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Are U.S. Federal Reserve Notes Backed by Anything?

When someone asks if anything backs the U.S. dollar anymore, the answer is usually: nothing but confidence in the United States economy and/or government. And this evaluation is true…sort of. After having conducted some in-depth financial research, I can confirm that this assessment isn’t technically correct (which, as everyone knows, is the best kind of correct).

It is a little known fact that Federal Reserve notes are legally backed by certain assets sitting on the balance sheets of the United State’s 12 Federal Reserve Banks. I have pulled a pertinent explanation from the notes of the Federal Reserve’s 2017 audited financial statements:

Federal Reserve notes are the circulating currency of the United States. These notes…must be fully collateralized. All of the Reserve Banks’ assets are eligible to be pledged as collateral.

To satisfy the obligation to provide sufficient collateral for outstanding Federal Reserve notes, the Reserve Banks have entered into an agreement that provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve notes issued to all Reserve Banks. In the event that this collateral is insufficient, the Federal Reserve Act provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks.

At December 31, 2017 and 2016, all Federal Reserve notes outstanding, net, were fully collateralized. At December 31, 2017, all gold certificates, all SDR certificates, and $1,554 billion of domestic securities held in the SOMA were pledged as collateral. At December 31, 2017, no investments denominated in foreign currencies were pledged as collateral.

So surprisingly, the currency in your pocket is actually backed by something more than unicorns and fairy dust!

Now for the caveats. This backing only applies to physically printed U.S. Federal Reserve notes. It doesn’t include digital U.S. dollars, like those in your checking or savings account. This is in spite of the fact that dollars in deposit accounts can generally be freely exchanged for Federal Reserve notes on demand.

It also excludes U.S. coinage, which is considered fiduciary money. Incidentally, this is the same reason you can’t use a dump truck full of pennies to pay off your mortgage.

Federal Reserve Assets Pledged As Collateral Against Federal Reserve Notes

	Book Value			Market Value
	Dec. 31, 2017		Exchange	Dec. 31, 2017
	in millions		Rate	in millions
Gold Certificates	$ 11,037	@	$42.22/$1302.50	$ 340,477
SDR Certificates	$ 5,200	@	$ 1.42	$ 7,405
Treasuries & MBS	$ 1,554,000			$ 1,554,000
Grand Total	$ 1,570,237			$ 1,901,882

The first collateral specifically mentioned in the Fed’s financial statements is gold certificates. These are holdovers from the pre-1934 era, when the United States was still on the gold standard. Originally, $20.67 was exchangeable for a single troy ounce of fine gold. However, gold was gradually revalued during the 20th century until its official government price was frozen at $42.22 in 1973.

So the $11 odd billion in gold certificates on the Fed’s balance sheet actually represents a claim on approximately 261.4 million troy ounces, which is very nearly the entirety of the United State’s gold reserves. At the December 31, 2017 spot price of $1,302.50, these gold certificates had a market value of over $340 billion.

The next asset used to collateralize Federal Reserve notes is SDR certificates, otherwise known as Special Drawing Rights. SDRs are composed of a basket of national currencies that are important in global trade and finance. Right now each SDR is composed of 0.58 U.S. dollars, 0.39 euros, 0.09 British pounds, 1.02 Chinese Yuan and 11.90 Japanese Yen.

The SDR currency basket is reweighted every 5 years to reflect changing economic positions, with the next reassessment scheduled for 2021.

The Federal Reserve Banks have pledged all 5.2 billion of their SDRs as collateral against outstanding Federal Reserve notes. Each SDR had an exchange rate of $1.42 at December 31, 2017, giving this collateral a total value of $7.4 billion.

The final collateral backing Federal Reserve notes are domestic SOMA (System Open Market Account) securities. SOMA securities consist primarily of U.S. Treasuries and government agency MBS (mortgage-backed securities) that the Fed has purchased on the open market. As of Q4 2017, there were $2,546 billion of Treasuries on the Fed’s balance sheet and $1,818 billion of MBS.

