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When is a Reserve Not a Reserve?
by Professor von Braun
June 19th, 2006
Market commentary of recent times is getting more amusing as both bulls and bears try to promote, by way of explanation, their various viewpoints. Every move up or down in either stocks or commodities or housing sets off a chorus of "it's topped out" or "we are off to new highs". Usually accompanying this chorus is the statement 'I told you so!'
Human nature being what it is we all are either bulls or bears, as in positive on something and/or negative on something else. Sometimes we forget that to be bullish on one thing we need to be bearish on something else. We are warned by various commentators & economists that there is either too much debt, or not enough credit, or rising commodity prices are hurting manufacturers, or the currency is too strong or too weak, or the prospect of deflation, or inflation, or even hyperinflation may be upon us. Then we get the interest rate line -- as in they need to be raised, lowered, left unchanged or whatever.
We also hear that if the housing market collapses it's all over for the consumer as there will be no money available for them to spend -- no home equity left to extract -- which will impact on various new order manufacturing bases around the planet. China of course gets a mention as do other lower cost producers such as Korea, Thailand, and so on. Meanwhile the IMF, an organization well past its user date, has, with a little bit of help from the US, appointed itself as the monetary policeman of the world's banking systems.
Various G7, G8, G9 or G10 finance ministers continue to meet in secluded settings at various locations, as do central bankers from time to time, discussing matters of money; obviously a subject dear to their hearts, but do they really understand their predicament?
In a recent piece entitled The Mark of the Bust by Martin Mayer published in the NY Times, 6/17/06, (www.nytimes.com) Mr. Mayer references the rise in the numbers of the quantity of US government and agency securities held "for foreign official and international accounts" (that is, for foreign central banks and finance ministries) to $1.63 trillion by the Federal Reserve banks. He concludes that this increase is troublesome by virtue of the fact that foreign private investors see fewer attractive places to put their export earned US $'s back into the US economy.
Instead they are selling these dollars back to their respective central bank's that have no option other than to deposit these with the Federal Reserve acting as custodian. These funds are used to buy the aforementioned US government and agency securities. These agencies include of course Freddie Mac and Fannie Mae. Fanny 'may' do what? - one could well ask but that is another story. Their paper is federally guaranteed and currently about $500 billion of the reported $1.63 trillion held is invested in 'agency securities'. (Some time ago I wrote an article about real estate and pointed out that for a transaction to take place there needs to be both a house buyer and there also needed to be willing lender and I wondered at the time who was indirectly bankrolling the current housing boom.)
We also hear, repeatedly, from 'official' and 'semi-official' sources that the record trade deficit is not a problem and there is a certain degree of truth to that statement depending of course on who said it and where it was said.
Certainly the deficit is not directly a major concern for the US, rather it's more of a problem for those Central Banks that are holding US dollar denominated reserves, which is most of the world's banking systems.
This issue would not be the problem it is today if the US had not closed the gold window back in August of 1971, when surplus central-bank-held US dollars could, up until that time, be redeemed for gold. The original idea, adopted at the Bretton Woods conference in 1944, of the US dollar being the world's reserve currency was that the dollar was as good as gold and it was redeemable by other central banks at a fixed price, which was $35.00 per ounce.
The European countries increased their gold holdings through the 1950's and 60's by redeeming dollars for gold, accumulating a collective 12,000 tonne and leaving the US with about 8,000 tonne.
Today, some 35 years later we have Central Banks holding previously unheard of amounts of US government and agency securities which are not redeemable for anything at all. We also have the IMF telling these CB's that they need to buy more. Well you are damned right they do because their 'reserves' are not really reserves at all and the only place the CB's can put them is into US government paper. Yes there are quasi- alternatives and yes, US dollars can be purchased from the CB's by private and corporate investors and used for making purchases within the US, or they can be used to pay for oil imports but they can not 'officially' be exchanged for gold. At current gold prices (cash $578.00) to convert the $1.63 trillion 'promises to pay' (i.e., to settle the transaction and remove the obligation) held on behalf of 'foreign' central banks and finance ministries by the Federal Reserve would require 2.75 billion ounces [85,500 tonnes] of gold. Now depending on whose numbers you take as being factual, the US treasury may have left about one-tenth of this, and it is not currently for sale.
