headerwebIs the Government Playing You?

How the Government Borrows Money

Dear Readers,

There’s been a lot of unnecessary political drama over the past few weeks, notably the big issues with the debt ceiling and government shutdown. This put many investors – including technical traders and analysts – on edge and on the sidelines.

But as I clearly stated in my last few letters – unless you’re an American government employee – none of this should’ve worried you; the markets would likely move higher:

“With the amount of money in deposits growing at the banks and being used as collateral for big stock market bets, the markets could continue to move higher this year.”

Of course, a U.S. default would’ve been disastrous; more so for what America represents, rather than the actual outcome of a short-term default. One default in a set of bonds doesn’t directly affect other bonds, but would cause lending rates to skyrocket. The domino effect of this would’ve been very bad.

Now despite everything that is happening around the world, including recent record-breaking bad loans across Spanish banks, the European recession, Japanese turbulence, and Brazilian inflation, stock markets continue to move higher.

Over the past few weeks, I explained exactly why and how the stock market is moving higher – and why it will continue to move higher – despite all economic worries:

And if you go back a little further to my Letter, “The Story of the Year“:

“Never make short term bets against an entity that can print unlimited amounts of money.”

Now take a look this chart:

fed-assets-vs-s&P-500

This is a chart comparing the Fed’s total balance sheet starting August 2008 (now over a record-high of $3.81 trillion and growing) to the S&P 500 (which has now reached a record high close of 1744.50 this Friday).

While many of you understand the situation (as I can see in the comments and emails), there are some that still have yet to grasp why and how QE has flowed into the stock market.

So this week, I am going to start with the most basic concept: how money/currency works.

How Money Works

Let’s use the United States as an example.

The United States is a world power and a first world nation. It has to spend money to maintain this status by building roads, providing healthcare and public services, and funding wars.

But all of this money has to come from somewhere.

Historically, most of this money came from taxes and government-owned corporations.

But as the world power grew – through wars and economic activity – so did its spending habits.

Taxes were no longer enough to cover all of the bills.

So – like every one else – when you don’t have enough money, you borrow it.

When the government spends more than it brings in, it’s called deficit spending.

How the Government Borrows Money

The U.S. treasury, the department of the U.S. government that manages all of the Federal finances, borrows money by issuing a bond.

A bond is simply a piece of paper – a promissory note – that says if you give me money now, I will pay you back in X amount years, with interest.

These pieces of paper are then sold through a bond auction where the world’s largest banks participate in buying part of this national debt.

The banks then sell these bonds to other investors, such as investment funds and countries like China and Japan.

(China owns more than $1.28 trillion in U.S. Treasuries, according to the July 2013 figures released by the U.S. Treasury. This is equal to nearly a quarter of the U.S. debt held overseas and nearly 8% of the United States’ total debt load of more than $17 trillion. Since China owns all of this debt and since the government generates income through taxation, your kids will be taxed in the future just to pay China back.)

Since America is the world’s largest economy, among other things, the demand for their promissory notes has never been an issue.

But over the past years, record amounts of these bonds have been issued; so much that the banks had to turn to someone else to buy them.

But who?

Who is the Largest Single Buyer of America’s Federal Debt (aside from the government itself*)?

(*The U.S. Social Security Trust Fund is the largest single holder of America’s national debt, but they’re part of the government. Yes, the government can sell debt to itself but it will have to pay it back by issuing more bonds borrowing more money.)

Welcome the Fed, America’s central bank – a private bank controlled by bankers, and not the U.S. government.

The Banks – who purchase these bonds from the Treasury – sell Treasury-issued bonds to the Fed, who in turn gives these banks yet another piece of paper in exchange.

This piece of paper is essentially another IOU from the Fed to the Banks, just like the IOU from the Treasury to the banks.

Its like when you or I write a check, we’re giving someone an IOU that they can redeem at a bank.

The only difference between our IOU and the Fed’s IOU to the banks, is that we have to have that amount available in our bank account for someone to cash that IOU – otherwise, that check bounces.

