Most of the things we use every day like computers, cellphones and so on, we have a least some cursory knowledge of. We know not only how to use them, but maybe even where, how and by whom they are made. Even some respected producers of gold bullion like the US Mint are relatively well known, including among people who don’t own gold. It is astonishing then how little we know about the creation of something that we use every day, that we couldn’t live without, money.
Have you ever thought about how money is actually created? I don’t mean the technical process of printing paper money but the inner workings in the financial sector that result in the creation of ‘new’ money. Understanding the answer to this question becomes even more important as we live in times of growing inequalities, an exploding national debt and continuous budget deficits.
The last time that America had a balanced budget was in 2001. Continuous budget deficits since then have let our national debt balloon to a staggering 18.6 trillion Dollars. That is almost 58.000 Dollars per US citizen. Our generation alone won’t be able to pay back this mountain of debt. American children and grandchildren that are not even born yet will still bear this heavy burden.
Yet do you see a chance for a Democratic or Republican presidential candidate to get elected this year on a platform of austerity? Unlike Greece that has been forced to adopt strict austerity measures by the European Union, American governments will likely continue to spend more than they earn for the foreseeable future. Whoever wins the upcoming presidential election in 2016, he or she will be elected on a platform of promises to provide this or that benefit to the public.
The democratic presidential candidate Hillary Clinton, for example, talks about paid family leave and universal access to preschool for all of America’s children in her campaign. If she was elected, how would these new programs be paid for? The Department of the Treasury is in charge of managing government revenue. Since government expenditure exceeds government revenue, the treasury will raise new capital by issuing treasury securities.
There are various types of treasury securities, for example treasury bonds, treasury bills, treasury notes and so on. To make it really easy to understand, let’s just say that these various U.S. treasury securities are promises by our government to pay the buyer of the security annual interest until the maturity date (final date of a financial instrument) at which time the principal (the price of the financial instrument) will be paid back as well. So basically, when the American government is selling treasury securities, it is borrowing money that can be spent today, but that will have to be paid back in the future. Treasury securities are sold at an auction.
Even though individual investors can participate in such an auction, most securities are sold to institutional investors. These institutional investors are banks, insurance companies, pension funds, other government institutions, foreign national banks and so on. It is interesting to note that Social Security owns the largest amount of US securities, so one government agency owns most of our national debt.
Now, not all of the institutions that bought our securities will keep them until the maturity date. A large part of the securities will be sold on the secondary market for a profit before they mature. In recent times, the Federal Reserve bought large amounts of US treasury securities on the secondary market. The Federal Reserve Act prevents the FED from buying them directly at the auction.
By now, the Federal Reserve owns about 12 percent of our national debt. That is more than China, which as the largest foreign holder of our national debt owns about 8 percent of it. Where it gets really adventurous is how the FED is paying for the securities it buys on the secondary market. Not with gold or paper currency but with another promise, kind of like a check drawn on an empty account. The institutions that sell their securities to the FED will receive a credit that they can add to their accounts. This credit can be applied to the bank’s reserve requirements. So the FED is basically turning debt into currency that can be spent today.
When the securities mature some day though, the treasury will have to pay the FED back but until then the currency supply will be inflated, leaving more money in the economy and for the federal government. Of the total United States money supply of more than 4 trillion Dollars, most of it only exists in electronic form. Only about 1.4 trillion Dollars actually exist as printed paper currency and coins.
The US Treasury does not only get money from the sale of securities. It also collects taxes through the IRS and has paper currency printed by the Bureau of Engraving and Printing and coins minted by the US Mint. Whichever currency the US Treasury has available will be handed over to the various government departments. These departments will then spend that money for their various services, for example to finance healthcare, education and so on.
Sooner or later, the currency that is brought into circulation by the government will be deposited on private bank accounts, for example by the government clerk who deposits his salary. Now, once these private banks receive that money, they can use it to speculate in the stock market or real estate market or do whatever else they like with it. The only requirement that the banks have to fulfill is to keep a certain part of their deposits in stock. That is called the fractional reserve and for most bank deposits it is set at 10 percent. However, it can also be 3 percent or even 0 percent for smaller banks and special kinds of deposits. So besides keeping this small fraction of the total deposits in reserve, the banks can do with the rest whatever they want. Mostly they will loan it out for a profit.