Because the Federal Reserve Banks have only pledged $1,554 billion of these SOMA securities as collateral against Federal Reserve notes, it is anyone’s guess as to how much of the collateral is Treasuries versus MBS.

The Federal Reserve measures compliance with its collateralization requirements by using the book value of its pledged assets (excepting SOMA securities, which use par value). Using market value instead results in a slight over-collateralization, mostly due to the Fed’s gold certificate holdings. So at the end of 2017, the $1,571 billion of U.S. paper currency in circulation was actually backed by $1,902 billion in Federal Reserve assets. This represents a 121% collateralization ratio.

Of course, all this talk of real assets backing our cash sounds great at first blush. But there are still some serious drawbacks to the arrangement.

For one thing, U.S. currency is not officially redeemable for anything – not even the collateralizing assets! In fact, it is difficult to conceive of a situation in which the Fed would be forced to redeem Federal Reserve notes using its pledged assets.

The next stumbling block is that gold certificates and SDRs represent the lion’s share of the central bank’s “hard” (i.e. non-dollar denominated) assets. There is simply no way the Fed (or the U.S. Government for that matter) would allow these vital anchor assets to be paid out to currency holders.

In addition, the bulk of the collateralizing assets (81.7% by market value) are Treasury and MBS securities. But if these were actually paid out to dollar holders, it would only entitle them to receive more currency in the future, which would presumably be Federal Reserve notes too! The logic here is a bit circular, as you can tell.

As a final blow, the provision requiring all Federal Reserve notes to be collateralized does nothing to restrict additional future issuance. All the Fed must do in order to legally issue more currency is purchase additional Treasury or mortgage-backed securities on the open market (with digital dollars created out of thin air) and then pledge these fresh assets as collateral against newly printed Federal Reserve notes.

So in the final analysis, the Federal Reserve assets backing U.S. paper currency is more of an accounting relic from a bygone era of responsible central banking, than a true safety net. Because of this, I recommend that investors hedge some of their dollar exposure with tangible assets like precious metals, antiques and gemstones. That way, if the worst should ever happen, you don’t have to hope that the Fed makes good on its (almost certainly) empty promises.

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World War II and the Bankruptcy of the British Empire

Photo Credit (CC 2.0 license): Smabs Sputzer

World War II is one of most interesting periods in financial history, particularly because the sweeping conflict caused the bankruptcy of the British Empire to unfold with stunning speed. It took barely more than 10 years for the British pound sterling to go from a respected global reserve currency to a second-class credit.

Between the World Wars, from 1919 to 1938, the British Empire ostensibly reached the zenith of its power. It achieved its greatest geographical extent in the early 1920s, when it controlled almost 1/4 of the world’s surface area and nearly the same proportion of the earth’s population. Unfortunately for the British, this façade of colonial dominance was largely an illusion.

But it was a very powerful illusion all the same. Throughout the 1930s, Great Britain was viewed as one of an elite group of superpower nations that included France and the United States, as well as upstarts Germany and Japan.

And Britain’s currency, the pound sterling, supported this mainstream narrative. Until 1931, the pound had been the world’s reserve currency, with each pound equal to a British gold sovereign containing 0.2354 troy ounces (7.32 grams) of pure gold. Even after the Great Depression forced Great Britain off the gold standard, the pound still traded for around $5 on the FX markets during the mid to late 1930s. This was actually a slightly stronger rate than when both the U.S. and the U.K. had been on the classical gold standard before the early 1930s.

But the outbreak of World War II shattered this fantasy and quickly ushered in the bankruptcy of the British Empire. The first inkling of the disaster to come occurred when the pound plummeted from $4.61 to $3.99 in the harrowing month of September 1939, after it became apparent that Nazi Germany wasn’t backing down in its quest for European hegemony.

Pre-1931 British Gold Sovereigns for Sale on eBay

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Because the United Kingdom was ill-prepared for the outbreak of hostilities, it naturally sought to procure additional supplies and materials from abroad – most notably from the United States. But the U.S. was keen to preserve its neutrality in the European conflict.

