Rasmussen, of Rasmussen Reports, released this statement today following yesterday’s Congressional Budget Office report on the nation’s debt:

The Congressional Budget Office (CBO) yesterday reported that the federal budget deficit is projected to reach $1.1 trillion in 2012. That number is troubling enough but the reality is much worse. The United States will actually go about $4 trillion further in debt during the year.  

The difference comes from the fact that government accounting procedures simply ignores the cost of benefits being promised for future Social Security and Medicare recipients. While precise estimates vary as to how much these promises cost, they are in the range of $3 trillion annually. It is important to note that the CBO is not to blame for this accounting gimmick. That agency typically does a sound job of operating within the ground rules established by Congress. Unfortunately, the rules often make little sense.

As former CBO Director Douglas Holtz-Eakin explained to Scott Rasmussen, “The debt from the past is a problem, but the future potential debt is a crisis.”

The government does not recognize the debt piling up for future Social Security and Medicare benefits because they have officially determined that no such liability exists.

As explained in the Federal Budget, “The Federal Government uses the term ‘trust fund’ very differently from the private sector. The beneficiary of a private trust owns the trust’s income and may own the trust’s assets.”

However, “the Federal Government owns and manages the assets and earnings of most federal trust funds.” As if that wasn’t enough, the government “can unilaterally change the law to raise or lower future trust fund collections and payments or change the purpose for which collections are used.”

In other words, the money in government trust funds can be diverted to pay for anything the politicians want to spend it on. The government treats all the money as if it’s in a single pot that can be spent on anything according to the whims of Congress.

Only 10 percent of voters favor this approach but the Supreme Court has supported this interpretation and declared that the government has no legal obligation to pay promised benefits. Scott Rasmussen explains how this works in his new book, The People’s Money: How the American People Will Balance the Budget and Eliminate the Federal Debt.

Rasmussen notes that “The simplest way to get people to make bad decisions is to give them bad information. That’s the way con men work, and that’s how America’s Political Class led America into a fiscal crisis. For several decades, the federal government has consistently and systematically misled the American people about federal spending, deficits, and the federal debt.”

Rasmussen notes that the actual federal debt is closer to $120 trillion rather than the $16 trillion discussed in Congress.

Another gimmick used by politicians is amazingly simple. As 62 percent of voters recognize, when politicians today say they are cutting spending, they are really talking about nothing more than reducing the growth of spending. The impact of this is staggering.

Using the official definitions, the CBO last year presented estimates of what would happen if Congress lived up to its promise to “cut” federal spending by $2.5 trillion over a decade. If that happened, the CBO showed that actual federal spending would go from $3.6 trillion in 2012 to $5.8 trillion in 2021. Only a politician could consider that a spending cut.

In addition to highlighting how the Political Class deceives voters, Scott’s new book shows a clear-headed, heavily researched and data-driven ways to cut trillions from the national deficit with a focus on the three categories that make up the bulk of federal spending (national security, Social Security, and Medicare).

By finding budget solutions with public support, the book includes proposals that are sure to offend every faction of the Political Class… and every Member of Congress This is part of a pattern that has been repeated many times in American history with the public a few decades ahead of the politicians and the politicians struggling to defend the status quo.

“Rickards gets the reader’s pulse surging…, telling readers that Fed chair Ben Bernanke “is engaged in the greatest gamble in the history of finance.”

“Bernanke’s attempt to print America’s way out of its economic jam is in essence the declaration of a currency war on the entire world.”

The talk is all about jobs, jobs, jobs in Washington and on the campaign trail as the unemployment rate continues to be elevated and long-term unemployment is higher than ever. Since getting government out of the way isn’t an option, late last year congressional leaders decided to turn up the volume while crying that American workers are being damaged by China’s undervalued currency — the renminbi (or yuan).

Bipartisan support was summoned to declare China a currency manipulator, triggering retaliatory tariffs on Chinese imports in hopes that China would allow the renminbi to rise against the dollar.  

Scott Paul, who heads the Alliance for American Manufacturing, told American Public Media, “If we were able to revalue the yuan, it would make our exports substantially more competitive, not only in China but also globally.”

But the Obama administration declined to finger China as a manipulator, causing a frustrated Mr. Paul to lament, “I’m disappointed that President Obama has now formally refused six times to cite China for its currency manipulation, a practice which has contributed to the loss of hundreds of thousands of American manufacturing jobs.”

During the debates and on the campaign trail Republican presidential contender Mitt Romney has said repeatedly he would cite China for manipulating its currency the first day he takes office.

Reasonable people tend to tune out the Washington noise — rightly believing most of it is meaningless grandstanding. But the continued hectoring in China’s direction is likely not so harmless. Combined with the Federal Reserve’s stated policy to keep interest rates at virtually zero until the end of 2014, these are the sounds of Currency War III (CWIII) in its initial stages.

The big picture is that governments inevitably reduce the value of their currencies to their intrinsic value. But in the meantime, politicians are looking for votes, and governments look for advantage over competing governments. It is not just rockets and bombs that are fired; war is raged on the economic front, with currency manipulation as the primary weapon. It is this brutal economic warfare that is the subject of James Rickards’s outstanding new book, Currency Wars: The Making of the Next Global Crisis.

Fans of financial TV will recognize Rickards as a fast-talking, straight-shooting pundit on banking and the macro economy who actually talks seriously about the world returning to some form of gold standard. In fact, in Currency Wars, he lays out a plan to return to gold and sees it as the only way the financial world can avoid collapsing into total economic chaos.

But before he gets there, Rickards gets the reader’s pulse surging with the warning of a complete collapse in the book’s preface, telling readers that Fed chair Ben Bernanke “is engaged in the greatest gamble in the history of finance.”