Even though your bank can and will loan out 90 percent or even more of your deposited funds, your bank statement will still show the full deposit amount. The amount that is loaned out is simply replaced by an IOU, called bank credit, so that it will appear that the full amount of your money is still there. In fact, only 10 percent or less is still in the bank’s vaults, called vault cash. It gets even better than that. By loaning out a part of your money to someone else, the bank basically creates new currency out of nothing.
Let’s use a deposit of 1000 Dollars and a reserve requirement of 10 percent as an example. Maybe your employer just paid you 1000 Dollars in cash for your hard work in a job that you probably hate. As a responsible citizen, you’ll bring your newly earned cash to your bank, thinking your bank will keep it safe for you.
After your ten hundred-Dollar-bills just went into the bank’s cash register and you leave the bank with your newly printed bank statements in hand, you might want to say hello to that young skater kid just entering the bank or whoever other bank customers you see. Maybe one of them just took out a loan for 900 Dollars, so nine out of your ten hundred-Dollar-bills might be in the hands of someone else before you even reached home, where your wife will probably ask you why you came home so late.
So 100 Dollars of your hard-earned money will still be in the bank’s vaults, 900 Dollars will be in the hands of someone who took out a loan and another 900 Dollars will still appear to be in your account according to your bank statement (since your bank replaces the loaned out amount with IOU’s which are currency). So now 1900 Dollars of currency are in existence and your bank basically created 900 Dollars out of thin air. Even Harry Potter can’t do that trick. And the banks can do that trick several times over. So maybe the borrower of your 900 Dollars won’t spend that money right away. Maybe it will first be deposited on another bank account at yet another bank. Then this other bank can and will loan out 810 Dollars of that 900 Dollar deposit to someone else. Now 2710 Dollars will already be in existence out of an initial 1000 Dollars. This process repeats itself over and over again. 1000 initial Dollars can create up to 10.000 Dollars in bank credit. It could be even more since the reserve requirements are not 10 percent for all kinds of deposit as mentioned above.
The bottom line is that most of the currency that exists only exists as numbers on a computer. According to some estimates, a staggering 97 percent of all currency in existence are created in this way in the banking system. So this process leads to a rapid increase in the currency supply which might superficially seem to be a good thing. What could be wrong with more currency in existence? One word. INFLATION. The original meaning of inflation is an increase in the currency supply. Since the amount of currency increases much faster than the real values that our society produces in the form of goods and services, it will inevitably lead to an increase in prices. Back in 1918, one gallon of gasoline cost a mere 0.25 Dollars for example.
These days, many Americans are paying more than 2.5 Dollars per gallon. One interesting fact is that if you paid for your fuel with gold, you would pay a lower price now than back then. The supply of gold changes slowly over time, despite continuous mining and occasional new gold discoveries. In fact, all the gold that was ever mined in the history of the world would fit into 2 Olympic-size swimming pools.
The essential element of real money (as opposed to currency) is scarcity. Whereas gold and other precious metals are and will always be relatively scarce, the currency that is floating around in our economic system is not. New currency is being created every day yet salaries increase rarely if ever. If you see your fixed salary as a percentage of an ever expanding monetary pie, then your share is actually getting smaller every day. No wonder that it has become harder to support a family from a single salary. In the 1950’s, families with one breadwinner were the norm. Now, many families not only have both adults working, but working multiple jobs as well just to make ends meet.
One thing is all too certain. The IRS will happily collect your taxes, no matter how hard it is for you to earn your salary. And that tax revenue will be used to build roads, bridges and better schools, right? Actually, about 26 percent of all tax revenue (that the IRS hands over to the treasury) is nowadays used to pay the interest on treasury securities. So a large part of your taxes will end up enriching the banks that bought these securities.
In order to be able to pay the interest (and pay back the principal) on outstanding government debt, new money must continuously be borrowed into existence. If we all stopped borrowing, no new currency would be created that we need to pay back our existing debt. If governments around the world were somehow able to magically flip a switch and only spend within their means henceforth, no new money would be created to pay back their outstanding debt. That makes it obvious that the debt ceiling will be raised again and again and again, until our current unsustainable financial system will come crashing down.