As a result, the U.S. government adopted a “cash and carry” approach to selling goods in November of 1939. This allowed any combatant nation to purchase materials from the United States, provided they pay in hard money (gold, U.S. dollars or U.S. securities) and find a way to transport the material themselves.

Great Britain found itself in an excellent position to take advantage of the United State’s cash and carry policy. The British Empire was primarily a maritime power and still maintained a tenuous control over the all-important North Atlantic shipping lanes, despite attempts by Nazi U-boats to disrupt those routes. So the U.K. transported massive amounts of gold bullion, U.S. dollars and U.S. securities to the United States in exchange for desperately needed supplies.

But as Hitler’s Wehrmacht steamrolled through Continental Europe, Britain’s prospects dimmed considerably. The surrender of France in June 1940 was a particularly devastating blow to the U.K.’s war effort. In the summer of 1940, as the Battle of Britain raged over English air space, Winston Churchill and his cabinet began to come to the realization that the bankruptcy of the British Empire was quickly approaching if drastic action wasn’t taken.

First Britain resorted to some creative financing. The U.S. had previously expressed interest in leasing airfields in certain British possessions for military purposes. Although Churchill had initially rebuffed the proposal, the exigencies of total war soon forced him to reconsider.

On September 2, 1940, the U.S. and Great Britain formalized their Destroyers for Bases Agreement. In exchange for 50 obsolete U.S. Navy destroyers, Britain agreed to give the U.S. 99-year, rent-free leases on naval and air bases in various locations in Newfoundland and some Caribbean islands.

Around the same time, Churchill approved a vitally important secret mission that is commonly known as the Tizard Mission today. Named after its leader, British scientist Henry Tizard, it was the wholesale transfer of cutting-edge British technologies to the United States in September 1940. This was done in the hope that the U.S. could perfect and mass produce these inventions in time to have a significant impact on the outcome of the war.

These top-secret technologies included microwave radar via the cavity magnetron, the proximity fuse, schematics for a prototype jet engine and the Frisch-Peierls memorandum on the viability of a nuclear bomb, among others.

The technology passed to the Americans during the Tizard Mission was theoretically a gift, with no explicit, reciprocal payment demanded. However, it is reasonable to assume that Churchill secretly hoped such a generous gesture would obligate the Americans to continue supplying the British war effort, even if the teetering Empire was not able to meet the strict guidelines of the United State’s cash and carry philosophy.

World War II Era British Currency for Sale on eBay

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By late 1940, the British Empire’s bankruptcy was imminent. On December 8, 1940, Prime Minister Churchill wrote a letter to this effect to President Roosevelt. In it Churchill stated:

The more rapid and abundant the flow of munitions and ships which you are able to send us, the sooner will our dollar credits be exhausted. They are already, as you know, very heavily drawn upon by the payments we have made to date. Indeed, as you know the orders already placed or under negotiation…many times exceed the total exchange resources remaining at the disposal of Great Britain. The moment approaches when we shall no longer be able to pay cash for shipping and other supplies.

Consequently, President Roosevelt pushed the U.S. Congress for the passage of the Lend-Lease Act. This legislation would drop the pretense of American neutrality by authorizing the shipment of weapons, ammunition and other war materials to the Allied countries (primarily Britain, Free France and China) in exchange for the leasing of military bases in Allied territory during the war. No money would change hands; instead this would effectively be a U.S. donation to the Allied cause.

But as a prerequisite for the passage of the Lend-Lease Act, the United States demanded that Great Britain open its books, thus revealing the intimate details of its financial insolvency to the U.S. Secretary of the Treasury, Henry Morgenthau.

In addition, the Roosevelt administration insisted that an important British-owned, U.S.-domiciled company be sold in order to confirm that they had definitively run out of liquid U.S. dollar assets. The British duly complied, announcing the March 1941 fire-sale of the American Viscose Corporation – a manufacturer of synthetic textiles and the largest U.K. holding left in the U.S. The company only realized a fraction of its appraised value.

The Lend Lease Act was finally passed on March 11, 1941. U.S. weapons and supplies soon flowed into the bereft British Empire in massive quantities.

