Government Money or Sound Money

September 22, 2008 – The term ‘government money’ has been bandied about a lot in recent weeks. It is being portrayed as a near miraculous elixir with wonderful results when used for bailouts past, present and future. But government money comes with limitations. It is not a magic potion, and cannot cure all the ills of the financial system. More importantly, it is not even money at all – it’s debt.

Before the invention of the printing press and more recently, the computer, money was a tangible asset. In ancient times, it was something one raised, like cattle. Eventually money became something that was mined, namely gold and silver. But central banking changed the essential nature of money, or to be more precise, what we use as currency. The tangible assets, i.e., gold and silver coin, remained in the central bank’s vault, and instead a piece of paper called a “banknote” circulated as currency in their place. Because of government legislation, gold and silver coin were eventually supplanted by bank paper currency and other forms of bank currency, namely, deposits that circulate by check, wire transfer and a plastic card.

Money became a bookkeeping entry on a bank’s balance sheet, which today is simply a computer record. This so-called ‘money’ is not money at all in any historical or genuine sense, namely, a tangible asset. Rather, it is a liability of a bank. It is a debt, which means it has counterparty risk and therefore is fundamentally different from gold and silver because tangible assets do not have counterparty risk. The value of this new and modern money is entirely dependent upon the quality of the bank’s assets, which no longer are gold and silver sitting safe and secure in a vault.

Bank assets have devolved and today are the loans they make to individuals, companies and of course, governments. The aggregate value of these loans is shrinking. They are becoming worth less, which explains why banks today are in deep trouble. In short, debtors are walking away from their debts. Too many loans were made to people who could not repay them.

Even where banks have security as collateral for their loan, the value of this security is less than the loan value in many cases. Too many loans were made against overvalued real estate, and in some cases were 120% of an already overvalued house price.

The Mortgage Bankers Association has reported that the inventory of homes now in foreclosure or late on payments is 9.2%, the latest in a string of new records. It is a staggering statistic. Loan payments are not being met on about 1 of 11 houses that have a mortgage, which is about 2/3rds of the homes in the United States.

What are these houses with defaulted mortgages worth? No one really knows. It is just one of the problems with which banks are struggling. To illustrate the problem, consider the balance sheet of Lehman Brothers before it filed for bankruptcy.

Its latest quarterly balance sheet reported to the SEC shows that Lehman had $613 billion of liabilities and $26 billion of equity. This high leverage made it vulnerable to a diminution in the value of its assets, which according to Barron’s includes “$45 billion of troublesome real-estate assets”. Lehman is of course now bankrupt. Lehman’s liabilities are greater than its assets after taking a ‘haircut’ to assets to reflect its bad loans. This haircut is greater than its $26 billion of capital. Is this valuation of its assets realistic, too pessimistic or more ominously, too optimistic?

Well, answering that question is the crux of the problem with today’s financial system. No one knows the true value of Lehman’s assets, probably not even Lehman itself, which is the fundamental problem with ‘money’ today. When the dollar was on a gold standard, there was no uncertainty about its value. It was worth the stated weight of gold, and could be redeemed for that weight of gold upon demand.

Lehman is of course an investment bank, so its liabilities do not circulate as currency. That privilege is given only to commercial banks, but most commercial banks are in the same predicament as Lehman. Their liabilities that circulate as currency are only as good as the assets that back them. Those assets no longer are gold and silver. They are loans, many of which are dependent upon housing.

The value of bank assets today is based on promises, and as we are now seeing, promises are often broken. Many mortgage loans are not worth the paper they are written on. The result is that there are gaping ‘black holes’ on the asset side of bank balance sheets, just like there were during the Great Depression. Therefore, the liabilities backed by these worthless assets are worthless too. Consequently, it is reasonable to conclude, even though bank financial statements are opaque, that the liabilities of many banks are probably greater than the value of their assets. How big is this ‘black hole’ in the banking system?