Nobody can predict when that day will come. Paper money will become near worthless then, maybe just like in Germany in the 1920’s, when workers burned paper money to heat their homes. Even though the eventual collapse of our current financial system is unavoidable, the powers that be have an interest to keep the current system going as long as possible. After all, the institutions that buy our national debt instruments get their cut 3 times.
- when they sell some of their purchased US Treasury securities in the secondary market for a profit to the FED or other buyers
- when they collect interest on the securities that they decided to keep
- when the owners of the FED collect their annual dividend of 6 percent
Yes, you read that correctly. The Federal Reserve has owners. It is the only federal institution that is owned by someone. Have a look at the Federal Reserve Act online. There it says that the stockholders of the Federal Reserve shall receive an annual dividend of 6 percent. Stockholders are by definition the owners of a business.
So who are the stockholders of the Federal Reserve? That is very difficult to ascertain. Most of the Federal Reserve stock was initially purchased by some of the biggest American commercial banks. Some of these banks have since merged or were acquired by other banks, so it is impossible to know who owns these shares now. But it would seem logical that the same banks that buy American treasury bonds at a bond auction and then sell them at a profit to the Federal Reserve have a vested interest to hold Federal Reserve shares.
Whoever the current stockholders of the FED may be, our current financial system that is built on ever increasing debt enslaves us all, since we will have to pay with our taxes of tomorrow for the current government’s deficit spending. The financial markets have collapsed before (most recently in 2008) and they will collapse again sooner or later. Sovereign nations have had to declare bankruptcy before and countries like Greece currently only stay afloat due to massive bailouts. Some governments have even tried to print their way out of trouble like Zimbabwe in 2008/9.
Whenever financial markets were in turmoil in the history of the world, people turned towards real values that can’t be faked or printed. Usually, that meant gold and silver. Of course, it could also be other precious metals like platinum, palladium or precious stones like diamonds. But whereas dealing with diamonds or other precious stones requires expert knowledge to evaluate the 4 C’s (color, clarity, carat and cut), buying and selling gold and silver is made easier by the fact that their authenticity and precious metal content can be more easily verified.
Gold Bullion Coins, Rounds or Bars?
Gold bullion can be bought in the form of gold coins (contemporary as well as historic coins), gold bars and gold rounds. Gold rounds look like coins except that they don’t have a face value and are minted by private mints. Whereas many gold bullion coins are well known (and traded) all around the world, there are arguably no gold rounds that have achieved international brand recognition. Gold rounds are generally cheaper than gold coins though.
Gold bars are the obvious choice when buying a large amount of the metal since they are widely available in sizes of 10 oz, 1 kg and even larger. However, gold bars also exist in small sizes of as little as 1 gram and some producers have come up with gold bars that can be broken up into smaller parts, such as the Valcambi Suisse CombiBars. These divisible products would come in handy when our current financial system collapses as customers could easily pay for their purchases with these small gold bar segments. However, that convenience has a price as smaller gold bars are more expensive to produce and are therefore available for higher premiums (surcharge above the gold spot price). A further advantage of gold bars is that they are nearly always made out of 99.99% pure gold.
Gold bullion coins, on the other hand, exist with different gold purities. South African Gold Krugerrands are perhaps the world’s most widely known (and traded) gold bullion coins, but their gold purity is with 91.67% much lower. The “Call of the Wild” gold bullion coins that the Royal Canadian Mint produces are probably the purest gold bullion coins (99.999% purity). Most other gold bullion coins like American Gold Buffaloes and Canadian Gold Maple Leafs are just as pure as gold bars (99.99% purity), but there are also some famous gold bullion coins like Chinese Gold Pandas that are ‘only’ 99.9% pure. Historic gold coins (pre 1933) are usually only 90% pure but usually have an added collectability value.
As far as the security of gold bullion products is concerned, many producers have come up with innovative ways to assure customers of the authenticity of their products. The authenticity, purity and weight of gold bars are guaranteed by the assayer through assay cards and/or stamps. Some gold bullion bars contain unique serial numbers and smaller bars are usually fully enclosed in tamper-proof packaging. The American Sunshine Mint produces its gold bullion bars with micro-engraved security marks.
The Royal Canadian Mint tries to prevent the counterfeiting of its gold bullion coins through the use of micro engraving and radial lines. Counterfeiting of gold bullion bars and coins is, unfortunately, a growing problem. That’s why it is so important to buy your gold and silver only from reputable dealers.