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Ever since the beginning of the financial crisis and quantitative easing, the question has been before us: How can the Federal Reserve maintain zero interest rates for banks and negative real interest rates for savers and bond holders when the US government is adding $1.5 trillion to the national debt every year via its budget deficits? Not long ago the Fed announced that it was going to continue this policy for another 2 or 3 years. Indeed, the Fed is locked into the policy. Without the artificially low interest rates, the debt service on the national debt would be so large that it would raise questions about the US Treasury's credit rating and the viability of the dollar, and the trillions of dollars in Interest Rate Swaps and other derivatives would come unglued.

In other words, financial deregulation leading to Wall Street's gambles, the US government's decision to bail out the banks and to keep them afloat, and the Federal Reserve's zero interest rate policy have put the economic future of the US and its currency in an untenable and dangerous position. It will not be possible to continue to flood the bond markets with $1.5 trillion in new issues each year when the interest rate on the bonds is less than the rate of inflation. Everyone who purchases a Treasury bond is purchasing a depreciating asset. Moreover, the capital risk of investing in Treasuries is very high. The low interest rate means that the price paid for the bond is very high. A rise in interest rates, which must come sooner or later, will collapse the price of the bonds and inflict capital losses on bond holders, both domestic and foreign.

The question is: when is sooner or later? The purpose of this article is to examine that question.

Let us begin by answering the question: how has such an untenable policy managed to last this long?

A number of factors are contributing to the stability of the dollar and the bond market. A very important factor is the situation in Europe. There are real problems there as well, and the financial press keeps our focus on Greece, Europe, and the euro. Will Greece exit the European Union or be kicked out? Will the sovereign debt problem spread to Spain, Italy, and essentially everywhere except for Germany and the Netherlands?

Will it be the end of the EU and the euro? These are all very dramatic questions that keep focus off the American situation, which is probably even worse.

The Treasury bond market is also helped by the fear individual investors have of the equity market, which has been turned into a gambling casino by high-frequency trading.

High-frequency trading is electronic trading based on mathematical models that make the decisions. Investment firms compete on the basis of speed, capturing gains on a fraction of a penny, and perhaps holding positions for only a few seconds. These are not long-term investors. Content with their daily earnings, they close out all positions at the end of each day.

High-frequency trades now account for 70-80% of all equity trades. The result is major heartburn for traditional investors, who are leaving the equity market. They end up in Treasuries, because they are unsure of the solvency of banks who pay next to nothing for deposits, whereas 10-year Treasuries will pay about 2% nominal, which means, using the official Consumer Price Index, that they are losing 1% of their capital each year. Using John Williams' (shadowstats.com) correct measure of inflation, they are losing far more. Still, the loss is about 2 percentage points less than being in a bank, and unlike banks, the Treasury can have the Federal Reserve print the money to pay off its bonds. Therefore, bond investment at least returns the nominal amount of the investment, even if its real value is much lower. (For a description of High-frequency trading, see: here)

The presstitute financial media tells us that flight from European sovereign debt, from the doomed euro, and from the continuing real estate disaster into US Treasuries provides funding for Washington's $1.5 trillion annual deficits. Investors influenced by the financial press might be responding in this way. Another explanation for the stability of the Fed's untenable policy is collusion between Washington, the Fed, and Wall Street. We will be looking at this as we progress.

Unlike Japan, whose national debt is the largest of all, Americans do not own their own public debt. Much of US debt is owned abroad, especially by China, Japan, and OPEC -- the oil exporting countries. This places the US economy in foreign hands. If China, for example, were to find itself unduly provoked by Washington, China could dump up to $2 trillion in US dollar-dominated assets on world markets. All sorts of prices would collapse, and the Fed would have to rapidly create the money to buy up the Chinese dumping of dollar-denominated financial instruments.

The dollars printed to purchase the dumped Chinese holdings of US dollar assets would expand the supply of dollars in currency markets and drive down the dollar exchange rate. The Fed, lacking foreign currencies with which to buy up the dollars would have to appeal for currency swaps to sovereign debt troubled Europe for euros, to Russia, surrounded by the US missile system, for rubles, to Japan, a country over its head in American commitment, for yen, in order to buy up the dollars with euros, rubles, and yen.

These currency swaps would be on the books, unredeemable and making additional use of such swaps problematical. In other words, even if the US government can pressure its allies and puppets to swap their harder currencies for a depreciating US currency, it would not be a repeatable process. The components of the American Empire don't want to be in dollars any more than do the BRICS.

However, for China, for example, to dump its dollar holdings all at once would be costly as the value of the dollar-denominated assets would decline as they dumped them. Unless China is faced with US military attack and needs to defang the aggressor, China as a rational economic actor would prefer to slowly exit the US dollar. Neither do Japan, Europe, nor OPEC wish to destroy their own accumulated wealth from America's trade deficits by dumping dollars, but the indications are that they all wish to exit their dollar holdings.

Unlike the US financial press, the foreigners who hold dollar assets look at the annual US budget and trade deficits, look at the sinking US economy, look at Wall Street's uncovered gambling bets, look at the war plans of the delusional hegemon and conclude: "I've got to carefully get out of this."

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http://www.paulcraigroberts.org/

Dr. Roberts was Assistant Secretary of the US Treasury for Economic Policy in the Reagan Administration. He was associate editor and columnist with the Wall Street Journal, columnist for Business Week and the Scripps Howard News Service. He is a contributing editor to Gerald Celente's Trends Journal. He has had numerous university appointments. His book, The Failure of Laissez Faire Capitalism and Economic Dissolution of the West is available here. His latest book,  How America Was Lost, has just been released and can be ordered here.

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China has been trying to dump the worthless dollar... by Ginger McClemons on Tuesday, Jun 5, 2012 at 12:00:03 PM
Correction:  Sheared then eaten.   ... by Tom Madison on Tuesday, Jun 5, 2012 at 3:34:07 PM
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who are betting on a finacial meltdown also have t... by Paul Repstock on Wednesday, Jun 6, 2012 at 3:42:22 AM
PCR hits it on the head, again. This is one of the... by Scott Baker on Wednesday, Jun 6, 2012 at 3:58:16 AM
Generally, I like your ideas and thoughts. You adm... by BFalcon on Wednesday, Jun 6, 2012 at 9:06:50 PM
This was put together by the Economic Policy Insti... by E. J. N. on Wednesday, Jun 6, 2012 at 6:12:29 PM
Paul correctly states, "High-frequency trades now ... by Alan MacDonald on Wednesday, Jun 6, 2012 at 7:35:11 PM
But, have we not done this to ourselves? A view f... by Paul Repstock on Wednesday, Jun 6, 2012 at 9:17:27 PM
Though I admit to my culpability, I do not exonner... by Paul Repstock on Wednesday, Jun 6, 2012 at 9:40:24 PM
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