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We’re pleased to republish this guest post by Paul Belanger. Paul is the author and owner of the website, Evidence Based Wealth, and the YouTube channel belangp, where he’s published over 10 years of research and analysis of gold. He’s also the author of Evidence Based Wealth: How to Engineer Your Early Retirement, available for purchase at Amazon.com. This post does not necessarily reflect the views of Monetary Metals.
In light of the recent rise in interest rates, I started preparing to write an article discussing the conditions that need to prevail to make a US Government bond a reasonable investment. In the process it dawned on me that in order to do the subject justice I needed to lay some groundwork, specifically exploring the definition of investment. So expect to see another article soon comparing gold to the 10 year treasury soon. In the meantime this article will discuss the differences between investments, speculation, and money. I believe these differences are of great importance to anyone who wants to have an investment philosophy (i.e. the thing that makes it possible to stick to an investment policy or strategy).
The Importance of Definitions – What the Heck is a “Dollar”?
Precise definitions are of critical importance. Without them, exchange of ideas through language suffers. Enforcement of law becomes impossible. Does this sound like hyperbole? Imagine a person hired you to seal his driveway in exchange for two chickens, a simple barter transaction. You get to work and finish the job in the hot sun. Upon completion of the work, the other party hands you two fuzzy yellow balls, each weighing less than an ounce and easily fitting in one hand. You realize that you have just been handed two hatchlings and not the two full grown chickens you were expecting. You complain. It is at this point that the other party pulls out a dictionary and shows you the definition of chicken: “a domestic fowl kept for its eggs or meat, especially a young one”. It is at this point you realize that even if you had executed a written contract you would have no recourse. You had not defined precisely what would be accepted as payment.
Of equal importance is the constancy of definitions. Once upon a time the Imperial unit of length, the yard, was the length of a man’s belt. Which man? Who knows? In the 12th century, King Henry of England ruled that the yard should be defined as the distance from his nose to the thumb of his outstretched arm. Did the yard change as the king aged? Imagine trying to build a structure that was specified to be a certain number of yards in each direction. Would you need to summon the king to come so that you could verify you built it to the proper specification? In 1855 an official standard for the yard was adopted in England. The definition was based upon the distance between two gold plugs installed in a forged bronze bar at 62 degrees Fahrenheit that was 38 inches long by one square inch (don’t get me started on the definition of the inch). Fortunately today we have very precise and constant definitions of units of length measure.
So what does all of this have to do with investing? After all, it is unusual to transact using chickens as payment. Most people you ask will say that we use Dollars and other currency units in settlement. And the definition of the Dollar is widely accepted and it is constant, right? Not really.
The original definition, or should I say definitions, of the Dollar was provided in the coinage act of 1792 as being one of the following: 371.25 grains of pure silver, 416 grains of standard silver, 24.75 grains of pure gold, or 27 grains of standard gold (the astute reader will recognize that this definition fixed the recognized value of a grain of pure gold to be 15 times that of the same weight of pure silver). Someone who signed a contract to borrow a specific quantity of Dollars knew precisely the amount of gold or silver coin that needed to be tendered to discharge the loan. The lender had the same understanding. Granted there were some problems created from having multiple definitions, chief among them was the disappearance of either gold or silver coins from circulation if market forces determined one metal was more valuable than the 15:1 ratio; however, at least the meaning of Dollar was codified by law. But another problem of having multiple definitions was it allowed the debtor to discharge his “Dollar” debt with the metal of his choosing, a problem for the creditor but a definite advantage for the debtor.
As market forces caused one type of coin or the other to disappear from circulation the US Government responded by adjusting the amount of metal serving as the definition of the Dollar. For example, in 1834 a new coinage act was passed which lowered the gold content of the Dollar to 23.2 grains of pure gold and 25.8 grains of standard gold. This effectively changed the ratio of silver to gold from 15:1 to 16:1. In effect it made it more likely than before that a debtor would satisfy their Dollar debt with gold than with silver coins. It also made dollar debts easier to discharge, a benefit for debtors and a detriment for the creditors.
