The US Federal Reserve (the Fed) is only months away from going broke.
Technically, this means its liabilities will exceed its assets and it’ll be trading insolvent.
Our own Reserve Bank of Australia (RBA) is in the same boat already, after losing $37 billion last year.
Now, a normal bank would go bust if this was the case.
But central banks aren’t normal. They can go on operating even though they’re ‘broke’ by normal definitions.
So does any of this matter?
That’s what we’ll look at today…
1934 on repeat
I shared this chart with subscribers of my Crypto Capital service recently:
Source: Andy Jagoe
This diagram shows our current hierarchy of money.
As you can see, the debt of the US Government sits at the top of the tree with the Federal Reserve pulling the strings.
But it wasn’t always this way…
For three quarters of the 20th century, gold was the top layer of money too:
Source: Andy Jagoe
Then, in 1971, President Nixon took the US off the gold standard once and for all. And since then, the US dollar has been king.
A key point to understand is that every other form of money, including our own Australian dollar, is further down the pecking order.
That’s why a lot of countries, like Japan and China, tried to get hold of US Treasuries (the top layer of money) in the past.
They used US dollars to support the value of their own financial system, though, this trend is starting to reverse, as I’ll explain shortly.
But for now, the US still remains top dog.
So what happens then if the Fed goes broke, as seems to be imminent?
Well, we have a precedent…
You see, in 1934, the Fed did go bust.
Back then, the US was still on a gold standard and the Fed had to hold enough gold at $20.67 per ounce to back their US dollar banknotes.
Gold was the Fed’s asset that backed the banknotes which were the Fed’s liability.
This is basic double-entry accounting. Your assets (plus equity) must match (balance with) your liabilities.
Hence the name ‘balance sheet’.
Anyway, in 1934, the Fed’s balance was shaken up.
In the depths of the depression, the US Government suddenly ended gold convertibility for private citizens and ordered the Fed to hand over its gold reserves to the US Treasury department — the finance department of the US Government.
In other words, the Fed now only had liabilities on its books and zero assets.
Why did this matter?
Well, a central bank with no assets isn’t an independent force anymore. It’s merely another arm of the government, reliant on politicians for its funding and very existence.
That’s a problem.
A political currency becomes subject to the political whims of the day. This makes it less trusted by other countries.
So back then, some enterprising US officials came up with a novel solution to this conundrum.
It was this…
The US Treasury Department provided the Fed with gold certificates equal to the amount of gold they’d just pilfered.
These certificates were ‘non-redeemable’, which meant the Fed couldn’t actually take back the gold.
But as an accounting trick, it did its job. The gold certificates ensured the Fed had the ‘assets’ to cover its liabilities.
Over time, gold was silently shoved to one side as ‘layer one’ money in favour of US Government debt.
And what was once the core of the entire US financial system is, today, an inconsequential fragment of the total balance sheet.
[Editor’s note: The Fed actually still has those certificates on their balance sheet! But they represent a tiny US$12 billion out of a US$8.5-trillion balance sheet.]
The trillion-dollar coin solution
This history lesson is important for two reasons…
First, to show you how base layer money changes over the years, even if it’s not always directly obvious to us in the public how.
But secondly, to show you how ridiculous the monetary system is at its very core.
I mean, we’re talking about literally making up a fake asset to cover up an accounting hole.
This is the kind of thing you might expect from some shonky back street accountant. But from the ‘eminent’ economists of the world’s premier economic institution?!
It’d be funny if it wasn’t so serious.
And the bad news is nothing has changed.
Take one crazy proposal to deal with the US’s burgeoning debt load, for instance…
In recent times, serious people in the US Government have actually floated the idea of minting a ‘trillion-dollar coin’ to solve the debt issue.
How it works is completely loopy, yet entirely possible in the system we live in.
You see, because of a legal loophole, the president of the US has sole authority to direct the issue of commemorative coins.
These are usually $5 or $10 coins to celebrate a famous occasion or important person.
But the rules don’t put an upper limit on the value of these commemorative coins.
So, the idea is that the president could order the minting of a one-off $1 trillion ‘commemorative’ coin.
They would then deposit this coin with the Fed and voila, problem solved!
The US Government’s debt load would reduce by US$1 trillion.
If that sounds ridiculous, that’s because it is. But as the gold story from 1934 showed, these are the kind of ideas our money actually runs on.
It reminds me of the old quote from Henry Ford who reportedly said almost 100 years ago:
‘It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.’
Which brings us back to the original question.
Does it matter if the Fed is about to go broke?
The curtain is being pulled back
Well, yes and no.
Yes, it matters in the long term, as I’ll explain shortly.
But in the short term, things will go on as normal. Though, there is one immediate tangible cost to the US budget when the Fed starts making losses.
You see, right now, the Fed share profits to the tune of US$100 billion a year with the US Government.
But they’re about to make losses so big, it’ll wipe out their equity and make them technically insolvent.
They’ll be broke.
As these losses build, they have to cover them first before they can start paying the government a dividend again.
And US$100 billion a year isn’t chump change (it’s about four times the annual budget of NASA, for a start), especially for the current debt-laden US Government.
But apart from that immediate consequence, business will go on as usual for the Fed.
As I said before, central banks aren’t normal banks, so the rules don’t apply to them.
But the longer-term consequences of what happens next are probably more important to think about.
How ridiculous can things get before people realise what a sham it all is?
I liken it to the famous scene in The Wizard of Oz, when they pull back the curtain to find the ‘all powerful wizard’ is actually a frail, old man talking through a loud speaker.
You can’t help but feel we’re getting close to that stage with the US dollar and the current financial system.
Many countries were already starting to lose faith in the US dollar as a store-of-value asset.
The main issue is this ever-growing debt pile:
Source: US Money Reserve
If you hold US Treasuries, you’re holding the debt of the US Government. What if they can’t pay it back?
The confiscation of Russia’s US Treasury holdings last year in response to the Ukraine war was another warning shot to countries like China and India.
What good is holding US Treasuries if the US decides to confiscate it for some reason?
Everyone, everywhere, is asking themselves, can we still rely on US money? And if not, what comes next?
This is certainly an open question right now.
And now with the Fed about to go broke too, we seem to be approaching some sort of crunch point.
What does this mean for investors?
In my opinion, make sure you own hard assets like commodities, energy stocks and infrastructure, and Bitcoin [BTC].
Real ‘stuff’ that’s in demand and can’t be printed at will.
The rest could end up being as valuable as Monopoly money…
Editor, Money Morning