Some restaurants have a sign above the cash register that reads: “In God We Trust. All Others Pay Cash.” The question is, can you trust the cash?
Once upon a time, U.S. dollars were backed by gold and silver. The U.S. Treasury held gold and silver in its vaults, and then printed Treasury Certificates. For example, from 1878 until 1964 the U.S. Treasury issued Silver Certificates like the Five Dollar Certificate shown above.
Printed on the front is this inscription:
THIS CERTIFIES THAT THERE IS ON DEPOSIT IN THE TREASURY OF
THE UNITED STATES OF AMERICA
FIVE DOLLARS
IN SILVER PAYABLE TO THE BEARER ON DEMAND
Yes, believe it or not, before 1964 you could present a five-dollar bill to the U.S. Treasury and get $5 in actual silver metal.
Fiat Currency
Now open up your wallet and take out a five-dollar bill. Actually any denomination bill will do. At the very top it says FEDERAL RESERVE NOTE. Notice first of all that it is not issued by the U.S. Treasury, but by the Federal Reserve. Also notice that no where does it certify that there is any silver or gold on deposit for which you can exchange the note. However, on the the front of the note there is this inscription:
THIS NOTE IS LEGAL TENDER
FOR ALL DEBTS PUBLIC AND PRIVATE
The Federal Reserve, a.k.a The Fed, is charged with creating all the U.S. Dollars that are in existence. This is fiat currency. Fiat is from Latin for “Let it be done.” The words “legal tender for all debts public and private” means you can legally settle your debts using this money. Rather than having value because it is backed up by gold or silver, it is decreed to be money by government fiat.
How Does The Fed Create Money?
First, think how it was created in the past when money was backed by gold. The United States Treasury would have to somehow acquire actual metallic gold which it would store in a big vault, like the one at Fort Knox, Kentucky. Then the Treasury would either mint coins with the gold, or print paper money that represent gold in the vault. The amount of money they could mint or print was limited to the amount of gold they held in their gold reserves.
Today money creation is much simpler. It is created by the Fed out of thin air. Yes, that’s right, out of thin air. The benefit of fiat money is they can produce as much money as is needed, whenever its needed. Whenever the Fed wants to create new money, they buy debt securities from the U.S. Treasury like T-bills, Treasury notes or Treasury bonds. Treasuries are I.O.U.’s from the U.S. government that pay interest. In essence, the Federal Reserve gives cash money to the U.S. Treasury and gets back IOUs.
To pay for these securities, the Fed writes a check just like you or I would write a check. But unlike you and me, the Fed doesn’t have money in their checking account to cover the check. For each check they write, new money is created. Wouldn’t it be nice to have a checking account like that? (I have heard of NOW accounts. That would be a WOW account!) You could just keep buying and buying and never overdraw your account. Well it turns out that is exactly what the Fed has been doing for the past couple of years since the economic crisis began.
Here’s a chart from the Federal Reserve that shows how much they hold in various kinds of government securities:
On 12/26/2007 the Fed held $755 Billion in securities. As this article is being written in January 2008 the balance is over $1,845 billion, 2.44 times as much. It is clear that the Federal Reserve has been creating a lot of money to during this crisis.
Exactly what kind of securities does the Fed hold? This chart shows the breakdown:
The biggest chunk of securites are U.S. Treasuries. But clearly the big increase has been in mortgaged-backed securities. On Jan 7, 2009 the Fed held no mortgaged-backed securities. Since then they have purchased $908 billion dollars worth. They have also purchase $160 billion worth of federal agency debt. Together, that is over a trillion dollars of new debt securities added to the Fed’s balance sheet. Many people would call these newly acquired debt securities “toxic assets”. It is possible that much of that debt will not be repaid, so those securities may be only worth pennies on the dollar.
On thing the Fed has been trying to accomplish is to keep mortgage interest rates down so that when millions of Adjustable-Rate Mortgages (ARMs) reset in 2010, 2011 and 2012 the rates will be low. They hope to stem the tide of foreclosures and keep the housing market from collapsing further. Currently, 30-year fixed-rate mortgages are 5.29% (4.97% 1-month ago). These are historically low rates which are artificially being held down by the extraordinary actions of the Fed.
What are the consequences of these unprecedented Fed actions? Nobody really knows, but there must be consequences. If you pay a trillion dollars for assets that end up being worthless, somebody has to take the loss. Ultimately somehow U.S. citizens and taxpayers will be on the hook. Unless there is a way to stick it to foreigners!