Bernanke’s attempt to print America’s way out of its economic jam is in essence the declaration of a currency war on the entire world. Mainstream economists are oblivious to the real-world gun battle, resting comfortably amongst their equations and graphs.

But while academics may choose to go about their business unperturbed, the average person shouldn’t believe they have that luxury; as Rickards writes, “the new currency war is the most meaningful struggle in the world today — the one struggle that determines the outcome of all others.”

Before chronicling CWI and CWII, Rickards tells of participating in a war-games exercise at the Applied Physics Lab located between DC and Baltimore. There were no simulated missile launches or ground assaults in this mock battle; the only weapons used were financial — currencies, stocks, bonds, and derivatives.

Almost all the participants had military and think-tank backgrounds, with the only Wall Street types being the author and a couple of guys he recruited.

When the Russian team floated the idea for a gold-backed currency, threatening the dollar’s status, one of Rickards’s teammates, described by the author as “our Harvard guy,” couldn’t grasp the implications of the Russian move. “Gold is irrelevant to trade and international monetary policy,” sniffed the Ivy Leaguer. “It’s just a dumb idea and a waste of time.”

Despite it being a war-games exercise, the administrative cell even declared Russia’s gold move “illegal.” Rickards reminded the participants that it was not so long ago that the world had gold-backed currencies and the move was then reconsidered and deemed merely “ill-advised.”

When the Drudge Report featured Vladimir Putin calling for a gold-backed alternative to the dollar the following morning, Rickards and his guys were vindicated, but the academics remained unconvinced of gold’s relevance.

The author explains that while currency wars are fought on the world stage, they begin with a domestic economy lacking in growth, with high unemployment, a weak banking sector, and worsening public finances. With economic growth stymied, time and time again, countries look to depreciate their currencies to promote export growth and investment.

Many historians mistakenly describe much of the period from 1870 to 1914 as a deflationary dark age. Rickards doesn’t fall into that trap. He explains that this period of the classical gold standard was marked by gently falling prices leading to increased productivity, raised living standards, and the first glimpses of globalization.

The classical gold standard, besides being self-equilibrating, operated like a club, with members strictly adhering to the unwritten but well-understood rules. Free-market forces prevailed; government interventions were minimal; exchange rates were stable; and there was no US central bank to mess up monetary matters.

This monetary tranquility was jarred with the creation of the Federal Reserve in 1913. In Currency Wars, Rickards leans to the standard story that the Panic of 1907 gave rise to the Fed’s creation, but, as Murray Rothbard explained in his History of Money and Banking in the United States: The Colonial Era to World War II,the Federal Reserve Act was just a part of the wave of legislation brought about by the Progressive movement.

Big business was tired of competing and continually innovating to stay ahead of falling prices. Business would much rather use the power of government to establish and maintain cartels in an effort to ensure high profits. The plan was “to transform the economy from roughly laissez-faire to centralized and coordinated statism,” wrote Rothbard.

And while Rickards is right in noting that America has a long history of hating central banks, a movement by the Washington and financial elites to form what was to become the Federal Reserve System was actually started with the Indianapolis Monetary Convention in 1896. The 1907 panic added fuel to the fire, but much of the political groundwork was already laid.

What Rickards calls Currency War I began with the German hyperinflation in 1921 and ended with France breaking with gold in 1936 at the same time England was devaluing the pound sterling. In between were continuous monetary fireworks.

Austrian-leaning moviegoers who’ve seen Woody Allen’s Oscar-nominated Midnight in Paris and wonder how or why an amazing collection of literary and creative US expatriates ended up in Paris in the mid-1920s won’t be surprised to learn that there is an economic answer. Rickards explains that the French franc collapsed in 1923 allowing Ernest Hemingway, Scott and Zelda Fitzgerald, and Gertrude Stein to afford comfortable lifestyles in Paris converting their dollars from home.

The classic gold standard was long gone, replaced by a deeply flawed gold-exchange standard that allowed centrals banks to inflate, causing the boom of the 1920s and therefore the required correction of the 1930s exacerbated by government policy. FDR started his term in office by closing banks and then confiscating the people’s gold. The language of FDR’s order is chilling, giving citizens until May 1, 1933, to deliver to the Federal Reserve System “all gold coin, gold bullion and gold certificates now owned by them” with the threat of a $10,000 fine or ten years in prison.

Citizens received $20.67 per ounce from the government, only to watch their new president move the price up to $35 an ounce over three months — a 70 percent devaluation.

Rickards places Currency War II from 1967 to 1987. In between CWI and CWII was the Bretton Woods era, described by the author as a period of “currency stability, low inflation, low unemployment, high growth and rising income.”

But as Henry Hazlitt and Jacques Rueff predicted, the phony gold-standard scheme created by John Maynard Keynes unraveled, setting the stage for CWII.

CWII began with a number of crises in the British sterling, and then a flight from the dollar into gold, with French president Charles de Gaulle calling for a return to the gold standard. The French president “helpfully offered to send the French navy to the United States to ferry the gold back to France.”

This all led up to Richard Nixon preempting Hoss and Little Joe on August 15, 1971, telling the nation he was closing the gold window. The president blamed international speculators for having to interrupt America’s favorite TV program, but money printing and budget deficits were to blame. Nixon also instituted a 10 percent surtax on all imports, effectively devaluing the dollar in the trade arena.

The devaluation was to spur employment, but within two years the United States was mired in recession. The United States suffered three recessions from 1973 to 1981, while purchasing power dropped by half from 1977 to 1981. Suddenly, “stagflation” was on the tip of everyone’s tongue.

