|July 26, 2013
Kiev, UkraineOver the past several decades, people around the world have become so brainwashed that few people really give much thought anymore to the safety of their currency.
It’s not something people really understand… there’s apparently some Wizard of Oz type figure at the top of the hill pulling all the levers of the monetary system. And we just trust them to be good guys.
This is partially true. Today’s financial system is dominated by central bankers who have been awarded nearly dictatorial control of global money supply.
In allowing them to set interest rates, they are able to control the ‘price’ of money, thus controlling the price of… everything.
This power rests primarily in the hands of four men who control roughly 75% of the entire world money supply:
- Zhou Xiaochuan, People’s Bank of China
- Mario Draghi, European Central Bank
- Haruhiko Kuroda, Bank of Japan
- Ben Bernanke, US Federal Reserve
Four guys. And they control the livelihoods of billions of people around the world.
So, how are they doing?
We could wax philosophically about the dangers of fiat currency. Or the dangers of the rapid expansion of their balance sheets. Or the profligacy of wanton debasement through quantitative easing.
But let’s just look at the numbers.
In theory, a central bank is like any other bank. It has income and expenses, assets and liabilities.
For a central bank, assets are typically securities or commodities which have value in the international marketplace, such as gold or US Treasuries.
Central bank liabilities are all the trillions of currency units floating around… dollars, euros, yen, etc.
The difference between assets and liabilities is the bank’s equity (or capital). And this is an important figure, because the higher the capital, the healthier the bank.
Lehman Brothers famously went under in 2008 because they had insufficient capital. They had assets of $691 billion, and equity of just $22 billion… about 3%.
This meant that if Lehman’s assets lost more than 3% of their value, the company wouldn’t have sufficient cushion, and they would go under.
This is exactly what happened. Their assets tanked and the company failed.
So let’s apply the same yardstick to central banks and see how ‘safe’ they really are:
– US Federal Reserve: $54 billion in capital on $3.57 trillion in assets, roughly 1.53%. This is actually less than the 1.875% capital they had in December. So the trend is getting worse.
- European Central Bank: 3.69%
- Bank of Japan: 1.92%
- Bank of England: 0.843%
- Bank of Canada: 0.532%
Each of these major central banks in ‘rich’ Western countries is essentially at, or below, the level of capital that Lehman Brothers had when they went under.
What does this mean?
Think about Lehman again. When Lehman’s equity was wiped out, it caused a huge crisis. The company’s liabilities instantly lost value, and almost everyone who was a counterparty to Lehman Brothers lost a lot of money because the company could no longer pay its debts.
Accordingly, if the US Federal Reserve’s assets unexpectedly lose more than 1.5% of their value, the Fed’s equity would be wiped out. This means that any counterparty holding the Fed’s liabilities (i.e. Federal reserve notes) would lose.
More specifically, that means everyone holding dollars.
Theoretically if a central bank becomes insolvent, it can be bailed out. It happened in Iceland a few years ago.
There’s just one problem with that thinking.
Iceland’s government wasn’t in debt at the time. So they were able to borrow money in order to bail out their central bank. Today the government is in debt over 100% of GDP, but the central bank is solvent.
But governments in the US, Europe, Japan, England, etc. are all too broke to bail out their central banks. These governments are already insolvent. So if the central bank becomes insolvent, there won’t be anyone to bail them out.
This is one of the strongest indicators of all that the financial system as we know it is finished. When central banks can no longer credibly issue liabilities, and their home government are too broke to bail them out, this paper currency standard can no longer function.
Such data really underscores the importance of owning real assets such as productive land and precious metals.
Given its nominal roller coaster ride lately, there has certainly been a lot of scrutiny and skepticism about gold.
But to paraphrase Tony Deden of Edelweiss Holdings, if you dispute the validity of gold as a hedge against declining fiat currency, that makes you, by default, a paper bug. Can you really afford to be confident in this system?
[To be continued on Monday… when I’ll give you some even more surprising numbers.]
Monday’s continuation below: MF
July 29, 2013
Here’s a question– if you’re in the Land of the Free, do you think those green pieces of paper in your wallet are dollars?
They’re not. A US dollar was defined by the Coinage Act of 1792 as 416 grains of standard silver.
No, those green pieces of paper are Federal Reserve notes. “Notes” in this case meaning liabilities to the central bank of the United States.
That makes you, me, and anyone else holding those green pieces of paper essentially creditors of the Federal Reserve, whether we signed up for it or not.
As we explored on Friday, the Fed is theoretically like any other business. On one side of its balance sheet, it has assets. On the other side, it has liabilities.
The Fed is unique, though, in that its liabilities– namely Federal Reserve Notes– are passed off as money in the Land of the Free.
And they have a legal monopoly in this money business. Just ask Bernard von NotHaus, the founder of Liberty Dollar who was labeled a domestic terrorist and convicted for minting silver coins to be used as a competing money.
Moreover, the Fed has the ability to increase its liabilities at will. Mr. Bernanke can conjure additional Federal Reserve notes out of thin air and pump them into the system.
And at this point, thanks to a long-standing policy of wanton money printing, the Fed has more liabilities than ever before in its history. By an enormous margin.
This precarious balance sheet is dangerous, because if the Fed goes bust, everyone loses.
Is it even possible for a central bank to go bust? Definitely. Zimbabwe and Tajikistan are infamous examples.
And most recently it happened in Iceland. The banking system there collapsed from being so highly leveraged, and Iceland’s central bank suffered tremendous losses.
The end result was insolvency, and the central bank’s liabilities, i.e. the Icelandic kronor, went into freefall, losing 60% against the dollar and euro in a matter of days.
So yes, it does happen. And the consequences are devastating.
But how likely is it that the Fed could go bust?
In its most recently published balance sheet, the Fed listed assets valued at $3.5 trillion.
Most of this is US Treasuries and ‘agency’ debt securities. You probably remember those– the toxic mortgage debt that blew up a few years ago like Fannie Mae and Freddie Mac. Not exactly low risk.
Meanwhile, the Fed has become one of the biggest creditors of the United States government… which has managed to accumulate more debt than any government in the history of the world.
Of course, the only way the US government can pay interest to the Fed is by going into even more debt (which the Fed then has to buy).
Every time this happens, the Fed’s already razor-thin capital gets smaller and smaller, and the Fed’s balance sheet becomes riskier and riskier.
In fact, the Fed’s capital ratio (1.53%) is lower than Lehman Brothers when they went bankrupt in 2008.
But what happens if the Fed becomes insolvent?
In the case of Iceland, the government bailed out its central bank.
Iceland’s government went from being essentially debt free to having debts in excess of 100% of the country’s GDP, just to bail out the bank.
But the US, Japan, and Europe are already too indebted to bail out their central banks. An insolvent government cannot bail out an insolvent central bank.
The IMF is not an option either. The US, EU, Japan, etc. make up roughly half of the IMF capital quota– these are the countries who fund the IMF, not the other way around.
There really is no backstop for the Fed. The buck, so to speak, stops here. And with a capital ratio of just 1.53%, the Fed’s balance sheet is already in precarious financial condition.
Given that the Fed’s assets are so closely tied to the finances of the US government, the outlook should concern independent, thinking people.
If they go bust, the value of Federal Reserve notes (i.e. ‘dollars’) is going to plummet… along with the paper wealth of anyone holding them.
Senior Editor, Sovereign Man