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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