Paul Volcker took over as Fed chairman and quickly hiked interest rates, looking to stop the price inflation. The price of gold collapsed along with the inflation rate, and the dollar strengthened. According to Rickards, both Volcker and Ronald Reagan should be given credit for the dollar’s turnaround.

But dollar strength finally got in the way of export jobs and the Plaza Accord of September 1985 was an attempt to drive down the greenback’s value primarily against the yen and the mark. And it worked, from 1985 to 1988; the dollar fell 40 percent against the French franc, was cut in half against the yen, and fell 20 percent against the mark.

However, the devaluation did little for the US economy, and by 1987 monetary authorities met in Paris at the Louvre. The Louvre Accord was hatched to stop the dollar’s fall. The Bank of Japan’s willingness to expand its money supply to depreciate the yen would fuel one of the biggest stock-market bubbles of all time, with the Nikkei stock average roaring from around 10,000 in 1985 to a peak of 38,957.44 on December 29, 1989. More than two decades hence, that market still hasn’t recovered.

Currency War III has just begun, and the author contends that, in addition to national issuers of currency, participants also include the IMF, the World Bank, the United Nations, hedge funds, global corporations, and private family offices of the super rich. After 40 years of massive money printing and explosion of derivatives, CWIII will be fought on a massive scale, with a real risk of a collapse of the entire monetary system.

So how’s this currency war to end all currency wars going to turn out? The author paints a scary picture, using complexity theory and behavioral economics. Although the framework is different, the results follow Ludwig von Mises’s outline of the three stages of inflation.

In Mises’s stage one, government prints all the money it can, because prices don’t rise nearly as much as money supply. In stage two, the demand for money falls, which intensifies price inflation. Finally, in stage three, prices go up faster than money supply. A shortage of money develops, and people urge government to print more; when the government does this, prices and money supply spiral upwards.

Rickards develops hypothetical thresholds wherein the dollar is repudiated. Up to an uncertain number, people can begin to repudiate the dollar to no effect on prices or the dollar’s value. But once a critical threshold is passed, the collapse is triggered — as Hemingway once wrote about how bankruptcy happens — first slowly, then all at once.

A small change in preferences among just a few people could lead to a collapse, because the financial framework is a weakly constructed Keynesian contraption of fiat money and government deficits. Any one of thousands of events could trigger the collapse, and, as the author notes, the last straw will not be known until after the fact.

Rickards explores four potential outcomes for the dollar: multiple reserve currencies, special drawing rights, gold, and chaos. For those interested in how much the price of gold would have to be, under various gold-coverage ratios to different monetary aggregates, this part of the book is especially interesting, reminding me of what Murray Rothbard used to say to those claiming there wasn’t enough gold in the world to have a gold standard. “You could have a gold standard with a single ounce,” he said. It’s not about the amount; it’s about price.

Rickards comes to a price of $7,500 an ounce, far above today’s price. But as the author points out, the change in the value of the dollar “has already occurred in substance. It simply has not been recognized by markets, central banks or economists.”

Inevitably, chaos is the most likely outcome of the latest currency war, and while the author sketches out possible scenarios for how it might play out, no one really knows. Suffice it to say, it won’t be pretty. Unfortunately, a currency war is neither a spectator sport nor a game. We all have to participate, and do our best to survive.

Douglas French is president of the Mises Institute…He received his master’s degree in economics from the University of Nevada, Las Vegas, under Murray Rothbard with Professor Hans-Hermann Hoppe serving on his thesis committee.

The Fed has effectively extended its zero interest rate policy (ZIRP) for another 18 months. The reason stated is “low rates of resource utilisation and a subdued outlook for inflation in the medium run”. More important perhaps and unsaid is the presidential election due later this year and the need to finance a deficit that seems impossible to cut.

The Fed is running huge risks with its extended ZIRP, principally with monetary inflation morphing into price inflation. To help achieve its low inflation target the Fed uses the Personal Consumption Expenditures Price Index (PCEPI), which assumes that consumers switch spending from higher priced goods to those that are stable or falling. The result is that this index rises at about one-third less than the Consumer Price Index, which itself rises at less than half the CPI calculated on the more honest methodology used before 1980. The upshot is that the Fed uses inflation targets that are so heavily adjusted that they are effectively meaningless.

To the Keynesians at the Fed, subdued inflation is linked with a sluggish economy, and here the Fed is very selective in its approach. It admits that employment is picking up, and household spending “continues to advance”; but instead chooses to worry over slowing fixed investment and a depressed housing sector. Surely, whatever your views, there are enough signs of economic stabilisation to justify sitting on the fence, instead of committing to ZIRP for an extra 18 months.

I take the view that Gross Domestic Product is likely to surprise on the upside, as I wrote in an article for GoldMoney on 10 January. In that article I gave concrete reasons why, and suggested that money will begin to flow from capital markets into the economy. This is important, because GDP is only a money quantity and can rise without any underlying economic progression – the difference being reflected in the prices of goods and services. So GDP can actually rise with no underlying improvement in economic activity, it merely reflecting higher prices.

Changes in the prices of goods and services are actually impossible to measure and so cannot be quantified. Under-reporting price increases by using an index approximation such as the GDP deflator, which represents price inflation similarly to the PCEPI, artificially inflates real GDP. It will be interesting to hear what excuse the Fed comes up with then for the continuing for even longer with ZIRP. The reality is that the Fed and other central bankers are cornered and have only one tool left: issue as much paper money as it takes to prevent systemic financial calamity. This realisation is only just dawning on individuals with savings to protect, which is why precious metals were right to rise so sharply.

