The US national debt since 1790 measured in ounces of gold.

Below there is supposed to be a chart of the total US national debt divided by the official price of gold before 1933 and the LBMA fix since 1933. Interesting to note, while most have had the perception that the debt has been growing since 2001, in terms of gold it has cut in half to the same level as the early eighties. Clearly, the higher the market price of gold the lower the value of non-redeemable debt. Like much of economics, this is counter intuitive and against the general public perception that the debt has been growing.

The zero interest rate policy and the consequences thereof.

Would the entire financial system be destroyed if rates go back up to normal levels?

There is no greater economic variable than interest rates.

Derivatives for interest rate products are the largest financial markets, both with exchange traded and over-the-counter negotiated derivatives.  Trillions of dollars in value depends upon what may happen to interest rates of any duration on any given trading day.

Due to the unsustainable deficits started during the administration of G. W. Bush, currently, short term interest rates are effectively zero in the United States.  The Federal Funds target rate remains at one quarter of one percent, twenty five basis points.  Without interest on reserves paid by the central bank, the Federal Funds rate would probably be at zero or even below.  The most widely quoted London inter-bank short term rate remains been below one percent.  Even ten year government notes only yield less than three percent.  Yet for several years now, there has been talk about an imminent rise in interest rates.  What does this situation indicate?  

Japan was first to implement the zero interest rate policy to fund their large debt created by their model welfare state.  Liquid credit and real estate correspondingly boomed through the 1980's.  In some places with the highest priced real estate per square foot in the world -- the price was too high to finance at high interest rates.  Why would any prudent lender possibly speculate that real estate could be worth more than the cash flow produced?  Such questions seems easy to ignore when prices could not be stopped.  During those years some Japanese banks would park reserves with rival banks for a small return because they couldn't find any deals with enough cash flow.   They couldn't find enough assets to balance their liabilities.

Unfortunately, no economy can keep artificially increasing wealth versus foreign competitors just by pretending their real estate keeps appreciating.  Such conditions create the realities that currency speculators dream of.  Notwithstanding financing costs of a model welfare state; preventing economic destruction by artificially supporting real estate with interest free money was the primary purpose of implementing a zero interest rate policy.  

America has also started a race to the bottom during the nineties, when it was discovered that artificial profits in the real estate market could be created without working to create value, by simply lowering interest rates. If incomes remain the same and interest rates go down, then there is a higher percentage of that income available to stimulate the economy by purchasing all of the new technology coming to market at the turn of the century.

Devaluing a currency with interest rate parity also makes exports more competitive, which has been the primary policy on which Japan has banked. The problem with surfing to the top of a wave of artificial wealth is that there is nowhere left to go but down.

Can the zero interest rate policy continue in America?  The media constantly trumpets fear and greed about increasing interest rates to sell their programming.  Warnings about inflation are often sounded as prudent financial advice. Yet what would happen if the Federal Reserve wasn't bluffing about the end of quantitative easing?

There are four major groups that would be destroyed by a rise in short term interest rates levels considered 'normal' in America over the past several decades:

Real Estate Borrowers

Choosing to finance with fixed or floating interest rates, becomes a major financial decision.  If rates went back to levels considered cheap only ten years ago, an avalanche of foreclosures will make the current record number seem dull.  Borrowing against real estate has long been the driving force of the American economy.  Like the Japanese, lenders here had no problems with loans for valuations above what the cash flow could sustain.  Now, it is extremely unlikely that real estate will ever rally again above the previous highs without massive devaluation of the currency in real terms.  Floating rate loans make margins for landlords wider on the way down, but if rates go up many landlords and homeowners will become renters themselves if not homeless.

If interest rates went back up then the real estate market would be destroyed.

Swap Dealer Banks

Interest rate swaps are derivatives contracts traded in the over the counter market.  Based upon a fixed notional sum, both counter-parties 'swap' fixed payments for floating payments for a term of up to fifty years. This is why swaps are often called 'anti-bonds' because the buyer receives a floating rate while paying a fixed rate, as the seller receives a fixed rate while paying the buyer a floating rate -- whereas buyers of bonds receive a fixed rate.  The primary use of interest rate swaps are for hedging against a rise in floating interest rates.