The trade deficit continues to this day, reported on in some circles as an extreme willingness by foreigners to lend the US money when the truth of the matter may well be that they, those pesky foreigners, have no choice, other than to continue the charade. All they can hold is debt of the issuer since, as previously mentioned from 1971, the dollar has been a non-redeemable debt instrument, albeit one that is still widely accepted, without of course the obligation it carried when it was appointed, at the suggestion originally of the British, the world's reserve currency.
So what's missing from this picture? We have all heard the bearish case for paper assets and some of us have heard the bullish case for hard assets, some of us have even acted on it and have accumulated gold and silver positions, but there appears to be a shortage so far of raging bear markets. Yes, the NASDAQ topped out in 2000; yes, the housing market looks like its topped out; yes, the commodity markets look like they have topped out, and so on. The speculators keep speculating,, the hedge funds keep hedging, or is it 'a-maze-ing' and the dollar appears to be holding its own -- well sort of.
We have yet to hear a clear description of what the economic/financial/monetary 'problem' actually is and who exactly is the holder of said unidentified problem. Now this is not surprising since the creators of whatever the problem actually is are not going to tell you that their creation is the problem. Nor are the willing holders of the problem going to admit to their mistake either, not yet anyway. After all, the Marshal (in the form of the IMF) may come riding into town and give them a lecture on correct monetary policy.
I suspect that by now some of the owners of these central banks are beginning to see that their banking systems have been compromised in the sense that they now hold 'reserves' that they have no control over and that they can't spend/redeem/get rid of. Instead, they must hold ad infinitum, and what's even more interesting is they must continue to hold more and more of them.
Now how will this 'problem' play out? If foreign non-government institutions and individual investors can not find 'worthy' investments in the United States and are swapping their US dollars for their respective local currencies and either investing the proceeds or leaving funds on deposit, how does this impact the US economy? Does this point to deflation, inflation or hyperinflation or none of the above? What do you get when you have a non-redeemable currency as the world's premier reserve held by central banks everywhere that not everybody wants? What do they spend it on? What do they swap it for?
Does the real estate market get a final lift to higher levels as foreign CB's look for higher returns via the GSE's? Do the US stock markets continue their decline as foreign capital leaves? Ah but it can't leave as it will end up in the hands of their respective CB's and come back to the US. That leaves the bond market which could see increased buying and lower interest rates on T-Bills, something I suspect will be troublesome for Mr. Bernanke.
Back in the seventies the US at least had a trade advantage with a strong manufacturing base and products that people and companies in other countries wanted. Now, however, the main export appears to be paper, and not very good paper at that.
Now I would have to think that two things might happen here, the first being that the smart 'smart' money is accumulating the metals while the CB's are trying to keep the gold market under control, and there could be an event that spooks the CB's which could lead them to sell some of the 'official and international accounts' that are holding the likes of Fannie Mae & Freddie Mac paper.
Additional investment funds could flow out of the US markets into the hands of the foreign central banks and they would become an even bigger contributor to the current $1.63 trillion of 'official' holdings most likely in T-bills.
I suspect that some of it could end up in the metals market and that's when the potential for a meltdown begins. The US Government seemed to get rather friendly with Iran once it became known that Iran was both buying gold and considering pricing oil in Euros. If Iranian oil began to be settled in Euros then there is even less reason to hold dollars, which could either free up or compromise more CB US-dollar-denominated reserves.
Back in the 1970's there were non-specific predictions made by some very fine economists and bankers about the dangers of this 'new' type of monetary system, (not the least being the non-accountability aspect of the issuer,) but only a few mentioned the non-redeemability aspect as being the greatest danger for all participants other than the originator. I guess we are about to find out what that actually means.
For additional information and some interesting reading on this subject matter visit www.cmre.org.
The Prof can be contacted by email at email@example.com
Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.
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