To compound difficulties for the British, it soon became apparent that the crown jewel of their empire, India, would not remain under British rule for long once the war was over. This political development made it impossible for the British to attempt to partially recover the cost of the war from India. And to make the British Empire’s grave financial situation even worse, it was clear that many of its other colonies would also demand their independence once the war concluded.

When World War II finally ended, the pound-dollar exchange rate was $4.03, the level it had been pegged at by the Bank of England at the beginning of the conflict in 1939. But the British Empire’s fiscal situation had deteriorated massively during the intervening years, leaving its currency extremely overvalued.

World War II Era British Silver Coins for Sale on eBay

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As part of its war-time negotiations with the United States, Great Britain had agreed to open up its consumer markets to U.S.-made goods after the war. This severely undercut post-war profits for British businesses. In addition, by 1945 the British economy had completely converted to a war-footing and was slow to retool to meet domestic consumer demand.

Like all warring nations, Great Britain had borrowed heavily to help fund its war effort. In 1945, Britain’s aggregate debt (much of it held by foreign interests) was a staggering £21 billion, which was equivalent to over 75,000 metric tons of gold at then current exchange rates. This was more than 2.5 times the combined national gold reserves of every country on earth at the time!

In other words, it was a sum that could never be paid back without resorting to currency devaluation.

Britain’s initial emergency move was to remove all silver from her circulating coinage. From 1920 until 1946, every British denomination from the tiny 3-pence to the massive crown (5-shilling coin) had been struck from 50% fine silver. Starting in 1947, the British Royal Mint changed over to a base-metal, cupro-nickel alloy, allowing the government to save money on coinage costs. In addition, the British Royal Mint could “mine” the existing circulating coinage for its silver content, gradually replacing it with less expensive base-metal coins.

But the coup de grace came on September 19, 1949 when the British Chancellor of the Exchequer, Stafford Cripps, was finally forced to devalue the once prestigious pound sterling from $4.03 to $2.80 – an overnight 30% loss of purchasing power. With this stunning act, the British pound definitively lost its global reserve currency status. The bankruptcy of the British Empire was complete.

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The Top 5 Mistakes Collectibles Investors Make

Thinking of investing in vintage collectibles or antiques? Don’t make these 5 big mistakes that plague many collectibles investors!

1) Believing that what worked in the past will work equally well in the future

Although this myth isn’t unique to collectibles investors (indeed it is often shared by financial advisors and pundits), that doesn’t make it any less dangerous. The logic goes like this:

Because this (fill-in-the-blank) collectible has appreciated strongly over the past 5, 10 or 20 years, then it must be destined to deliver good returns in the future as well. So you should load up on those late 1970s Star Wars toys, Mid-Century Modern furniture or vintage Coca-Cola memorabilia.

But this superstition runs afoul of the old investing adage, “past performance is no indication of future results.”

What happens instead is that the collectible in question eventually runs into the law of large numbers. In a nutshell, this dictum states that it becomes increasingly difficult to compound growth as values rise ever higher. I’ve already discussed this fascinating concept in greater detail as it applies to the rare U.S. coin market.

Let’s conduct a thought experiment. Early Star Wars toys are valuable today because the movies were so successful – an outcome nobody expected at their initial release in 1977. Everybody in the world has heard about Star Wars at this point. How does the franchise get any bigger or more famous?

If you are buying vintage Star Wars toys today hoping to see the same investment returns they’ve experienced over the past 40 years, you are implicitly hoping Star Wars becomes even more culturally influential in the future. While this outcome isn’t completely impossible, it is exceedingly unlikely.

2) Expecting low quality collectibles to appreciate in value

Collectibles investors are faced with a marketplace that is absolutely saturated with low quality vintage junk. Antique malls, thrift stores and flea markets are all overrun with poorly made plastic and cardboard memorabilia from the 1970s, 80s and 90s.

Beanie babies, Cabbage Patch Kids, (post-1980) baseball cards and (modern) comic books are just a few examples of these junk collectibles. These throw-away items (and many, many others just like them) were mass-produced by the millions with little thought given to their durability, craftsmanship or future desirability. This sad state of affairs is reflected in their pricing, where these collectibles are almost universally available for just a few dollars each (and oftentimes even less).