When the Fed writes an IOU to the banks, it doesn’t have to have anything:

“When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money.” – Federal Reserve Bank of Boston, Putting It Simply (1984)

If there are no deposits at the Fed, how does the Fed give cash to the banks?

Easy. It writes another IOU to the banks. And since the Fed is neither audited, nor are there are any real bank deposits taking place, it’s literally creating free money.

Now here’s where it gets fun.

Madoff

When the government spends money building roads, providing social aid, or funding wars, they are essentially funding more workers and soldiers who then take their hard-earned money and deposit it back at the banks.

But when you deposit your money at the bank, the money doesn’t just sit there for safekeeping.

In fact, once your money is there, the bank can use it to make more money by lending it back out to you, or make big bets on the stock market by using YOUR money as collateral (see Why Banks are Being Forced to Create a Stock Market Bubble).

Furthermore, it can do this with insane leverage because a bank is only required to have a certain percentage of your money available at any given time. The remainder of your money is used to fund investments or loans that the bank makes to other customers, including you.

This is called fractional reserve lending.

Currently, banks in the U.S. are required to have a certain amount of money in their system, known as reserves. These required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with the Fed.

In the U.S., the average fractional reserve-lending ratio is 3%* – meaning that if you deposited $100 at the bank, the bank can take $97 of it to make loans or gamble on the stock market.

(*This number can be as low as 0% – depending on the amount and on different classifications. We can save this for another story next time.)

Not only are banks able to use most of your money to make big bets, they now have a record amount of money in deposits from selling bonds to the Fed.

And, as I mentioned last week, with so much money sitting in the banks, the banks are practically forced to invest and make even bigger bets on the stock market.

One look at the chart above and you can see how the Fed’s asset purchases have fueled the stock market.

How Big Can the Bubble Get?

If you remember in my Letter “A Shocking 2011 Cover-Up,” I showed you that the Fed purchased an astounding 61% of the total net Treasury issuance in 2011.

According to Bloomberg, the Fed bought 90% of new bonds in 2012.

While the ultimate stock market bubble is being created, there is so much more room to grow in terms of paper asset appreciation. The amount of leverage now in the system is beyond anything you could imagine.

While I believe things are most certainly not what they appear, I am not one to say the world is about to end, nor will I scream doom and gloom…yet.

Those who protest that the Dollar and other currencies will collapse soon because of this paper asset bubble should ask themselves one thing:

“Do you see paper currency EVER not being used?”

The world is so intertwined in central bank currency that it would take an absolute world war conflict to change that.

This is not to say the markets are safe, but reality is that money continues to enter our system – and much of it has barely even been used…

Where is the Market Headed?

Let’s take a look at the data from September 13, 2012, since the Fed’s asset purchases have been more steady over the this time with QE3:

fed-asset-s-&P-500-trend

If record asset purchases – QE – continue over the next few weeks and months (and all signs point to this being the case), then the chart’s outlook is very simple: We should see the S&P move to a smashing new record of 1800 before the end of the year – that’s a gain of more than 23% for 2013.The trend forecast remains relatively the same, even using numerous trend equations such as linear, power, logarithmic, etc. (polynomial used in above chart).

Why Gold Price Has Not Spiked

It’s hard to talk about currency without talking about gold.

I received a lot of questions regarding gold prices and it’s becoming more tedious to find specific answers for every day price actions.

So to really make it simple, my answer to all gold price questions is this:

Gold, like the financial system, is now traded as an IOU – just like currency.

As such, it can be manipulated by the banks and other institutions the same way currency has been (you’re seeing this everywhere, with the UK’s Financial Conduct Authority now joining the probe on currency manipulation.)

If a $5.3 trillion-a-day foreign currency market can be manipulated, then manipulating the gold market – of which the total value of all gold ever mined is around $7 trillion at current prices – seems like a walk in the park.

The fundamentals for higher gold prices are all there, but there are obviously occurrences that suggest gold price manipulation. It’s going to take a serious probe by world organizations on gold price manipulation to truly send gold to the levels that people like Peter Schiff predict in the near term.

And since all buyers of gold would rather pay a cheaper price anyway, whose going to lead the way in a global investigation?

 

Until next time,
Ivan Lo

The Equedia Letter

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