 ten years ago that is now worth $1 million but never bothered to update that value on their personal balance sheet, they might believe that their net worth is only $100,000. In reality, with a correct balance sheet, it’s actually $1 million. But suppose they had found a creditor willing to lend not against their inaccurate, undersized balance sheet, but against a balance sheet developed by the creditor that correctly reflected the value of the property. Over this ten year period, suppose they had borrowed $500,000. Certainly, there’s some self-deception involved here, since the individual might erroneously think their creditors are a gullible bunch. In reality, they are simply confused about their net worth, which is actually $400,000 to the positive, not negative $400,000. But if the creditors can legally repossess the asset in the event of default, they won’t have a problem with the size of the loan. It is easily covered by the value of the asset.
To carry on with the example, suppose that one day the property owner finally realized the error and corrected the balance sheet value to $1 million. Suppose that they then went to their creditors and asked for a $750,000 loan. Imagine their surprise when it was refused, since the addition of that debt to the $400,000 already owed would render them instantly insolvent.
This example illustrates the absurdity of the proposal that the Treasury can unlock over a trillion dollars of capital, and borrow against it, by correcting a bookkeeping error. That might work if the Treasury had not undertaken to rack up $36 trillion in debt in the period since 1973, but that’s clearly not the case today. Simply put, the gold stock has already been borrowed against. Creditors have lent this sum of money to the US government with the knowledge that the gold stock is already implicitly underpinning the debt, even though today it can only underpin a small portion of it.
In an earlier post, I discussed why the fiat monetary system does not simply implode given that it is notoriously unstable, based as it is on the widespread extension of credit to parties with neither the means nor the intent to repay. The basic reason is that there is, as yet, a substantial quantity of implicit value within the fiat monetary system. Fiat is underpinned by entrepreneurs laboring relentlessly, for a continually declining rate of return, to create goods and services which have tangible, measurable value and for which actual consumer demand exists. Those same entrepreneurs also possess massive, incredibly productive capital assets found all over the world which also have measurable, tangible value. These productive assets thus far provide sufficient tax revenue for governments, at least in the industrialized world, to at least service their debts. Default, while a looming problem for many peripheral economies, is nowhere near being imminent for the large industrial economies, particularly so for the US government.
The state itself, as massive as it is in nearly every country, also possesses tangible assets with tremendous measurable and transparent value. The US government, for instance, owns vast tracts of land all over the United States. Governments at all levels own innumerable office building, airports, port facilities and recreational properties which have recognizable and acknowledged market value. That includes the gold currently possessed by the Treasury.
To say that the currency relationships in a fiat system are underpinned by tangible, measurable assets is not to say, however, that they are redeemable for money. The fiat monetary system has no money in it; there exists no possibility of ending a credit relationship with redemption for a tangible commodity such as gold. Fiat is not only based on credit, but mandatory credit. Everyone who holds a bank note is, ultimately, a creditor to the central bank. Not only that, you are an unsecured creditor. You hold no title to any government assets that might be repossessed as would be the case in a normal credit relationship. Mandatory credit is a perpetual loop in which prior credit relationships cannot be ended but instead must be rolled by issuing new bonds sufficient to cover previous interest and principle. Productivity gains coupled with ongoing declines in the cost of credit have enabled producers, for the most part, to stay ahead of the debt curve. But that debt curve is rising exponentially and entrepreneurs can never hope to win that race. There exists a continuous battle between debtors struggling to create sufficient collateral to service the debt and governments engaging in activities that impair or even destroy the same collateral. Even if the government did nothing to impair collateral, the rise in debt will eventually overwhelm all creditors; it’s merely a question of when.
To the extent that a fiat monetary system functions at all is obviously not due to being comprised of assets which are redeemable for money (gold) or which could be legally repossessed by creditors. Rather the fiat system is implicitly and informally underpinned by collateral with measurable, transparent value. This underpinning is not without grief, however. The foundation of a fiat system is more like sand as opposed to concrete. Crises in the financial system occur whenever the debt load exceeds the value of the collateral or when the collateral is impaired rendering it incapable of adequately servicing the debt. In extreme cases, collapse occurs when collateral is severed completely from the monetary system.
