February 11, 2002 – Argentina’s debt default and economic bust has been moved out of the headlines by the collapse of Enron, as if one debacle was not related to the other. But these two seemingly disparate events are actually very much related. They both highlight the fragility of today’s money and banking system, which is globally interlinked in a complex arrangement of interconnected debts and promises to pay.
Bankers are loath to have anyone question their judgement, prudence and banking practices. Questions in these areas – which are often very embarrassing to the banks – of course undermine confidence in the banking system, but that observation in itself is important. It highlights the nature of banks, which are so often a problem. It explains why banks are indeed so fragile.
It is confidence, not innate value, which keeps the banks afloat. And it is this confidence, and the occasional lack thereof, that cause banks to periodically seek taxpayer bailouts from the government.
This fragile structure upon which banking has been constructed can be seen in the table below, which I call the ‘Monetary Balance Sheet of the US Dollar’. This term will be familiar to long-term readers, but I haven’t presented the monetary balance sheet in these letters for several years, the reason being that the solvency of the banks has not been seriously questioned since the Asian currency crisis. Though the banks’ solvency – or I should say, present insolvency – is not yet widely perceived to be a problem, a parade of problems from Argentina, Enron, K-Mart, Global Crossing and the lesser known bad debts being piled up at the banks make their insolvency critically important.
Monetary Balance Sheet of the US Dollar as of October 31, 2001
(denominated in billions of units of account called dollars)
|Gold @ $278.40||$72.8||Federal Reserve Notes||$580.6|
|IOU’s Owed to Banks||7,959.8||Bank Deposits||7,452.0|
The above table puts into perspective one undeniable fact about the dollar. Though we often lose sight of this fact that the Dollar is merely a creation of accounting, it is important to recognize that the Dollar is in essence nothing but a liability of the financial institutions that create dollars. These institutions are the Federal Reserve and the nation’s banks. Though the credit worthiness of Microsoft, GE and dozens of other corporations may be better than most banks, MSFT and GE are not part of the money-issuing monopoly. They do not have the privilege of issuing liabilities that circulate as currency.
Because the Dollar is a liability (i.e., someone’s promise), the quality of the Dollar is only as good as the assets on the monetary balance sheet. It is these assets that give the Dollar its value, a recognition based upon the most fundamental accounting premise that liabilities are only as good as the assets supporting them. If the assets did not have value, then the liabilities we call dollars would have not have any value either and would not circulate as currency.
The 8,032.6 billion of dollars circulating as currency – what together are referred to as M3, a broad definition of the quantity of money – take two forms. First, there are the liabilities of the Federal Reserve, the notes that we use as cash currency. Presently there are 580.6 billion of dollar-denominated Federal Reserve notes circulating as currency. Then there are the 7,452.0 billion of dollars issued by the banks, which are a deposit currency that circulates with checks, wire transfers and other forms of bank-to-bank payments.
Turning to the asset side of the monetary balance sheet, there is $72.8 billion worth of gold in the Federal Reserve. This dollar value is calculated by using the December 2001 month-end gold-to-dollar exchange rate of $278.40 per ounce of gold. The other assets are the $7,959.8 billion of IOU’s owed to the banks by the various individuals, businesses and governments who owe money to the banks.
While we often speak of the quantity of money – M3, or presently $8,032.6 billion – we rarely if ever hear about the quality of money. But the assets of the monetary balance sheet in fact determine whether the dollars that circulate as currency are fairly valued, over-valued or under-valued. And the dollar’s valuation can be determined by one very important question.
Are these IOU’s on the monetary balance sheet really worth $7,959.8 billion? That is the single question of paramount importance.
There are, no doubt, some bad loans in these assets — some $22 billion worth of loans made by US banks to Argentina, over $10 billion worth of loans made to Enron, and countless billions of loans to others in financial trouble. These include bankrupt companies like K-Mart and Global Crossing, which are unable and/or unwilling to repay their debts. It also includes those companies that are bankrupt in all but name – companies whose bankruptcy we will see unfold in the weeks and months ahead.
For now, the market is ignoring these problem assets. But for how much longer? Not much longer, given current indications of the gold price.
It is a basic fact of accounting that balance sheets are always in balance. Assets must always equal liabilities. Sometimes arcane accounting practices (like the many nuances often employed to determine whether to carry assets at book or market value) distort this relationship between assets and liabilities. And it is these distortions in the balance sheet of companies that has presented opportunities for legendary investor Warren Buffett and lesser well-known investors to seek out hidden value in a company. But what is true for any one company’s balance sheet is also true for an aggregate of bank balance sheets and their mix of assets and liabilities – the dollars that circulate as currency.
Balance sheets must always balance. And there are two alternatives to bring a monetary balance sheet back into balance.
The obvious alternative is for the price of gold to rise, offsetting the deterioration in the value of the IOU’s. For example, if the true value of the IOU’s is only $7,900 billion, then the value of the gold in the Federal Reserve has to rise by $59.8 billion, which would mean a gold price of $507 per ounce.
The other alternative is that if the assets decline by $59.8 billion, then the liabilities have to decline by $59.8 billion. This decline in M3 is what happened in the US during the Great Depression. The failure of thousands of banks made the liabilities of these banks worthless, which caused M3 to decline back then by approximately one-third.
Similarly, today this gap between assets of lesser value and outstanding liabilities shows what is now occurring in Argentina. The only difference between these two examples is the monetary standard – gold in the case of the US in the 1930’s and the US dollar today in Argentina. And just like the US dollar was devalued against its standard of gold in the 1930’s, the peso is now being devalued against its standard – the dollar.
Thus, the connection of Enron and Argentina are important. Between these two economic collapses, over $30 billion worth of assets on the monetary balance sheet have disappeared. Assets are now nominally less then liabilities, which is an imbalance that the market never ignores.
The price of gold is rising to bring the monetary balance sheet back into balance. The rising gold price is filling the ‘big hole’ in the balance by assets that no longer have any value.
Balance is being restored by the first alternative. It is not being restored by a reduction in liabilities because government policy since the 1930’s has declared that depositors will not lose the dollars they have on deposit in the banks.
Lastly, you may be wondering why I have ignored bank equity from the above balance sheet. The reason is simple. There isn’t any available equity.
It must be recognized that banks are highly leveraged, over 20-to-1. Thus a 5% decline in assets will wipe out a bank’s equity. So between their illiquid assets that cannot readily be turned into cash and the probable losses that will occur in an economic downturn leading to a bust in their loan portfolio, banks will be lucky to have any equity left. And this analysis ignores their huge derivatives portfolio, which as we saw in the case of Long Term Capital Management and are now beginning to recognize with Enron, is a catastrophe waiting to happen.
Therefore, the monetary balance sheet is an accurate portrayal of the dollar, and the thin thread of weak promises upon which it is hanging. This thin thread that points out the fragility of banking in my view is destined to snap, like it did in the US in the 1930’s, like it did recently in Argentina, and like it will soon snap in Japan. That this ‘snap’ seems to me inevitable is one of the reasons why I have said that the dollar has three years – and no more than five years at most – before it goes the way of the Argentine Peso.