The half dozen largest major dealers in the interest rate swaps market also must mark their positions to market usually based upon  the 3 month British Bankers' Association London Inter-Bank Offer Rate. Representing the 'sell side' of the trade, these firms own trillions in risk to counter-parties receiving the floating rate payments.  So long as the 3 month LIBOR rate remains below the fixed rates they receive in return, the sell side banks continue to earn a nice spread. However, if floating interest rates rose sharply, these swap dealers might find themselves in a situation where they are paying out much more than the fixed amounts they are receiving.  They would become an avalanche of offers, all trying to hit the same disappearing bid on the Chicago Mercantile Exchange Eurodollar futures settled to LIBOR, further pressuring short term interest rates.  If short term rates went to just five percent, the scenario would be systemically catastrophic for these banks requiring immediate credit expansion by monetary authorities to prevent a total systemic economic meltdown scenario.

The Federal Reserve System Open Market Account

The central bank maintains a portfolio of securities which now includes agency securities and mortgage backed securities in addition to the traditional portfolio of United States treasury securities.

Following an unprecedented liquidity expansion, the System Open Market Account of the Federal Reserve remains around 3.46 trillion dollars.  Not only is the size of the portfolio larger than ever before, the duration is also longer and thus riskier.  The large dollar value at risk per basis point of this portfolio creates the possibility of extremely large losses by the central bank.  What would happen to the value of the System Open Market Account if interest rates went back to levels that were considered low ten years ago?

http://www.newyorkfed.org/markets/soma/sysopen_accholdings.html

One of the methodologies for measuring value at risk of a fixed income portfolio is known as the DV01, the dollar value that the portfolio will gain or loose per basis point.  Currently, the DV01 of the System Open Market Account of the Federal Reserve is almost three billion dollars.  So for every interest rate increase of one basis point, the SOMA will loose three billion dollars.  If interest rates go back up two percentage points then their portfolio would loose three billion times 200 bps, or six hundred billion dollars.  This is why the Fed must continue to maintain a zero interest rate policy despite previous talk of monetary tightening.  Even with a high water mark on their illiquid portfolio of mortgage bonds the net present value of the Federal Reserve is still currently negative. Hence, by holding their portfolio until maturity they can avoid having to realize massive losses that otherwise would make them insolvent under the Federal Reserve Act.

Even still, they changed their accounting rules to create 'negative liabilities' in their account for interest on Federal Reserve notes due to the US Treasury. That liability account represents a royalty payment for the license to monopolize banking -- whereby any remaining net profits not otherwise lost to the primary dealers are paid to the treasury.

One way to think of it is that the central banking cartel pays a tax rate of 100% of all 'profits' to the treasury as a franchise fee for that monopoly license to print currency.  Now, the accounting rules allow this liability account to have a negative balance to prevent depletion of the capital account below zero.  It would be like you saying to your bank that you should be allowed to bounce checks, because if you make money in the future, you can defer the tax payment to the treasury.

Of course, this also presumes that the Federal Reserve could become profitable in the future despite their underwater assets and if interest rates increases don't destroy their balance sheet.

Despite the current insolvency of the central bank under the Federal Reserve Act, media economists will still say current economic conditions are positive, stocks should be bought, gold should be sold, & the value of the dollars that you are earning aren't shrinking.

Nevertheless, there will be no selling or tapering by the Federal Reserve until conditions improve.  They blame the labor market, and in a way they are not really lying, just trying to communicate with the subtle language of the economist.

Unless real incomes go up, rents cannot go up, real estate cannot go up, and interest rates cannot go up.  However they are not sincere about the gravity of the situation or their insolvency despite pretending negative liabilities are somehow assets.

The United States Federal Government Entities

Representing the single largest collection of debtors on the planet, the United States of America and all associated borrowers represent trillions of 'assets' to others held worldwide.

The ability to exchange these debts as 'assets' allows the United States to secure enough energy to maintain economic and naval stability. Nothing short of worldwide political stability and international trade is what is at stake.  An interest rate increase really is the greatest clear and present danger to the United States.

The Confederate States of America fell when the naval blockade of New Orleans stopped shipment of cotton to England for delivery against cotton guaranteed bonds, and the Confederate grey-back in London fell from fifty cents on the silver dollar to two cents on the silver dollar.

The difficulty of financing just the normal debt of 16 trillion becomes directly proportional to the costs to sell more debt.  Our government can no longer afford to pay a decent rate of return to lenders and still have money left over to govern.  Without aggressive budget cuts and Clinton style debt repurchases, low yields on treasuries will be permanent.