In his first public comments since stepping down as a Fed governor last March, Kevin Warsh said there is a place for exceptionally accommodative monetary policy to provide “important transitional support for an economy.”  

“But recent policy activism — measures that go beyond a central bank’s capacity or traditional remit — threatens to forestall recovery and harms long-term growth,” Warsh said, according to excerpts of remarks prepared for delivery to the Stanford Institute for Economic Policy Research.

Warsh was the only member of Bernanke’s inner circle with close ties to Republican lawmakers. An inflation hawk, Warsh nevertheless voted in favor of the Fed’s groundbreaking moves to ease monetary policy after the financial crisis, including two bond-buying programs that swelled the Fed’s balance sheet to unprecedented levels.

But Warsh apparently grew increasingly uncomfortable with the dovish stance of the central bank. Shortly after the Fed launched its second round of so-called quantitative easing, in November 2010, Warsh publicly expressed doubt over its effectiveness.

He announced his resignation the following February, and is currently a visiting fellow at Stanford’s Hoover Institution.

Since Warsh’s departure, the Fed has embarked on still more easing, signaling last August its intent to keep rates ultra-low through at least mid-2013. On Thursday it extended that low-rate vow through late 2014.

The Fed also began publishing policymakers’ forecasts for short-term interest rates and adopted an explicit inflation target for the first time, setting the target at 2 percent. Bernanke said both moves would clarify the Fed’s policy decisions, making them more effective.

Bernanke also opened the door wide to a third round of quantitative easing, saying continued low inflation and high unemployment would create a case for it.

On Thursday, Warsh took aim at Bernanke’s latest communications push and his recent foray into housing policy.

“Central bank transparency is good, but transparency that delineates future policy breeds market complacency,” Warsh said. “It threatens to undermine the wisdom of crowds and the essential interchange with financial markets.”

Warsh also was critical of leaning on government-run mortgage finance firms to pull the country from its housing slump, a policy idea the Fed floated in early January in an unsolicited paper to top lawmakers outlining a number of ways to revive the sector.

The paper noted that exposing the firms to losses could be worthwhile if such actions could spur a vigorous recovery in housing, the bane of the current sluggish recovery.

Warsh disagreed.

“The government-sponsored housing entities remain sources of vulnerability to the U.S. economy, and repeated ad-hoc attempts to push Fannie Mae and Freddie Mac to take greater risks at taxpayer expense is deeply counterproductive,” Warsh said, according to the excerpts.

Warsh was to deliver his remarks at 5 p.m. Pacific/ 8 p.m. Eastern. The remarks will be carried live at siepr.stanford.edu/.

Tehran Pushes to Ditch the US Dollar

The official line from the United States and the European Union is that Tehran must be punished for continuing its efforts to develop a nuclear weapon. The punishment: sanctions on Iran’s oil exports, which are meant to isolate Iran and depress the value of its currency to such a point that the country crumbles.

But that line doesn’t make sense, and the sanctions will not achieve their goals. Iran is far from isolated and its friends – like India – will stand by the oil-producing nation until the US either backs down or acknowledges the real matter at hand. That matter is the American dollar and its role as the global reserve currency.  

The short version of the story is that a 1970s deal cemented the US dollar as the only currency to buy and sell crude oil, and from that monopoly on the all-important oil trade the US dollar slowly but surely became the reserve currency for global trades in most commodities and goods. Massive demand for US dollars ensued, pushing the dollar’s value up, up, and away. In addition, countries stored their excess US dollars savings in US Treasuries, giving the US government a vast pool of credit from which to draw.

We know where that situation led – to a US government suffocating in debt while its citizens face stubbornly high unemployment (due in part to the high value of the dollar); a failed real estate market; record personal-debt burdens; a bloated banking system; and a teetering economy. That is not the picture of a world superpower worthy of the privileges gained from having its currency back global trade. Other countries are starting to see that and are slowly but surely moving away from US dollars in their transactions, starting with oil.

If the US dollar loses its position as the global reserve currency, the consequences for America are dire. A major portion of the dollar’s valuation stems from its lock on the oil industry – if that monopoly fades, so too will the value of the dollar. Such a major transition in global fiat currency relationships will bode well for some currencies and not so well for others, and the outcomes will be challenging to predict. But there is one outcome that we foresee with certainty: Gold will rise. Uncertainty around paper money always bodes well for gold, and these are uncertain days indeed.

The Petrodollar System

To explain this situation properly, we have to start in 1973. That’s when President Nixon asked King Faisal of Saudi Arabia to accept only US dollars as payment for oil and to invest any excess profits in US Treasury bonds, notes, and bills. In exchange, Nixon pledged to protect Saudi Arabian oil fields from the Soviet Union and other interested nations, such as Iran and Iraq. It was the start of something great for the US, even if the outcome was as artificial as the US real-estate bubble and yet constitutes the foundation for the valuation of the US dollar.

By 1975 all of the members of OPEC agreed to sell their oil only in US dollars. Every oil-importing nation in the world started saving their surplus in US dollars so as to be able to buy oil; with such high demand for dollars the currency strengthened. On top of that, many oil-exporting nations like Saudi Arabia spent their US dollar surpluses on Treasury securities, providing a new, deep pool of lenders to support US government spending.

The “petrodollar” system was a brilliant political and economic move. It forced the world’s oil money to flow through the US Federal Reserve, creating ever-growing international demand for both US dollars and US debt, while essentially letting the US pretty much own the world’s oil for free, since oil’s value is denominated in a currency that America controls and prints. The petrodollar system spread beyond oil: the majority of international trade is done in US dollars. That means that from Russia to China, Brazil to South Korea, every country aims to maximize the US-dollar surplus garnered from its export trade to buy oil.