Then came the coinage act of 1853 which lowered the amount of silver defining “the Dollar” by approximately 7%. The law was in response to a scarcity of silver coins at the time. Gold discoveries in California flooded the market with gold, making silver more dear relative to gold (the bullion value of silver far exceeded the face value stamped on the coins). Debtors were choosing to discharge their “Dollar” debts with gold coins, meanwhile either hoarding silver coins or melting them down for their bullion value. Another provision of this law was that it authorized the mint to purchase silver for creation of coins but to only sell them to the public in exchange for gold. No longer could private owners of silver bring their silver to the mint to be coined for free. This was a major step away from bimetallism. At the same time, the reduction in the silver content defining the Dollar made discharge of Dollar debts easier. Again, this was a benefit for debtors and a detriment for creditors.
The coinage act of 1873 redefined the Dollar as 25.8 grains of alloyed gold and referred to silver coin in terms of “trade-Dollar”. This essentially demonetized silver by reducing silver coin to token status. Many believe this created substantial upward pressure on the price of gold, a true deflationary event that punished debtors and rewarded creditors (provided, of course, that the debts were honored).
Currently, the definition of a Dollar is very vague. Consult the Bullion Coin Act of 1985 and one will find that a 50 “Dollar” gold coin contains one troy ounce of fine gold while a 10 “Dollar” gold coin contains one fourth troy ounce of fine gold. Why one fourth and not one fifth as suggested by the difference in the Dollar value stamped on the coin? Perhaps this is only an academic question since nobody would use these coins to discharge their Dollar debts (the market value of the gold far exceeds the Dollar value stamped on the coins). Still, it does illustrate the ambiguity of the Dollar’s definition.
So what is the definition of the Dollar? Surely this is not an academic question. If you and I were to enter into a contract which specified payment in a certain number of “Dollars” would it not behoove both of us to understand what this “Dollar” is? Most people, if you ask them, would reply that this is a Dollar…
But is it? I have spent many years searching for the current legal definition of the Dollar. I’m not the only one who has struggled with this issue. There was great debate between 1776 and 1788 and again in the years following the Civil War about what would be deemed acceptable for the discharging of debt. The main issue was whether it was legal to force a creditor to accept paper currency in payment of a debt. When the Constitution was ratified in 1788 Article 1, Section 10 stated “No state shall coin Money; emit Bills of credit; make any thing but gold and silver coin a tender in payment of debts…”. (notice that it specifically says that no state shall but does not prohibit the Federal Government from doing so). But then the Legal Tender Act of 1862, which declared United States Notes (“Greenbacks”) to be legal tender, was passed requiring the acceptance of paper notes issued by the Federal Government to be accepted by creditors in settlement of debt. These paper notes were not redeemable upon demand for gold or silver but had to be accepted by creditors. The Supreme Court ruled in 1870 that this law was unconstitutional; however, in 1871 the Supreme Court (with new nominees appointed by President Ulysses S. Grant) overturned the 1870 decision. From that point forward paper notes had to be accepted by creditors, at least in the eyes of the law (though many who took advantage found themselves blacklisted by disapproving creditors).