Ultimately, the zero interest rate policy was the mathematically inevitable consequence of the Bush and Obama fiscal policies.  The only way a Marxist central banking model like the Federal Reserve is sustainable is when government never runs a deficit or has any debt.  It would be like only using your boat when it is on land, but you are guaranteed not to sink.

What about inflation?

Economists defend as sacrosanct the idea that price inflation causes interest rates to go up because holders of debt want a greater return to compensate for the decreased purchasing power.  You would flunk Economics 101 if you thought price inflation could be directly proportional to interest rates.  Yet is this true anywhere else than the simpleton two-dimensional world of the economics classroom blackboard?

Thus, theoretically central banks can stop price inflation by raising short term interest rates to reduce the quantity of currency in circulation.  Conversely, the central bank should be able to 'stimulate' increasing prices by lowering borrowing costs.  Forecasting changes to short term interest rates is the most often cited monetary policy news by the media.  Sure, this can be academically true in two dimensions and you will pass your quiz -- but if you ever risk real money you better buy a default swap on yourself from your economics professor because market realities are more multidimensional.

Price inflation may be inversely proportional to interest rates, but is not necessarily so.  Reducing the quantity of bids will definitely reduce volume, but will not necessarily reduce prices in the real world if sellers cannot profitably deliver below their marginal production prices.  What distinguishes this determination?  The two dimensional model fails to account for the fact that while all money is currency; all currency circulating 'as money' may not necessarily be real money.

Lawfully, only gold and silver are actually real money as per Public Law 93-110 of September 21, 1973, An Act to Amend the Par Value Modification Act, defining the United States dollar as gold equal to $42&2/9 dollars per fine troy ounce.  Everything else considered to be money is not lawfully real money, but only mere artificial currency denominated in terms of money.  What this means is that the treasury secretary is standing by; ready, willing, and able to purchase gold at the statutory price of $42.2222 per ounce or silver at $1.292929292929 per ounce to settle debts owed to the United States.  Of course, it's cheaper to pay off the government with paper notes and credit than gold or silver bullion at par.

While these details seem technical, the important point is that economists fail to note that historically price inflation was defined as increasing prices denominated in terms of gold and silver currencies, not credit fiat currencies.  Hence, price inflation measured with artificial credit dollars does not necessarily mean that there will be price inflation in terms of real gold or silver dollars, as historically understood.  Since 2001, the gross domestic product has been imploding in terms of gold and silver dollars.  Gold and silver rallies do not represent inflation but actually deflation because they represent a decrease in the exchange value of the artificial fiat credit dollar.

Prices of grain, America's largest export, have never been  'higher' in artificial credit dollar terms over the past few years.  Yet are grain prices really higher?  Prices of energy, America's largest import, have never been 'higher' in artificial credit dollar terms over the past few years.  Yet are energy prices really higher?

The massive rallies of gold and silver over the past decade represent real price deflation despite artificial fiat price inflation.  While the economic data measured in artificial credit dollar terms indicates inflation, real prices show the economy stagnating under crushing deflationary forces.  The following charts for silver dollar corn, silver dollar beans, and silver dollar wheat, illustrate that how prices are deflating in real terms while increasing artificially.

Note the following cash spread charts for corn, wheat, beans, crude, and gasoline priced in silver dollars.  Click on the link to open a chart in a new window.

Silver dollar corn.

Silver dollar wheat.

Silver dollar beans.

Silver dollar crude oil.

Silver dollar gasoline.

While our exports of grain may be booming in fiat dollar terms, the real prices as measured in silver have never been lower.  Gasoline at twelve silver cents per gallon is almost half of the approximately twenty five cents per gallon average price throughout the 1960's that was considered cheap by modern standards.  In 1964 the minimum wage was $1.25 silver dollars per hour.  The vast majority of wage earners today do not earn as much as a single ounce of silver per hour.  Do economically illiterate unions understand this concept?  This implosion of income as measured in real gold and silver terms is the real center of modern economic problems.