The US has reaped many rewards. As oil usage increased in the 1980s, demand for the US dollar rose with it, lifting the US economy to new heights. But even without economic success at home the US dollar would have soared, because the petrodollar system created consistent international demand for US dollars, which in turn gained in value. A strong US dollar allowed Americans to buy imported goods at a massive discount – the petrodollar system essentially creating a subsidy for US consumers at the expense of the rest of the world. Here, finally, the US hit on a downside: The availability of cheap imports hit the US manufacturing industry hard, and the disappearance of manufacturing jobs remains one of the biggest challenges in resurrecting the US economy today.

There is another downside, a potential threat now lurking in the shadows. The value of the US dollar is determined in large part by the fact that oil is sold in US dollars. If that trade shifts to a different currency, countries around the world won’t need all their US money. The resulting sell-off of US dollars would weaken the currency dramatically.

So here’s an interesting thought experiment. Everybody says the US goes to war to protect its oil supplies, but doesn’t it really go to war to ensure the continuation of the petrodollar system?

The Iraq war provides a good example. Until November 2000, no OPEC country had dared to violate the US dollar-pricing rule, and while the US dollar remained the strongest currency in the world there was also little reason to challenge the system. But in late 2000, France and a few other EU members convinced Saddam Hussein to defy the petrodollar process and sell Iraq’s oil for food in euros, not dollars. In the time between then and the March 2003 American invasion of Iraq, several other nations hinted at their interest in non-US dollar oil trading, including Russia, Iran, Indonesia, and even Venezuela. In April 2002, Iranian OPEC representative Javad Yarjani was invited to Spain by the EU to deliver a detailed analysis of how OPEC might at some point sell its oil to the EU for euros, not dollars.

This movement, founded in Iraq, was starting to threaten the dominance of the US dollar as the global reserve currency and petro currency. In March 2003, the US invaded Iraq, ending the oil-for-food program and its euro payment program.

There are many other historic examples of the US stepping in to halt a movement away from the petrodollar system, often in covert ways. In February 2011 Dominique Strauss-Kahn, managing director of the International Monetary Fund (IMF), called for a new world currency to challenge the dominance of the US dollar. Three months later a maid at the Sofitel New York Hotel alleged that Strauss-Kahn sexually assaulted her. Strauss-Kahn was forced out of his role at the IMF within weeks; he has since been cleared of any wrongdoing.

War and insidious interventions of this sort may be costly, but the costs of not protecting the petrodollar system would be far higher. If euros, yen, renminbi, rubles, or for that matter straight gold, were generally accepted for oil, the US dollar would quickly become irrelevant, rendering the currency almost worthless. As the rest of the world realizes that there are other options besides the US dollar for global transactions, the US is facing a very significant – and very messy – transition in the global oil machine.

The Iranian Dilemma

Iran may be isolated from the United States and Western Europe, but Tehran still has some pretty staunch allies. Iran and Venezuela are advancing $4 billion worth of joint projects, including a bank. India has pledged to continue buying Iranian oil because Tehran has been a great business partner for New Delhi, which struggles to make its payments. Greece opposed the EU sanctions because Iran was one of very few suppliers that had been letting the bankrupt Greeks buy oil on credit. South Korea and Japan are pleading for exemptions from the coming embargoes because they rely on Iranian oil. Economic ties between Russia and Iran are getting stronger every year.

Then there’s China. Iran’s energy resources are a matter of national security for China, as Iran already supplies no less than 15% of China’s oil and natural gas. That makes Iran more important to China than Saudi Arabia is to the United States. Don’t expect China to heed the US and EU sanctions much – China will find a way around the sanctions in order to protect two-way trade between the nations, which currently stands at $30 billion and is expected to hit $50 billion in 2015. In fact, China will probably gain from the US and EU sanctions on Iran, as it will be able to buy oil and gas from Iran at depressed prices.

So Iran will continue to have friends, and those friends will continue to buy its oil. More importantly, you can bet they won’t be paying for that oil with US dollars. Rumors are swirling that India and Iran are at the negotiating table right now, hammering out a deal to trade oil for gold, supported by a few rupees and some yen. Iran is already dumping the dollar in its trade with Russia in favor of rials and rubles. India is already using the yuan with China; China and Russia have been trading in rubles and yuan for more than a year; Japan and China are moving towards transactions in yen and yuan.

And all those energy trades between Iran and China? That will be settled in gold, yuan, and rial. With the Europeans out of the mix, in short order none of Iran’s 2.4 million barrels of oil a day will be traded in petrodollars.

With all this knowledge in hand, it starts to seem pretty reasonable that the real reason tensions are mounting in the Persian Gulf is because the United States is desperate to torpedo this movement away from petrodollars. The shift is being spearheaded by Iran and backed by India, China, and Russia. That is undoubtedly enough to make Washington anxious enough to seek out an excuse to topple the regime in Iran.

Speaking of that search for an excuse, this is interesting. A team of International Atomic Energy Agency (IAEA) inspectors just visited Iran. The IAEA is supervising all things nuclear in Iran, and it was an IAEA report in November warning that the country was progressing in its ability to make weapons that sparked this latest round of international condemnation against the supposedly near-nuclear state. But after their latest visit, the IAEA’s inspectors reported no signs of bomb making. Oh, and if keeping the world safe from rogue states with nuclear capabilities were the sole motive, why have North Korea and Pakistan been given a pass?