It can be a minefield trying to avoid these junk vintage items. For example, in the 1980s the Swatch Watch was a cultural phenomenon. These boldly colored and strikingly styled wristwatches were churned out by Swiss watch manufacturers in an attempt to win back some business from the flood of cheap quartz models that had decimated their market share in the late 1970s.

But Swatch Watches were meant to be low-priced, consumable fashion items. They were usually made from plastic cases with either cheap mechanical or quartz movements. In contrast, Seiko – a Japanese mid-tier watch brand – built mechanical watches during the same period to a much higher standard than Swatch Watches.

As a result, although vintage Swatch Watches look like they should be great collectibles, they are actually pretty terrible. On the other hand, collectibles investors can’t go wrong with desirable vintage Seiko mechanical wristwatches. Quality matters.

3) Ignoring demographic trends

Many collectibles investors don’t understand that (at least part of) the antiques market is a popularity contest driven primarily by demographics. In other words, popular vintage collectibles are generally fondly-remembered childhood items from the prime collecting demographic – people aged from their mid 30s to early 60s. Today, this primarily means collectibles from the 1970s and 1980s.

But while this is a well-documented phenomenon, collectibles investors will have a hard time cashing in on it. This portion of the collectibles market is often driven by whacky, unpredictable fads that make entry and exit points impossible to time with any degree of accuracy.

For instance, Elvis Presley memorabilia was huge in the 1980s and 1990s. Middle-aged Silent Generation and Baby Boomers couldn’t get enough of Elvis, who had been a staple of their youth. Late night television infomercials hocked Elvis commemorative plates, compact discs and figurines, among other things. Antique stores burst at the seams with vintage Elvis items. And it all sold too.

But where was the peak for Elvis memorabilia? Was it in 1983? Or perhaps 1989? Or maybe it was in 1996? I don’t know the answer to that question. And I doubt anyone else knows the answer, either. However, during those heady days it would have been seductively easy to convince yourself that the gravy-train would never end and that Elvis collectibles would remain popular forever.

But if you did believe the hype, you would have eventually paid for it. Today, Elvis’ fan base is dying off and his memorabilia is in terminal decline, with prices relentlessly dropping year after year.

Instead of chasing mercurial demographic fads, I believe most collectibles investors would be better served by sticking to high quality items with classic styling. Even if they go out of fashion temporarily, they will always become popular again at some point in the future due to their high build quality and timeless air. The Antique Sage’s 5 rules for investment grade antiques can help you choose the right vintage items.

4) Buying items that are damaged or in poor condition

Nothing can tempt a person to buy like low, low prices. And collectibles investors are all too human in this regard. But many times those low priced vintage items are cheap because they are either damaged or in poor condition.

However, savvy collectibles investors understand that there is no substitute for good condition. Yes, sometimes an item with certain material defects or age-related issues can be successfully restored. But even a successful restoration will invariably lower the value of a vintage piece versus a pristine, unrestored specimen.

The lesson here is clear. Always keep a close eye on condition (including any restorations) and don’t be afraid to walk away from a collectible or antique that has taken one too many dings.

5) Being unwilling to pay a modest premium for superlative pieces

This is a topic near and dear to my heart because I’ve learned about it the hard way. I previously wrote an antique investing article recounting my personal experiences with “the one that got away“. Unfortunately, this theme – failing to pay-up for terrific specimens – dominated the article.

One day you will come across a particularly fine collectible or antique. It may be in completely original, perfect condition. Or perhaps it will be an extremely rare item. It is even possible that a confluence of many different factors will combine to create a truly outstanding piece.

But when that day comes, you should open your wallet and happily pay the seller his asking price. As long as the price tag isn’t truly exorbitant, you will almost certainly make money by following this strategy. Don’t let $100 or $200 stand between you and a proverbial investment gem.

Read more thought-provoking Antique Sage investing articles here.

