Welcome to our Friday mailbag edition!
Every week, we receive great questions from your fellow readers. And every Friday, I answer as many as I can.
This week, we’ve got questions about the Fed’s “endgame”… bringing back the gold standard… and whether the U.S. government could ban cryptocurrencies like Bitcoin. Let’s dive in…
I can’t for the life of me understand how any money is created when the Federal Reserve buys bonds from the banks.
So, the Fed creates money to pay the banks for these bonds. But how do the banks get these bonds in the first place? Don’t they have to pay the Treasury for them? Or are they just given to them free of charge?
– Thomas R.
Hi, Thomas, thank you for your question. It’s certainly a head-scratcher, on many levels. But I’ll try to explain it as simply as I can…
The U.S. Department of the Treasury borrows money by issuing a Treasury bond and agreeing to pay interest on that bond in return.
Treasury bonds are considered high-quality bonds, given that they have the implicit backing (what’s called the “full faith and credit”) of the U.S. government.
The banks are given a portion of each new bond issuance to sell to customers – usually pension funds, corporations, and money managers.
And when I say “given,” I mean “allocated” by the Department of the Treasury. The big banks are considered “primary dealers.” They act as middlemen or brokers to the types of institutional customers I mentioned above.
Usually (but not always), the bigger the bank, the bigger the allocation.
And when the banks sell those bonds, they get a fee.
They can then do what they want with the money they get from the pension funds, etc. They don’t have to return any of that money to the Department of the Treasury. It’s basically free money to Wall Street.
The Department of the Treasury doesn’t keep its own bonds, however. The idea is to sell them and pay interest on them to the end holders, whether that’s the big banks’ customers or the big banks themselves.
The banks can also keep, or hold, some of the bonds they are given on their own books to sell at a later date. They would choose to do this if they wanted to keep some of those bonds on reserve at the Federal Reserve in case of emergency or crisis.
Technically, though, as we’ve seen, the Fed pays extra money in the form of quantitative easing (QE) in return for the bonds.
This means the Fed “buys” these bonds from the banks in return for cash it has fabricated out of thin air. With a few keystrokes on a computer, it transfers that fabricated money to the bank.
So the Fed adds real bonds to its book of assets. And it adds fabricated money into the banking system.
It’s really that simple… and that crazy.
It’s a triangle. The government “borrows” money through issuing bonds… the banks are the middlemen that sell those bonds (for a fee)… and the Fed is one of the main buyers.
I hope this helps you understand the intricacies of the Fed’s QE monetary strategy.
I have carefully studied your excellent explanations about the evolving distortion. My question:
The Fed is not a charity organization. So it asks the Treasury Secretary to give the corresponding amount of financial assets – mainly Treasury Bonds and mortgage-backed securities – before “printing” more money (or technically speaking, before increasing its reserves).
The Fed asks, in addition, a solid processing fee of likely 2.5% for the process. As a consequence, the government’s debts are further increasing. But it also means that the Fed is increasingly owning the financial assets in question, which means owing the U.S. government, if I am correct.
What is the endgame of such an evolution?
– Erwin S.
Hi, Erwin. First of all, thank you very much for writing in. This dovetails nicely with my response to Thomas above. Regarding the endgame, here is my belief…
In these distorted times, one of the Fed’s unspoken functions is to enable the government to finance the budget (issue debt) as cheaply as possible.
If the Federal Reserve keeps interest rates relatively low (they have been as high as 20% in the past), this keeps the amount of interest the U.S. government has to pay on its debt low.
That’s a game in itself, beginning and end.
In addition, the Fed is in the unique position of being able to flood Wall Street with cash. That’s because it has the ability to decide when to cut interest rates or buy more bonds from Wall Street, without any limit.
And it also helps the government fund itself more cheaply than it might otherwise be able to do if it just relied on the capital markets.
It’s all part of the Fed’s smoke-and-mirrors management of our finances, which I broke down in more detail in my response to Thomas above.
As you know, we have lost approximately 90% of our purchasing power since the Federal Reserve opened for business in 1914. It is time for a new gold standard.
As you know, gold cannot be devalued. As J.P. Morgan stated in his testimony before Congress in 1914, “Gold is money. Everything else is credit.” I would appreciate your views on this subject.
– Robert C.
Thanks so much, Robert!
If we still had some form of a gold standard today, a lot of things would be different.
For one, the Federal Reserve and other major global central banks would not have been able to build such massive books of assets.
Two, interest rates wouldn’t have been so low in recent years.
And three, overall cheap-money monetary policy wouldn’t be so much more helpful to corporations and mega-banks than it is to average people.
What the gold standard provided until 1971 was a mooring for the creation of money supply. That’s because gold can’t be fabricated out of thin electronic air like fiat dollars or yen or pounds can.
That would have provided an implicit cap on inflation – or, as you put it, purchasing power relative to the dollar or any other fiat currency.
One of the interesting things I discovered while researching my 2014 book, All the Presidents’ Bankers, was that Wall Street was very much a factor in pressing the Nixon administration to take the U.S. off the gold standard.
The reason was simple.
Since its inception, major Wall Street bankers sought the Federal Reserve to help them access cheap credit in exchange for keeping gold reserves there.