There is another consideration to keep in mind, one that is very important when it comes to making some investment decisions based on this situation: Russia, India, and China – three members of the rising economic powerhouse group known as the BRICs (which also includes Brazil) – are allied with Iran and are major gold producers. If petrodollars go out of vogue and trading in other currencies gets too complicated, they will tap their gold storehouses to keep the crude flowing. Gold always has and always will be the fallback currency and, as mentioned before, when currency relationships start to change and valuations become hard to predict, trading in gold is a tried and true failsafe.

2012 might end up being most famous as the year in which the world defected from the US dollar as the global currency of choice. Imagine the rest of the world doing the math and, little by little, beginning to do business in their own currencies and investing ever less of their surpluses in US Treasuries. It constitutes nothing less than a slow but sure decimation of the dollar.

That may not be a bad thing for the United States. The country’s gargantuan debts can never be repaid as long as the dollar maintains anything close to its current valuation. Given the state of the country, all that’s really left supporting the value in the dollar is its global reserve currency status. If that goes and the dollar slides, maybe the US will be able to repay its debts and start fresh. That new start would come without the privileges and ingrained subsidies to which Americans are so accustomed, but it’s amazing that the petrodollar system has lasted this long. It was only a matter of time before something would break it down.

Finally, the big question: How can one profit from this evolving situation? Playing with currencies is always very risky and, with the global game set to shift to significantly, it would require a lot of analysis and a fair bit of luck. The much more reliable way to play the game is through gold. Gold is the only currency backed by a physical commodity; and it is always where investors hide from a currency storm.

The basic conclusion is that a slow demise of the petrodollar system is bullish for gold and very bearish for the US dollar…

Marin Katusa is Chief Energy Investment Strategist for Casey Research.

January 26 – Bloomberg (Camila Russo): “Argentines are borrowing record amounts to buy cars as they park their savings in Volkswagens, Chevrolets and Fords to protect against inflation that economists say is running at about 25 percent a year. Secured loans… soared 61% last year to 16.6 billion pesos ($3.8bn), the biggest jump and the highest total in at least a decade… Vehicle sales in Argentina jumped 30% last year to a record…”

M2 (narrow) “money” supply rose $8.0bn to a record $9.763 TN. “Narrow money” expanded 10.2% from a year ago…[And still the Fed announces it will keep the Funds  rate at 0-.25% till late 2014...!!!]  

Money Notes:

One-month Treasury bill rates ended the week at 4 bps…Five-year T-note yields ended the week down 14 bps to 0.75%. Ten-year yields dropped 13 bps to 1.89%. Long bond yields ended down 4 bps to 3.06%….An index of investment grade bond risk declined 6 to a 5-month low 100bps. An index of junk bond risk fell 33 bps to a 5-month low 560 bps.

Ten-year Portuguese yields jumped 76 bps to 14.65% (up 187bps). Italian 10-yr yields ended the week down 35 bps to 5.88% (down 115bps y-t-d). Spain’s 10-year yields sank 52 bps to 4.93% (down 11bps). German bund yields declined 7 bps to 1.86% (up 3bps), and French yields declined 6 bps to 3.03% (down 11 bps). The French to German 10-year bond spread widened a basis point to 117bps. Greek two-year yields ended the week down 690 bps to 158.16% (up 3,262bps). Greek 10-year yields rose 13 bps to 30.99% (down 33bps). U.K. 10-year gilt yields fell 5 bps to 2.07% (up 9bps). Irish yields fell 16 bps to 7.16% (down 110bps)…

Freddie Mac 30-year fixed mortgage rates jumped 10 bps to 3.98% (down 82bps y-o-y). Fifteen-year fixed rates rose 7 bps to 3.24% (down 85bps y-o-y)…

Federal Reserve Credit increased $1.5bn to $2.905 TN. Fed Credit was up $486bn from a year ago, or 20.1%…

Global central bank “international reserve assets” (excluding gold) – as tallied by Bloomberg – were up $939bn y-o-y, or 10.2% to $10.186 TN. Over two years, reserves were $2.371 TN higher, for 30% growth.

Global Credit Watch:

January 27 – Bloomberg (Abigail Moses): “Opposition to payouts on Greek credit-default swaps from European Union policy makers is softening as disputes over a voluntary debt exchange threaten to push the nation into default. Any agreement between the Greek government and the… Institute of International Finance on debt writedowns will only bind 50% of investors in the 206 billion euros ($270bn) of notes being negotiated, Barclays Capital estimates. Hedge funds may resist a deal, seeking to get paid in full or compensated from insurance contracts.”

January 25 – Bloomberg (Lucy Meakin): “Portugal’s five-year notes slid, pushing the yield to a record-high 18.78%.”

January 25 – Bloomberg (Andrew Davis and Chiara Vasarri): “Italian Prime Minister Mario Monti said new European Union rules forcing governments with excessive debt to reduce it to within an acceptable level have ‘elements of flexibility’ that may make the regime less of a burden. The rule forces countries with debt over the EU limit of 60% of gross domestic product to cut the excess by 1/20th a year. The new measures will be phased in over three years, meaning Italian debt won’t be gauged by the 1/20th standard until approximately 2015.”

January 24 – Bloomberg (Emma Ross-Thomas and Jones Hayden): “Spain must meet its 2012 deficit goal, European Union Economic and Monetary Affairs Commissioner Olli Rehn said, rejecting calls from Budget Minister Cristobal Montoro to ease the target as the economy shrinks. Montoro urged the EU… to review the 4.4% goal, which was set by the previous government amid forecasts of economic growth. The gap amounted to 8% of gross domestic product last year, more than the last administration’s 6% target, as the economy slipped back toward a recession.”

