On the Differences between Federal Reserve Notes & ‘IOU Money’

If you own a ‘$100 Citibank deposit’, you’ve got $100, right? Wrong, sorry, you don’t. A claim upon something is different from the thing itself. So, a claim upon a dollar is different from a dollar itself. This – of course – seems patently obvious, even so, I contend that the implications are interesting (particularly for the contrarian investor). If we revisit my favourite analogy; money is to profit-seeking individuals as the sea is to fish, then it should be clear that such implications are – in fact – significant for most people.


Here, I dissect the money supply into – broadly – federal reserve notes & reserve balances and ‘IOU Money’. I consider the investment implications of current trends in these components of the money supply.


Federal Reserve Notes & Reserve Balances:


Federal Reserve notes and reserve balances (held by commercial banks) are direct liabilities on the Federal Reserve. If you own a $100 note, you have some kind of claim on the Federal Reserve’s assets. As I have described previously, these claims trade at ‘discounts from par‘. Meaning, the market reflects the fact that the dollar is – at most – as good as what it is backed by.


‘IOU Money’:


‘IOU Money’ – by contrast – is not a claim on the Federal Reserve. Rather, it is a claim upon the issuer, and is only as good as that issuer. This ‘IOU Money’ is what most people own and use on a day-to-day basis. So blurred is the consensual conception of money, that such IOU claims are termed ‘dollars’. Echoes of the repeated insight of Robert Prechter come to mind; he advocates owning dollars, but qualifies this by saying something like; ‘What I call dollars is not what most people call dollars’.


A Rising Trend in the Supply of Federal Reserve notes & Reserve Balances – A Falling Trend in the Supply of ‘IOU Money’:


It would seem that the ‘private sector’ portion of the economy reached its maximum capacity for leverage in either 2000 or 2008 (see charts below). Due to the nature of fractional-reserve institutions, there is an intimate connection between credit and ‘IOU Money’. So, arguably, the ‘private sector’ reached its maximum capacity to produce ‘IOU Money’ in either 2000 or 2008.


Total Credit Market Debt Owed (YoY)

Click to enlarge. Source: St Louis Fed

Domestic Debt Nonfinancial Sector - Business Sector

Click to enlarge. Source: St Louis Fed

Total Credit Market Debt - Household Sector

Click to enlarge. Source: St Louis Fed.


The trend that we’re left with is a downward contraction in the stock of ‘IOU Money’. However, in the developed world at least, the consequences are deemed to be so unfortunate that ‘IOU Money’-destruction is opposed with dogmatic ferocity. There seems to be a peculiar rejection of the truth that nothing material about the future is absolutely guaranteed to us mortals. Deposits – it is said – ‘should’ be unshakeably guaranteed. Therefore, the people at the Federal Reserve now spend most of their time worrying about preserving the ‘status quo’ of the monetary system. Their major tool has been to debauch their own liabilities (Federal Reserve notes & reserve balances) to reduce the burden upon ‘IOU Money’-issuers. It is by increasing their balance sheet that the Federal Reserve debauch their liabilities. Thus, we seem to be in an environment with a rising stock of Federal Reserve notes & reserve balances and a stagnating/falling stock of ‘IOU money’.


Long Gold reconciled with Short ‘risk assets’:


As I mentioned here, the investment community seems to be polarised into two camps; the inflation camp and the deflation camp. If you’re long gold, you’re deemed to be an ‘inflationist’ that shares the prejudices of the inflation camp. I have misgivings with this way of thinking; I can reconcile being long gold with being short (or just skeptical of) conventional risk assets.


Firstly, as Marc Faber pointed out in his recent report, gold – relative to other assets – is barely owned (see chart below). Yet gold is on the balance sheet of the Federal Reserve. So, as they fight to decrease the burden of their own notes (so as to attempt to preserve the existing supply of ‘IOU money’), they’ll inevitably dilute their own notes.


Gold % Pension Fund Assets

Click to enlarge. Source: Casey Research

My premise is that sometimes they’ll succeed in averting a credit collapse and that sometimes they won’t. Either way, they’ll at least try to avert a credit collapse. If this is a valid premise, then they’ll continually expand their balance sheet over the coming years. As fiat currencies trade at discounts from par, this will likely bring about increases in the gold price.


But what if they fail? Then – of course – gold could become subject to forced selling (as with everything else). However, as it is relatively unowned, it could outperform other assets in a general downtrend as well. I’m not saying that gold is a guaranteed win or anything like that, rather, I’m saying that it might be good to own on a relative basis. [This out-performance would become less pronounced as bullish sentiment on gold becomes progressively more emphatic (as then more people would be pressured to liquidate in a 'IOU money' collapse).]




There seems to be a tendency towards a rising stock of Federal Reserve notes & reserve balances and a falling stock of ‘IOU money’. This could be – at the same time – positive for gold and negative for traditional ‘risk assets’ (that are often regarded as ‘inflation hedges’).


See here for our collection of rare historical economic data.

Posted Apr 3, 2011