The most common type of crisis is a budgetary one where governments find that their debt service costs become overwhelming. Such budgetary crises have affected, and continue to periodically affect, all industrialized economies. The response to these crises is most often to shift some of the state collateral into private hands by means of the sale of state-owned enterprises. If the productivity of these entities can be sufficiently improved, this may restore the value of the collateral. Creditors in the fiat system (that is to say, anyone who holds even so much as a few banknotes) know that the government has effective control over valuable assets that it could hand over to creditors if need be. It’s not the case that the government must hand over the assets to creditors, but there is often an understanding that this could be the case. If a government ever made it clear that this could never be the case, no fiat monetary system would withstand that assault for long.
History is filled with examples of fiat economies in which the value of an economy’s collateral collapsed to near zero, with a recent example being Zimbabwe. Contrary to popular belief, that nation’s economic collapse was not simply a result of “printing” too much money. The country’s monetary system was massively underpinned by a well capitalized and highly productive commercial farming sector. For decades, the agricultural sector was able to generate sufficient tax revenue to allow the government to at least service its rapidly growing debt. When that industry was effectively taken over by squatters after 2000, the monetary system collapsed because most of the collateral had not just been impaired, but rendered non-existent. Farmers who were evicted from their land without a cent of compensation were denied the means to generate any income to service their debts. Because the land was in the possession of squatters, the value of the title deeds which supported the debts of the commercial farmers suddenly became worthless. With underlying assets stripped of any value, hyperinflation was the natural result as the currency finally came to be backed literally by nothing.
Shifted, But Not Extinguished
Collateral plays a crucial role in a gold standard as it provides the necessary security for the extension of credit. If a borrower defaults, the lender can repossess the asset that was pledged as security. This asset, in turn, can be redeemed for money. At this point, the prior credit relationship is removed from the balance sheet of the lender and any debt is extinguished through this act. In gold standard, no one would claim that loan collateral is money. A house pledged as security would not be considered the most marketable commodity with a high degree of utility. There is enormous friction involved in owning a house (upkeep, repairs, finding a renter); if a lender’s goal was to own a house, the lender would have purchased it outright instead of loaning the funds to someone else and then going through the trouble of repossession. Collateral is not money, and money is not collateral. Bonds in a gold standard can be redeemed for money; collateral in a fiat system cannot. A monetary system which tries to treat collateral as if it were money, while it might function in a progressively ineffective manner for decades, will inevitably be consumed by transactional friction.
To illustrate the previous point, even if a bankrupt government offered up range land in Wyoming as payment to a creditor, the creditor would be saddled with transaction costs and a burden of asset service that he would unlikely care for. Few creditors would be particularly thrilled with ownership of a sheep ranch, as a sheep ranch is a far cry from the most marketable commodity with a highest degree of utility. More critically, a government swapping physical assets (even gold in a treasury vault) for treasury bonds has no means of extinguishing the debt burden created by those bonds. The bonds will continue to circulate as if there had never been a budgetary crisis to begin with. The new owner of the sheep ranch will inevitably have to sell sheep for the same fiat bonds that he handed over to the state mere moments ago as purchaser of the ranch; he once again becomes a creditor to the same treasury that previously confessed its inability to manage its debt load. For that reason, reductions in spending, the sale of state assets and even a sharp drop in the rate of interest do not fundamentally alter the mechanics by which the fiat debt burden must grow exponentially; at most, such efforts buy time by postponing, but not eliminating, the possibility of the collapse of the fiat system.
It’s not merely the socialist camp which fails to understand the nature of fiat; this is also true for a large number of otherwise free marketers who constantly confuse money with credit. The fiat currency system is, at root, a chaotic and unstable approximation of a monetary system based on gold and sound credit. It has some of the peripheral characteristics of a gold standard, but none of the fundamental advantages. A fiat system approximates a gold standard about as well as roasted barley approximates coffee.
Wall Street Talk of Revaluing US Gold Isn’t Persuading White House; Financial Post, February 14, 2025