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The 1902 Sears Roebuck Catalogue – An Inflationary Retrospective

With the impending bankruptcy of Sears, I felt that now would be a good time to talk about the 1902 Sears Roebuck Catalogue. This 1200 page monster was the Amazon website of its day, allowing people from even the remotest corner of the country to purchase the latest goods and fashions from a trusted retailer at competitive prices.

Of course, one of the most notable aspects of the 1902 Sears Roebuck Catalogue is the startling difference between modern prices and the 1902 prices advertised in the catalogue. These dramatic price changes are attributable to inflation, which has been surreptitiously doing its wicked work on the U.S. dollar for a full century now.

My introduction to the 1902 Sears Roebuck Catalogue came as a child when I used to visit my grandmother’s house to mow her lawn. My grandmother had a reprint of the old book, which I always perused after finishing my lawn-mowing duties.

The thing that always fascinated me about the 1902 Sears Roebuck Catalogue was its inflationary implications – the staggering amount of purchasing power the U.S. dollar had lost between 1902 and the present day.

For example, a men’s solid 14K gold pocket watch with a 17-jewel, Waltham movement (which would have been state of the art at the time) cost between about $30 and $50, depending on the case options chosen (hunting cases were more expensive than open-faced cases).

A quick scan on eBay reveals that similar gold pocket watches in good condition are selling for anywhere from $400 to maybe $2,500 today (in 2018). Of course, if pocket watches were still produced today, you can bet that retailers would sell them for higher prices than secondhand ones fetch on eBay.

Or maybe instead of a gold pocket watch, you are interested in a breech-loading, double barrel shotgun with a solid walnut stock. The 1902 Sears Roebuck Catalogue had a full 11 pages of double barrel shotguns to choose from. Yes, these hunting guns could be anonymously ordered through the mail in 1902 – no identification necessary!

And their prices were almost unbelievably low by today’s standards. The cheapest examples cost around $8 or $9, while the very finest Remington shotgun with a Damascus steel barrel and an English walnut stock rung up at only $50. These same shotguns today run from just a few hundred dollars to several thousand dollars, depending on condition, rarity and a myriad of other factors.

Another interesting find in the 1902 Sears Roebuck Catalogue is the selection of concrete-filled steel fire safes for sale. These robust safes had stepped, 5-flange doors (in order to better resist explosives), applied-gold exterior decoration and built-in interior cabinets. Prices started at only $6.25 for a cut-down model and rose to a princely $32.25 for the largest size – a 1,150 pound behemoth with an inner steel security door.

In contrast, today it is tough to find a good burglary-fire safe for anything less than about $700. And prices can easily rise to $5,000 or more for high-security models. Yes, there are cheaper safes out there, but they are usually sub-par import safes straight off the container ship from China. If security is important to you, these low-quality, imported safes should be avoided at all costs.

As you can see, regardless of the product category, inflation has decimated the purchasing power of the U.S. dollar over the past 116 years. According to the Bureau of Labor Statistic’s CPI inflation calculator, the U.S. dollar has lost about 96% of its purchasing power between 1913 (when records were first kept) and 2018.

This means that every dollar in 1913 is equivalent to over $25 today. However, the BLS calculations use some questionable methodologies, including hedonic adjustments and substitution effects. Looking at actual prices paints a bleaker picture of inflation, with $1 of goods from the 1902 Sears Roebuck Catalogue equal to something closer to $50 or $100 of goods today – a stunning 98% to 99% loss of purchasing power.

In case you were wondering, the dollar suffered almost no inflation before 1933 because the U.S. was still on the gold standard at the time.

But we have come a long way from the days of the gold standard, and not in a good way. The fact is that the U.S. dollar has been progressively and systematically destroyed by its supposed protector, the U.S. Federal Reserve. This disturbing trend is even more blatantly obvious when one examines the secret history of 20th century U.S. currency.

This is why I recommend that investors position themselves in antiques, bullion, fine art and other hard assets over the coming years. The day is coming when the dollar’s slow motion collapse will transform into a terrifying plunge. I don’t know about you, but I want to own tangible assets that cannot be arbitrarily printed by a central bank when that time finally arrives.

Read more thought-provoking Antique Sage history articles here.

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