January 24 – Bloomberg (Henrique Almeida): “Portugal’s government owes 1.3 billion euros ($1.7bn) to construction companies that are struggling to survive the country’s economic slump, according to the head of the country’s biggest building industry group. The delayed payments are adding to difficulties in obtaining bank financing and stifling recovery in an industry where about 200 workers lose their jobs each day…”

January 24 – Bloomberg (Adam Ewing): “Europe can’t let efforts to strike a deal with creditors in Greek debt disable the region’s credit default swap market, said Christian Clausen, the president of the European Banking Federation. ‘You have to make sure the documentation is right so it can be a functioning market,’ Clausen said… ‘We need a functioning CDS market, even though some politicians don’t like it, we need it. That is the only way we can hedge risk.’”

January 24 – Bloomberg (Dakin Campbell): “Societe Generale SA and Credit Agricole SA were among French banks to have their credit grades cut by Standard & Poor’s after France was stripped of its top rating earlier this month. Societe Generale, France’s second-largest bank by market value, and Credit Agricole, the third-biggest, had their debt downgraded to A from A+…”

January 24 – Bloomberg (Zeke Faux and Sridhar Natarajan): “Bank bonds are rallying the most in more than two years as the U.S. economy gains strength and the European Central Bank’s emergency loans ease pressure that threatened to overwhelm the global financial system. Bank of America Corp. and Milan-based UniCredit SpA lead average returns of 1.46% this month through Jan. 20, following a gain of 2% in December…”

January 26 – Bloomberg (Joseph Ciolli): “Junk-bond trading volumes are rebounding to the highest level in 11 months as optimism the U.S. economy can weather Europe’s debt crisis kindles investor appetites for riskier assets. The average daily volume of publicly traded speculative- grade bonds rose to $4.92 billion this month, a 74% increase from December…. Sales of new junk bonds are accelerating at the fastest pace since September, and exchange-traded funds focused on the debt are growing at the fastest two-month pace since 2009.”

Global Bubble Watch:

January 27 – Bloomberg (Tim Catts): “Corporate bond sales worldwide have slowed from their record pace in the middle of the month as everyone from the Federal Reserve to the International Monetary Fund cuts forecasts for economic growth. General Electric Co., SABMiller Plc and Bayerische Motoren Werke AG led $287.8 billion of offerings this month, the slowest start to a year since 2008…”

January 27 – Bloomberg (Brian Womack and Douglas MacMillan): “Facebook Inc., the world’s largest social-networking service, is aiming to file for its initial public offering as early as next week… The company is discussing a valuation of $75 billion to $100 billion, said two people…”

Currency Watch:

The dollar index this week fell 1.6% (down 1.7% y-t-d). On the upside, the South African rand increased 2.5%, the Swiss franc 2.4%, the New Zealand dollar 2.3%, the Danish krone 2.3%, the euro 2.2%, the Mexican peso 2.1%, the Australian dollar 1.7%, the Singapore dollar 1.6%, the Canadian dollar 1.1%, the Brazilian real 1.1%, the British pound 1.0%, the South Korean won 1.0%, the Swedish krona 0.6%, the Taiwanese dollar 0.5%, and the Japanese yen 0.4%.

Commodities and Food Watch:

The CRB index rallied 2.5% this week (up 4.0% y-t-d). The Goldman Sachs Commodities Index rose 2.2% (up 3.4%). Spot Gold jumped 4.3% to $1,739 (up 11.2%). Silver surged 6.7% to $33.79 (up 21%). March Crude gained $1.23 to $99.56 (up 0.7%). February Gasoline rallied 5.0% (up 10%), and March Natural Gas recovered 15.2% (down 7.8%). March Copper gained 3.8% (up 13%). March Wheat jumped 6.0% (down 1%), and March Corn rose 4.9% (down 1%).

Japan Watch:

January 25 – Bloomberg (Cheng Herng Shinn): “An exodus of manufacturing jobs from Japan may prolong trade-balance concerns after the nation reported its first annual trade deficit in 31 years. Panasonic… is moving the headquarters of its $57 billion procurement operation to Singapore… Honda… said this month it will build its new NSX ‘supercar’ in Ohio as the company shifts more output to North America.”

January 26 – Bloomberg (Kyoko Shimodoi and Mayumi Otsuma): “Japan’s new bond sales may exceed 50 trillion yen ($644bn) in the year starting April 2015 should policy makers fail to implement a sales-tax increase, the Finance Ministry estimates.”

India Watch:

January 24 – Bloomberg (Kartik Goyal): “India’s economic growth is weakening more than anticipated and inflation remains ‘high’ as the rupee’s fall threatens to stoke price pressures, the central bank said… ‘The growth slowdown, high inflation and currency pressures, complicate policy choices,’ the Reserve Bank of India said… The ‘critical factors’ ahead will be ‘core inflation and exchange rate pass-through,’ it said, adding that keeping the ‘liquidity deficit’ in acceptable limits is also a priority.”

Asian Bubble Watch:

January 26 – Bloomberg (Seonjin Cha and Eunkyung Seo): “South Korea’s economy grew the least in two years in the fourth quarter as exports sank… Gross domestic product expanded 0.4% from the third quarter, when it gained 0.8%.”

January 25 – Bloomberg (Shamim Adam): “Singapore’s inflation rate exceeded 5% for a seventh month, and policy makers said prices will remain “elevated.”

Latin America Watch:

January 25 – Bloomberg (Karen Eeuwens): “Domestic flight demand in Brazil grew 16% in 2011 and 7% in December, compared with a year earlier, according to Brazil’s civil aviation authority.”

Unbalanced Global Economy Watch:

January 24 – Bloomberg (Sandrine Rastello): “The International Monetary Fund cut its forecast for the global economy as Europe slips into a recession and growth cools in China and India. The world economy will expand 3.3% this year and 3.9% in 2013, compared with September forecasts of 4% and 4.5%.”