Monetary authorities can pretend the economy is doing better with inflated, depreciated, artificial credit dollars -- but that might not necessarily be the case.  Unfortunately for monetary authorities, making artificial credit cheaper does not necessarily make real money cheaper.  If the central bank could increase the quantity of gold and silver in circulation, & not just artificial credit currency, then price inflation would really increase in real terms and not just artificially increase in fiat terms. Actually, central banks have been doing the opposite by purchasing gold despite deflationary forces.   In fact, expanding the supply of credit currency versus the supply of gold and silver has the opposite effect than expected, as other commodities tend to move in tandem with gold and silver.  Monetary authorities may have the power to force a contraction, but they can only permit an economy to expand. 

Like other markets, gold and silver also trade influenced by interest rates due to the fact that they represent foreign exchange versus a domestic currency.  If interest rates are too low versus the lease rates that precious metals can be borrowed against, there is no incentive to lease out metal out and earn a higher rate of return.  Hence, the tight supply chain based on limited refining capacity grinds to a screeching halt without the lease market, at the same time unsophisticated speculators swarm the market like insects, as hedgers cover large short derivative positions.  This is the cause for the deflationary death spiral our economists don't even recognize we are trapped in.  A crashing plane is not still flying just because it hasn't yet hit the ground and occasionally glides with some lift.

Gold and silver are the penultimate market forces behind deflationary spirals, completely independent and unconcerned with any bureaucratic policies.  No matter what, modern credit currencies cannot escape reflecting valuations denominated in gold and silver because of the arbitrage relationships between currencies and precious metals as de facto foreign exchange.    

Prices do not go up because there are more buyers than sellers.  Prices go up because there are less sellers than buyers.  Prices do not go down because there are more sellers than buyers.  Instead prices fall because there are less buyers than sellers.  Market markers sell liquidity by fading spreads, they do not profit from making narrowing spreads.  Often the most pivotal distinctions in markets seem trivial until way too late to do anything about it.  As said before, making credit cheaper does not necessarily make money cheaper.

Then what exactly is the real cause of this deflation?

For the non-economist, the term "fiscal policy" is defined as the actions of government budgets, spending, and taxation.  The fiscal policy of the United States is completely cancerous and like Japan requires continual debasement of the currency to finance the debt and keep exports competitive.  This addiction to debt is why real interest rates measured in precious metals such as the London Bullion Market Association Gold Forward Offered Rate have generally been negative for years except for times of extreme market volatility caused by short covering in the lease market.

Social insurance and income tax would be some of the largest aspects.  Like the general debt, the burden of social insurance pyramid schemes created in the 1930's has become unsustainable without major debasement.  Attempting to reorganize social insurance pyramid schemes, or creating new ones that mandate inclusion of younger payees does not help the problem.  Imagine how much everyone that paid in silver dollars before 1964 got ripped off.  Social insurance payments taken right out of paychecks do not circulate in the economy.  Social insurance and income tax royalties are highly deflationary (which bankers used to love) and destroy the velocity of currency in circulation.  All government taxation is deflationary, & especially with large interest payments to finance on the debt.  Now do you still think interest rates might go up?  Trade deficits are another deflationary force, for which the United States compensated with artificial real estate stimulus by lowering interest rates.  So how did that work out?

Inflation related data drives interest rate policy.  Ultimately, there will not be any increases in interest rates without massive price inflation first, which is like expecting to jump away from gravity.  Unless incomes increase because investment returns increase , this is unlikely to happen.  We are no longer a nation of shopkeepers that can just raise prices at whim like butchers, bakers, and candlestick makers of the French revolution.  The old concepts of the relationship between inflation in the quantity of circulation and the inflation of prices are no longer applicable now that we are not on a gold or silver redemption standard.  Really, much of the economic data is based on speculative interpretations of various useless metrics like the consumer price index that are subject to manipulation & become talking points for corrupt politicians instead of useful data.

So why has the zero interest rate policy failed to produce real price inflation despite conventional economic "wisdom" they keep trying to sell on the news?  As John Maynard Keynes said, "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist."

Hopefully everyone will stop buying before it's too late for America to finance energy imports.

When did the Federal Reserve know what?

The magnitude of recent monetary operations, have made decades worth of the central bank's most important data thereto, statistically insignificant.