So what does US law currently say about what a creditor must accept to discharge a Dollar debt? Title 31, Subtitle 4, Chapter 51, Subchapter 1 of the US Code states “United States coins and currency (including Federal reserve notes and circulating notes of Federal Reserve Banks and National Banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold and silver coins are not legal tender for debts. Ah! There it is! If I enter into a debt contract with you that specifies you will owe me a certain number of “Dollars” I must be prepared to accept as payment any US coin or currency or any Federal Reserve note. The number stamped on the coin or printed on the note specifies its Dollar value. In light of the changes of precious metal weight in the coins over time and in light of legal tender laws one can only conclude that the definition of the “Dollar” is the number stamped on an official coin or printed on an official paper note. The “Dollar” is a unit of debt. It’s a number on an accounting ledger. If you owe me fifty “Dollars” I am required to accept as payment from you one “Fifty Dollar” gold eagle or buffalo coin (unlikely you’ll offer this), or five “Ten Dollar” gold eagle coins (even less likely), or fifty “One Dollar” silver eagle coins (also not likely), or any combination of paper Federal Reserve Notes whose printed numbers add to “Fifty Dollars” of face value. I am NOT required to accept from you a digital transfer from your bank account to mine, even though this is the most common form of payment today. The “Dollar” debt your bank owes you, as reflected by your bank account balance, is not a form of payment a creditor must accept even if most creditors today prefer digital settlement. Though this may seem like a very subtle point, I can’t stress enough how critically important this is. Broader measures of money such as M1, which includes checking account balances and travelers checks, and M2, which includes savings account balances, certificates of deposit, and money market accounts, are not money at all! Creditors are not obligated to accept the transfer of bank credit in payment of debt. The physical Federal Reserve Notes printed by the US Bureau of Engraving and Printing are different because of their special legal status.
The keys to take away from all of this are: 1) today, the Dollar is nothing more than an accounting unit used to track units of debt, 2) the legally accepted means of settlement of Dollar debt has been changed many times, sometimes to the benefit of the debtors and sometimes to the benefit of creditors, 3) creditors (in Dollars) are required to accept as payment any US coin or note or Federal Reserve Note with an official US Government mark specifying the value of the currency in Dollars, 4) although other means of debt settlement are popular, they are not compulsory.
Principal and Capital
Now we are ready to discuss investment. I’ll warn you ahead of time that this discussion is going to lead us right back to the question of what money is, but I can assure you the round trip will be enlightening and useful. Benjamin Graham, often credited as being the father of value investing, once said that “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” It’s a good definition to dust off once in a while. I’ve personally found that adhering to Ben Graham’s definition has allowed me to avoid many costly mistakes. But this time, reviewing Graham’s definition has led me to a special conclusion.
Let’s take a moment to dissect Graham’s definition of an investment operation, starting with principal. As I said, words and their meaning are very important. According to my copy of Webster’s Dictionary, principal is “a capital sum lent on interest, due as a debt, or used as a fund, as distinguished from interest”. The etymology of the word principal is from the old French word prime or Latin primus meaning first, or the first part. So now what is this word “capital”? Again according to Webster’s capital is “any form of wealth employed for the production of more wealth”. So when Graham referred to safety of principal what he meant was a guarantee that the wealth deployed in the seeking of more wealth would be protected. There was some assurance of the return of the capital.
When we make an investment, what is the principal (or capital) we are trying to ensure is safe? Is it the sum of Dollars lent? Although convenient and popular, this choice is problematic. Since the rules governing what a creditor must accept in payment of a Dollar debt have been frequently changed, how can one be assured of the safety of what was lent? For example, one could have lent 270 grains of standard gold, or 10 “Dollars” for 3 years to a borrower in 1832 and received back coins containing only 258 grains of fine gold in 1835. As far as the law is concerned, if the contract called for the return of Dollars, the contract was fulfilled. No doubt the borrower was happy. Was the lender happy? From the standpoint of Dollars on his balance sheet his principal was preserved. If he was expecting a certain quantity of gold to be returned he was surely harmed. Perhaps this is the reason why gold clauses sometimes appeared in contracts, specifying the amount of gold to be returned rather than the number of Dollars. Of course, this changes the principal. The principal is no longer Dollars but gold.
It’s unusual to come across gold clauses in contracts today. Most debt is settled through transfer of ownership of Federal Reserve Notes. So, should we consider principal to be a particular Dollar sum of Federal Reserve Notes? This is not a trivial question. It is a question of great importance. Let’s explore this question.
In banking, one common practice to partially guarantee principal is to require collateral. For example, a bank may lend a specific sum at interest to a borrower who would like to purchase a house. Most banks will only lend 80% of the assessed value of the real estate and will require that the owner pledge the house as collateral. The bank will own a lien against the house until the loan is discharged. Thus, conservative banking does follow Graham’s definition of an investment operation.