But once they didn’t have to anymore, and they could keep paper money or debt in reserve instead, banks were free to take on more risk with their credit decisions.
This ultimately led to global credit crises in the late 1980s, 1990s, and of course, the 2008 financial crisis.
The Fed and other central banks eventually went overboard in their manufacturing of money in the wake of that crisis – and now again since the Covid-19 pandemic.
And that’s because they didn’t have to worry about a physical peg of any sort. Meaning they didn’t need to consider any limits in advance.
Personally, I’m a proponent of having some level of a gold standard resurrected. I think it would stabilize this massive money creation system we’ve seen since the financial crisis, and even to a smaller extent before that.
I also believe it would have curtailed the irresponsibility of excessively dovish monetary policy, as well as the private banking subsidies that central banks have provided.
That said, I think the chances of returning to the old gold standard are slim to none. But there has been rising speculation that the BRICS nations could issue some version of a gold-backed currency.
And this year, Texas legally contemplated an idea similar to the old gold standard. In April, it proposed Senate Bill S.2334 and House Bill. H4903.
Put simply, the bills call for a gold-backed digital currency. And that’s a big deal, whether the bill passes or not. Because it strengthens the idea of a gold-standard renewal.
If you missed my essay on that, catch up here.
Hi Nomi, I have resisted crypto investments because with the stroke of a pen, Congress or the Fed could lock out every crypto investor from exchanges and force them back into the international monetary system.
It sounds like a conspiracy theory, but with every country printing money to save themselves, what would keep central banks from allowing investors to crowd into crypto (the rich and poor) only to lock them out? The billions or trillions moved into crypto would simply evaporate!
Governments could care less about investor losses in a competing cryptosystem when survival of the central banks demands it. Any thoughts?
– Edward R.
Thanks for your question, Edward!
The idea that the U.S. government will ban Bitcoin is a popular notion – and for an understandable reason. Crypto could threaten a major source of the government’s power: the power to create money out of thin air and force everyone to use it.
But that hypothetical situation is a long way off. Right now, crypto poses no existential threat to the survival of the central banks.
It would also be entirely impractical for governments to ban Bitcoin and other crypto assets.
Governments in Argentina and Venezuela have laws restricting their citizens from accessing U.S. dollars. But these laws have little effect on their citizens’ desire and ability to use them. These actions just create a thriving black market.
While they may definitely restrict things, governments cannot make something that is valuable and desired by lots of people just go away by passing a law.
And in the case of crypto, it doesn’t really want to.
For one, it doesn’t want to miss out on any income from the industry. See, the crypto market is no longer just a fad. It has increased substantially in recent years. It’s worth $1.17 trillion today. At the peak in November 2022, it was worth around $3 trillion. That’s a lot of taxable revenue.
Under the current tax code, if you hold cryptos for 12 months or less, you must pay short-term capital gains tax on any profit made on the sale. That’s up to 37%, depending on your circumstances.
If you hold them for more than 12 months, your profits are subject to long-term capital gains tax. That’s up to 20%. So, instead of fighting it, we could see the government help crypto in the long run. (Especially if the SEC approves a Bitcoin ETF, opening the door for institutional investors to flood in.)
That’s not to say that the government can’t restrict things by prohibiting the buying and trading of Bitcoin. And that becomes more plausible with the introduction of a central bank digital currency (CBDC), which could provide a simpler means for such actions.
I’ve discussed extensively how a digital dollar would grant the government and Fed an unparalleled level of financial control over individual lives.
However, if government officials attempt to intervene in the Bitcoin space, they could encounter legal challenges rooted in constitutional rights, human rights, or regulatory frameworks.
Finally, when it comes to the broader discussion on CBDCs… There’s one more aspect to consider.
The adoption of the digital dollar could potentially sway people towards digital currencies. And, in turn, this shift could expedite the widespread acceptance of Bitcoin.
That’s because as people become more familiar with digital currency through the digital dollar, it will naturally make them more open to exploring Bitcoin.
So, if you’re seeking another reason to include Bitcoin in your investment portfolio, this could be it.
As I write this, the price of Bitcoin is still down about 57% from its November 2021 all-time high of about $68,000. And that’s a good thing. It means you can still buy it at lower prices before big financial institutions like BlackRock swoop in.
That said, I don’t recommend you put all your savings into Bitcoin – or any other asset, digital or not. Instead, consider investing a fixed amount of money on a regular basis, typically monthly or bi-weekly.
That way, you can buy more when the price is low and less when prices are high. This is called dollar-cost averaging.
But again, cryptos are speculative assets. Remember, even Bitcoin, is only 14 years old. It’s still a very new form of currency.
So, as with any speculation, don’t bet the house on it. You don’t need to allocate a big chunk of your portfolio to cryptos to see big gains. Even a small investment can go a long way.
And that’s all for this week’s mailbag! Thanks to everyone who wrote in.
If I didn’t get to your question this week, look out for my response in a future Friday mailbag edition.
I do my best to respond to as many of your questions and comments as I can. Just remember, I can’t give personal investment advice.
And if there are any other topics you’d like me to write about, I’d love to hear from you. Write me at [email protected].
Happy investing… and have a fantastic weekend!
Regards,
Nomi Prins
Editor, Inside Wall Street with Nomi Prins
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