Whither the Feds Gold

The idea of revaluing the USs official gold from $42.22 to the current market price popped up earlier this month in the Washington Post. If the Treasury's bling were valued at the spot price, we'd be sitting on a literal gold mine of nearly $288 billion, the article pointed out. CNN later asked why doesnt the Treasury and, by extension, the Fed realize those gains on their balance sheets? The idea that a revaluation of gold's official price might solve all the USs problems in particular those of the Federal Reserve is not so cut and dried. Before we get into the details, lets discuss the specific problems a revaluation is supposed to solve. The Federal Reserves balance sheet has deteriorated. Prior to the credit crisis, the Feds assets consisted almost entirely of low risk government debt. Since then the Feds balance sheet has become a repository for the bad assets that no one else wants to hold. The majority of the Feds assets are currently made up of loans to private institutions and mortgage-backed securities. The former include loans to shell companies that have bought the worst of a bankrupt Bear Stearnss and AIGs securities not the safest of investments. Not only has the quality of the Feds assets declined, but the quantity has exploded. Just over a year ago it reported assets worth $900 billion. Now it holds $2.2 trillion. This represents a huge increase in leverage. Before the crisis, the Feds capital ratio its percentage of capital to total assets stood at 4.5%. It has since fallen to 2.5%. Where before it had leveraged itself around 20:1, it is now leveraged 37:1 (see Fig 1). With share capital of around $50 billion, it wouldnt take a large loss to wipe out said capital and render the worlds largest central bank insolvent. About $110 billion has been lent by the Fed to support the questionable assets of Bear Stearns and AIG, so a 50% loss on these assets would do the job. The Feds deteriorating health is problematic. US dollars are a liability of the Federal Reserve, and as the Fed increases its odds of insolvency, people lose confidence in holding those dollars, spending them as quickly as possible. Inflation, a decline in the dollars purchasing power, is the result. Now back to the idea of revaluing gold. According to ex-Fed Governor Lyle Gramley and Peter Stella of the IMF, changes to the way in which the Fed accounts for its 261 million ounce gold stock might just save the day. The Feds gold is valued at a mere

$42 an ounce, far short of the $1100 market price. Marking its gold to market would result in a rise in the Feds gold stock from $11 billion to $283 billion. The Feds resulting capital gain a cool $272 billion would easily cushion any writedown on its Bear Stearns/AIG or MBS investments. Fed leverage would tumble from 37:1 to a conservative 7:1. Solvency assured, there would be no reason for dollar-holders to lose confidence, and therefore the inflationary threat would be eradicated. Voila! Unfortunately, the revaluation story is not entirely correct. The Feds gold stock does not actually consist of physical gold. Rather, the Fed holds certificates to gold held on its behalf by the US Treasury. Due to the rather odd fine print on those certificates, any capital gain earned from an increase in the official gold price would at this time appear to accrue to the Treasury and not the Fed. A bit of history will help explain this strange relationship between the Feds gold and the Treasury. Until January 30, 1934, the Feds then 195 million ounces gold stock, valued at $4 billion, was comprised entirely of physical gold. The Gold Reserve Act, passed that very day, forced the Fed to transfer all of this gold to the Treasury in return for $4 billion worth of gold certificates paper claims to gold. Oddly, these certificates were not payable in a fixed quantity of gold. Rather, a $10,000 gold certificate simply promised to pay to the bearer $10,000 worth of gold. The very next day January 31, 1934 the official price of gold was increased by the authorities from $20.63 to $35 per ounce. The Fed still held $4 billion worth of certificates convertible into $4 billion worth of gold at the Treasury. But the $4 billion worth of gold promised on the face of the certificates was now equivalent to 115 million ounces, far less than the day before when these same certificates could lay claim to 195 million ounces. By tweaking the gold price, the Treasury had effectively confiscated some 80 million ounces of gold from its bureaucratic cousin, who earlier had confiscated it from the public. The Treasury didnt sit on its new gold. It printed up new gold certificates using its 80 million ounces as collateral, brought them to the Fed, and had the Fed issue it $2.5 billion in newly

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printed currency. As in 1934, it appears the benefits of a modern revaluation would accrue entirely to the Treasury. At todays official price of $42.22, the Feds $11 billion worth of gold certificates currently lay claim to 261 million ounces of gold held by the Treasury. Say the official gold price was increased to $1100. As indicated on their face, the Feds certificates would still be worth $11 billion in gold. But these certificates would no longer lay claim to 261 million ounces of gold. Instead they would represent claims equal to a measly 10 million ounces. The Treasury would still have 261 million ounces in its vaults, but whereas before revaluation all this gold was held in trust for the Fed, now only 10 million would be held for the Fed. The remaining 251 million ounces would be free and unencumbered. The Treasury might choose to just sit on its new treasure trove. But most likely it would proceed directly to the Fed without passing go, deposit $276 billion worth of gold certificates (251m oz. x $1100), receiving in return a massive $276 billion stash of newly printed dollars. So, in sum, the Fed would not benefit from revaluation since the entire capital gain would be earned by the Treasury. Worse, the core problem of inflation a revaluation was supposed to combat would actually be exacerbated. Fed assets would grow without a corresponding increase in capital, increasing the Feds leverage. Furthermore, the Fed would have to issue $276 billion in new dollars to the Treasury a massive one time increase in the money supply. As the Treasury spent this hoard, ever more dollars sloshing through the economy would ignite inflation. And dont think the public would benefit if President Obama suddenly had $276 billion to spend on their behalf. While seemingly free, this stash would come at a cost. Like the kings of old who secretly reduced the metal content of coins to fund their wars, the Treasurys $276 billion war chest would be paid for by a raiding of the Fed, the dollar-holding public footing the cost as their dollars bought less. Nor would a revaluation help the Treasury out that much, since in todays world of $1.4 trillion budget deficits, spending at $2.1 trillion, and total debt of $12.8, a one-time $276 billion bonus just aint worth so much. Lastly, the Treasury may want to avoid revaluation of its gold stock because this would attract undue public, media, and political attention to golds monetary role after many years of being ignored, even trashed. It is very likely that the Treasury has unofficially lent and/or swapped a significant chunk of its gold to private counterparties. The re-marking of golds official price to market would lead to speculation about golds reemergence as a reliable central bank asset. Golds market price would surge. Since many powerful private institutions have borrowed Treasury gold only to sell it short, it is doubtful that either the Fed or the Treasury both populated with insiders connected to these private institutions would look fondly on a removal of the $42.22 price. To conclude, there is an odd relationship between the Fed and the Treasury and it remains unclear whether the Fed is really independent. On paper an increase in golds official price would hurt the former at the expense of the latter. The Fed will have to find some other way to fix its ugly balance sheet. What does seem clear is the first baby steps on the road to remonetization of gold are being taken.

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Speaking of gold, the metal recently rose above $1100. Gold investors tend to be a contrarian lot. When they see the price of gold hitting a record high, one half of their brain is gleeful, the other half grows suspicious and wants to sell against the trend. For now, the Pollittburo encourages your inner contrarian to relax. Searches run on Google for gold price an indication of mass interest in a given topic have yet to hit significant peaks, a pattern played out on previous spikes in the metal in early 2006 and 2008 (see Fig 2). In other words, the masses arent buying into this rally just yet. Perhaps all the more reason to add to ones position?

John Paul Koning jpkoning@pollitt.com

Toronto, Ontario November 23, 2009

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