Section 16, Subsections 1 and 2 of the Federal Reserve Act discusses the nature of Federal Reserve notes, the nature of the obligation, and their issuance: “Federal reserve notes, to be issued at the discretion of the Board of Governors of the Federal Reserve System for the purpose of making advances to Federal reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are hereby authorized. The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues. They shall be redeemed in lawful money on demand at the Treasury Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank.” Further “Any Federal Reserve bank may make application to the local Federal Reserve agent for such amount of the Federal Reserve notes hereinbefore provided for as it may require. Such application shall be accompanied with a tender to the local Federal Reserve agent of collateral in amount equal to the sum of the Federal Reserve notes thus applied for and issued pursuant to such application. The collateral security thus offered shall be notes, drafts, bills of exchange, or acceptances acquired under section 10A, 10B, 13, or 13A of this Act, or bills of exchange endorsed by a member bank of any Federal Reserve district and purchased under the provisions of section 14 of this Act, or bankers’ acceptances purchased under the provisions of said section 14, or gold certificates, or Special Drawing Right certificates, or any obligations which are direct obligations of, or are fully guaranteed as to principal and interest by, the United States or any agency thereof, or assets that Federal Reserve banks may purchase or hold under section 14 of this Act or any other asset of a Federal reserve bank. In no event shall such collateral security be less than the amount of Federal Reserve notes applied for. The Federal Reserve agent shall each day notify the Board of Governors of the Federal Reserve System of all issues and withdrawals of Federal Reserve notes to and by the Federal Reserve bank to which he is accredited. The said Board of Governors of the Federal Reserve System may at any time call upon a Federal Reserve bank for additional security to protect the Federal Reserve notes issued to it. Collateral shall not be required for Federal Reserve notes which are held in the vaults of, or are otherwise held by or on behalf of, Federal Reserve banks.”
There is a lot to unpack in these two subsections. I underlined the key points. First, notice that the Federal Reserve Notes are obligations of the United States and redeemable in “lawful money”. We’ve already discussed “lawful money”. It can be United States coins and notes or Federal Reserve Notes. Wouldn’t it be nice to take a $100 Federal Reserve Note to the Treasury and present it to be redeemed in two one ounce gold eagle coins? Well, the speech given by Richard Nixon on August 15, 1971 tells us why: “I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States”. So it’s theoretically possible the Treasury would give you the two one ounce gold coins, but according to legal tender laws the Treasury is more likely to redeem your Federal Reserve Notes with other Federal Reserve Notes (or perhaps the same ones). It is an option of the Treasury to redeem Federal Reserve Notes in gold, but not an obligation.
One would think being called “Federal Reserve Notes” that they are first and foremost an obligation of the Federal Reserve to the holder of the note holder. As was just discussed this is not so. They are an obligation of the Treasury. Perhaps this is why the only organization allowed to produce them is the Bureau of Engraving and Printing (a division of the US Treasury). The Federal Reserve DOES BORROW THEM from the Treasury, thus making them an obligation of the Federal Reserve TO the Treasury. This is why the next underlined part discusses collateral. When the Federal Reserve requests new Federal Reserve Notes it must post collateral of one of the listed forms, and it must be equal in value to the Notes (equal in value meaning having the same Dollar total). Thus the Federal Reserve Notes are a FULLY COLLATERALIZED debt of the Federal Reserve and the US Treasury is the creditor.