Non-Borrowed Reserves of depository institutions (your deposits that banks actually have instead of needing to borrow) started going negative [which is never supposed to happen] in early 2008 ... and the corresponding Net Free Reserves of depository institutions were in free fall by March 2008; long before the extent of the problem was announced.

http://research.stlouisfed.org/fred2/series/BOGNONBR?cid=123,

http://research.stlouisfed.org/fred2/series/NFORBRES?cid=123,

Also, before monetary authorities started rapidly giving their member banks more reserves than had previously exited.

http://research.stlouisfed.org/fred2/series/WRESBAL?cid=32215

Despite any sales pitch to the contrary about financial stability, central banks exist in order to subsidize the risk free profits of member banks with the full faith and credit of the government.

Arguments that an 'independent' central bank will better defend the value of credit currencies are obviously erroneous.

The only thing that makes the credit of the Federal Reserve Banks valuable is that it is good for the payment of taxes at par. Clearly, the world is willing to conduct business with credit based currencies, and there is nothing about the Federal Reserve or any other central bank that makes their credit more valuable than the credit of the government itself.

The treasury is also perfectly capable of auctioning and repurchasing it's own debt. For example, quoted on a zero coupon basis it could offer a security at ~$0.95 and bid ~$0.90 providing holders with a lien defining their risk. The treasury could also conduct a federal funds auction for depository institutions short reserves and liquidate failed institutions in receivership. Essentially, anything the private, for-profit, central banking cartel can do with fiat credit money, the public treasury can do interest free. Unfortunately for bankers, they need to find other ways to make money than expecting infinite government subsidization of risk free interest payments. Reducing the interest burden on governments and the correspondingly vicious deflationary taxation burden on the economy is the key to real economic growth, and more importantly - real economic stability.

GDP VS REAL GOLD AND SILVER DOLLAR GDP

The Gross Domestic Product balances, essentially the volume of non-wholesale transactions, are some of the most fundamental of all economic data. Nevertheless, GDP balances must be contrasted against the market prices of gold and silver in order to accurately reflect the real GDP on a long term basis against historical gold (1873-1933) dollars and silver (1933-1964) dollars. Liars may figure with various arbitrary indexes or other damned statistical lies that the gross domestic product is expanding, but real figures representing real commodities cannot lie, & most especially the two ultimate commodities that can reflect the historical value of all goods since time immemorial, silver and gold.

Real gold dollar and silver dollar GDP have been collapsing since an all time high in October of 2001. The current silver dollar real GDP was first reached in 1971 and the current gold dollar real GDP was reached in 1956.

The charts below graph the value of the Gross Domestic Product as expressed as a number of ounces of gold or silver. Rallies of gold and silver are not bubbles at all but actually anti-bubbles because they represent a contraction in the real value of credit and corresponding deflation in the value of credit based asset bubbles. The catastrophic economic consequences should be very alarming to politicians and monetary authorities with a laissez-faire attitude about debasing their way out of debt.

Contrary to the current defunct economics enslaving us, an economic crises cannot be solved by extending credit from helicopters or any other vehicles of military spending. Did debasing Germany's reparations with unbalanced budgets work? No, it did not work, and caused unprecedented price inflation, especially with foreign imports. The gross domestic product as measured in a debased currency was not as high as the real gross domestic product as measured in the value of foreign exchange. When the Japanese refused to borrow, the government decided to fiscally force economic expansion by borrowing for them, and thus Japan's debt as a percentage of GDP reflects that policy. Governments that debase their way out of debt achieve success only at real price.

Debasing debts with unbalanced budgets creates a vicious interest burden requiring more cyclical debasement. Where does it end? Historically, such irresponsible government spending causes collapse of foreign exchange markets leading to armed conflicts. Interconnectedness of globalist economies make the collapse of the foreign exchange value of any major currency a threat to the stability of all the others. Today, an inability of a debased dollar to finance energy imports is the single greatest clear and present danger threatening to bring the the entire United States military to a screeching halt.

The only real economic solution to the deflationary negative feedback loop is to increase real rates of return as measured in real goods, commodities. Inter-commodity spreads pressure markets that deviate too much from the center of gravity. Whether or not there is enough time for governments to bring spending under control before international trade is completely destroyed does remain to be seen. Real growth only comes at the price of drastically reducing the taxation burden on economies by reducing the interest burden on governments, & the continued course of debasement will not end well.

Gold and silver annual average pricing data from the LBMA and GDP data from the NIPA provided "as is" only.

COPYRIGHT MMXI BY JEFFREY MANDALIS WITH ALL RIGHTS RESERVED