According to a September 20th report by Associated Press: “The Bush administration is asking Congress to let the government buy $700 billion in toxic mortgages in the largest financial bailout since the Great Depression.” I’m not sure why they say “since the Great Depression” because the magnitude of this bailout far exceeds the largesse the feds bestowed on the banks back then.

The Associated Press report goes on to say: “The plan would give the government broad power to buy the bad debt of any U.S. financial institution for the next two years. It would raise the statutory limit on the national debt from $10.6 trillion to $11.3 trillion to make room for the massive rescue. The proposal does not specify what the government would get in return from financial companies for the federal assistance.”

No one can doubt any longer that the United States is run totally for the benefit of the banks. They get whatever they want. Secretary Paulson even brought out the old bromide to justify this pillaging of American taxpayers: “The financial security of all Americans…depends on our ability to restore our financial institutions to a sound footing.”

Note the use of the communistic “our” in Paulson’s quote. It’s not “our financial institutions”. I don’t own any bank stock, nor do most Americans. What’s more, it’s not the “financial security of all Americans” that is at stake here.

There are countless Americans who have been making the right financial decisions. They are prudent and have been saving for that proverbial rainy day. They are the 1/3rd of homeowners who do not have a mortgage and the vast majority of those homeowners with a mortgage who did not recklessly overextend their financial capacity with too much debt. They are also the renters who have refused to enter into reckless deals offered by the banks. Isn’t this vast majority of Americans more important than a few banks and their shareholders who know how to pull strings in Washington? Who is pulling the strings there for everyone who knows how to live prudently and within their financial means?

Unfortunately, no one, not even elected representatives. Too many of them have been bought by the banks with favors and political ‘donations’.

These unfortunate circumstances are not new. They have been around for decades and well recognized by many. For example, they are what Rep. Howard Buffett, father of famed investor Warren Buffett, railed about in a famous speech in 1948. Here’s what Rep. Buffett had to say about President Roosevelt’s dictate that ended in 1933. The ability to redeem dollars for gold and the impact it had on the American taxpayer.

“Before 1933 the people themselves had an effective way to demand economy [from politicians]. Before 1933, whenever the people became disturbed over federal spending, they could redeem their paper currency in gold, and wait for common sense to return to Washington. That happened on various occasions and conditions sometimes became strained, but nothing occurred like the ultimate consequences of paper money inflation.

When the people’s right to restrain public spending by demanding gold coin was taken away from them, the automatic flow of strength from the grass-roots to enforce economy in Washington was disconnected.

With a restoration of the gold standard, Congress would have to again resist handouts. If Congress seemed receptive to reckless spending schemes, depositors’ demands over the country for gold would soon become serious. That alarm in turn would quickly be reflected in the halls of Congress. The legislators would learn from the banks back home and from the Treasury officials that confidence in the Treasury was endangered.

Congress would be forced to confront spending demands with firmness. “The gold standard acted as a silent watchdog to prevent unlimited public spending.” Very well said, and without that silent watchdog speaking for the vast majority of Americans who live within their financial means, the vested interests will run roughshod over Washington. And the worst of the lot is the banking lobby.

Fortunately, we have a choice today not available in 1948 when Rep. Buffett spoke so eloquently to explain the problem Americans faced then and now. Americans can own gold and silver, which was outlawed by government dictate from 1933 to 1974. Americans can vote with their bank account, by avoiding as much as practical the dollar and instead holding gold and silver as their primary money and liquidity.

Rep. Buffett concluded his 1948 speech with some brilliant insight that still rings true today. The “connection between money, redeemable in Gold, and the rare prize known as liberty” is irrefutable because “In a free country the monetary unit rests upon a fixed foundation of gold or silver independent of the ruling politicians” and is “redeemable for a certain weight of gold, at the free option and choice of the holder of paper money.”

The choice is clear. Paper money or gold. Do you want to hold government money or sound money?