So now why would the Treasury require collateral against the Federal Reserve Notes it issues? Generally collateral is only something that is necessary as a contingency against the event of counterparty failure. What would happen if for some reason the Federal Reserve were to fail. This could happen for any number of reasons. One possibility is that the debts held as assets on the balance sheet go into default and are marked down to the point of the Fed having a negative equity position. Another possibility is that Congress decides someday to revoke the Federal Reserve’s charter. Regardless of the reason, the Treasury is still obligated to redeem the Federal Reserve Notes. Redeem them for what? Lawful money. And without a Federal Reserve can Federal Reserve Notes be considered lawful money? Maybe. It’s doubtful the voting public will tolerate that. So what is left? Gold. There’s only one problem. With the exception of the small amount of working stock held by the mint the Treasury does not have clear title to the gold held in its vaults. The Gold Reserve Act of 1934 required the Federal Reserve System to transfer ownership of all of its gold to the Treasury. In exchange, the Treasury issued gold certificates and gave them to the Federal Reserve for the amount of gold transferred. These gold certificates are not redeemable by the Federal Reserve on demand for gold from the US Treasury; however, the Treasury is not at liberty to sell the gold it holds without first retiring the gold certificates. At present the Federal Reserve has pledged $11,037 million of gold certificates as collateral against its Federal Reserve Note liability. The statutory gold price set by law is $42.2222 per troy ounce. So the gold certificates encumber 261.4 million ounces of gold. The Treasury reports to hold 261.5 million ounces of gold. So there you have it, all of the gold held by the Treasury is encumbered by gold certificates held by the Federal Reserve and 100% of these gold certificates have been pledged as collateral against the Federal Reserve Notes issued.
If at some point in the future Federal Reserve Notes no longer serve as lawful money and the Treasury is forced to redeem the existing Federal Reserve Notes for gold (a remaining lawful money) then each ounce of gold will stand good for 8505 Federal Reserve Notes. How did I arrive at this number? Quite simply I divided the 2,224,033 million Federal Reserve Notes subject to collateralization (Table 7 of the H4.1 report) by the 261.5 million ounces of gold held by the Treasury.
Don’t think the definition of lawful money will change again in the future? Well, it has changed at least half a dozen times in the past 250 or so years. Changing the definition of what is acceptable for the discharging of Dollar debt has a well established precedent. If Federal Reserve Notes were to lose their status as lawful money then the owner of Federal Reserve Notes will receive far less gold than what the notes will buy today on the open market. So giving Federal Reserve Notes the title of principal in a loan is certainly inappropriate.
What does this leave? What was the primus of the creation of Federal Reserve Notes in the first place? Gold. It is gold. Can gold be lent at interest? Yes. Yes it can. It is done all the time on the London Metals Exchange. I’m aware of at least one company in the United States that is seeking to make gold leases available to smaller holders of gold. So yes, gold can appropriately be labeled “principal”, provided the loan has a gold clause stating that the gold principal be returned as gold.
Gold clauses are not typical. You may find it very difficult to work a gold clause into a loan unless the counterparty is in the business of using and/or selling gold. So, gold should most likely be referred to as “capital” rather than “principal”.
A Few Words About Accounting Dangers
So if gold is “primus”, why would a person want to be a Dollar creditor? Why not simply shun the Dollar convention, save only gold as money, and account for wealth in gold ounces? The reason is that most people have Dollar denominated debts. If you have a mortgage, you have a Dollar denominated debt. If you have a car loan, you have a Dollar denominated debt. When the taxing authority sends you a property tax bill, it is a debt that must be discharged in lawful money. Gold can be tendered, but a creditor is only required to accept it at the face value stamped on the coin.
When debts and near term obligations are denominated in Dollars it makes sense to maintain your books using Dollars as the unit of account. To do otherwise is to risk not knowing whether or not you are solvent.
There is an exception. A person who is debt free may use whatever unit of account he or she pleases. A person with no debts is safe accounting for wealth measured in any unit.
Investment
Back to Graham’s definition of an investment operation: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” It is unfortunate, but because of the history of the government changing what is acceptable to discharge a Dollar debt, it is impossible to lend Dollars and meet the definition of an investment operation. There is no way to ensure the safety of principal. That said, it is necessary to loosen the definition a bit.
An investment operation could be viewed as “an operation which, upon thorough analysis, has a high likelihood of satisfactorily enriching the investor in his or her chosen unit of account, whether it be gold ounces, silver ounces, Federal Reserve Notes, etc.”
This was a long article, but I think it was a necessary one to pave the road for what is to come. In my next article I will discuss under what conditions an intermediate term Treasury Note can be considered a reasonable investment.