January 24 – Bloomberg (Agnes Lovasz): “The International Monetary Fund cut its growth forecast for central and eastern Europe, which as other regions in the world is threatened by ‘strains in the euro area,’… Central and eastern European economies will expand a combined 1.1% this year, down 1.6 percentage points from a September forecast, the IMF predicted… The revision mirrors a 1.6 percentage-point cut in the estimate for the euro region, which the IMF forecasts will contract 0.5%.”

January 25 – Bloomberg (Scott Hamilton and Jennifer Ryan): “The U.K. economy shrank more than economists forecast in the fourth quarter…, leaving Britain on the brink of another recession. Gross domestic product fell 0.2% from the third quarter, when it increased 0.6%.”

January 26 – Bloomberg (Chiara Vasarri): “Italian consumer confidence held at a 16-year low in January as Europe’s debt crisis forced austerity measures that may help push the economy into a recession this year.”

Central Banking Watch:

January 24 – Bloomberg (Carla Simoes and Andre Soliani): “Brazil will make room for a more ‘flexible’ monetary policy as the government seeks to ensure economic growth of at least 4% this year, Finance Minister Guido Mantega said.”

January 26 – Bloomberg (Matthew Bristow and Raymond Colitt): “Brazil’s central bank said there is a ‘high’ chance its benchmark rate will drop below 10%, signaling it remains focused on spurring economic growth even as record-low unemployment pressures consumer prices. Yields on interest rate futures plunged.”

January 25 – Bloomberg (Suttinee Yuvejwattana and Yumi Teso): “The Bank of Thailand cut interest rates for the second consecutive meeting… The central bank reduced its one-day bond repurchase rate by a quarter of a percentage point to 3%.”

January 24 – Bloomberg (Kartik Goyal): “India’s central bank unexpectedly cut the amount of deposits lenders need to set aside as reserves for the first time since 2009 and signaled future interest-rate cuts, joining BRIC nations in shielding growth. Stocks rose. The Reserve Bank of India reduced the cash reserve ratio to 5.5% from 6%.”

U.S. Bubble Economy Watch:

January 24 – Bloomberg (Timothy R. Homan): “Unemployment dropped in 37 U.S. states in December, pointing to broad-based improvement in the job market as the economy picks up… Payrolls increased in 25 states, led by Texas.”

Fiscal Watch:

January 26 – Bloomberg (Kathleen M. Howley): “In Honolulu… there’s a four-bedroom home priced at $785,000 that has views of the sun setting over the Pacific Ocean. The beaches of Waikiki are 15 minutes away. Starting this month, the property is available to buyers with a subprime credit score, limited cash reserves and a 3.5% down payment using a loan backed by the Federal Housing Administration. Without the agency, a buyer would need a 20% down payment and an unblemished financial history for a jumbo mortgage… The agency increased the size of mortgages it’s willing to insure to as high as $793,750 in Hawaii and $729,750 in the costly real estate markets of states including California, Florida, and Virginia.”

Muni Watch:

January 25 – Bond Buyer (Yvette Shields): “The combined burden of unfunded local and state pension liabilities on Chicago taxpayers rose to $103 billion in fiscal 2010 from just $19 billion a decade ago… The local and state toll of unfunded obligations on Chicagoans rose to $14,897 per capita in 2010 from $10,037 in 2008 and marked a dramatic jump from just $2,442 in fiscal 2000. Two of Chicago’s four funds and Cook County’s fund remain on course to run out of sufficient assets to cover obligations in the coming years. The total unfunded obligations of 10 Chicago-area public pension funds combined with the state rose to $103 billion based on fiscal 2010 actuarial figures, according to the Civic Federation of Chicago.”

January 26 – Bloomberg (Brian Chappatta): “U.S. state tax collections rose 6.1% from July to September, the seventh straight quarter of growth, and now exceed pre-recession levels, the Nelson A. Rockefeller Institute of Government said… Preliminary figures from 44 states also show revenue growth of 5.2% in October and November compared with the year-earlier period…”

There are reasons why Jean-Claude Trichet over the years repeatedly stated “the ECB would never pre-commit” on interest-rate policy. The Federal Reserve this week moved further to the opposite polar extreme, essentially pre-committing to near-zero rates through late-2014. The ECB has historically believed that market speculation based upon future policy expectations works to foment market excesses, imbalances and attendant fragilities. In contrast, the activist Federal Reserve believes that it has a fundamental obligation to intervene and manipulate to achieve market outcomes the committee believes will spur growth.

Unprecedented operations back in late-2008 took the Fed’s balance sheet from about $900bn to $2.2 TN. We were assured that the Fed had an “exit strategy.” I’ve always presumed “no exit,” and here we are today with Fed holdings at $2.9 TN. The economy is expanding, financial markets are strong and consumer price inflation is rather undeflationary – yet Dr. Bernanke is again signaling he is prepared for additional monetization.  

The Fed has for years operated with the premise that aggressive “Keynesian” stimulus has been necessary to stabilize a system hamstrung by post-Bubble headwinds. I’ve for as many years argued that the problem was being dangerously misdiagnosed. From my perspective, it has been much more a case of ongoing misguided “inflationism” sustaining history’s greatest Credit Bubble. And history is unequivocal: inflationism has an end-game problem. Again, it is analysis easily dismissed, although I am nonetheless convinced it will go a long way in determining what kind of world we and our children have to look forward to.

While I was chronicling the emergence of the mortgage finance Bubble back in 2002, Fed Governor Bernanke was crafting the Fed’s case for novel reflationary policymaking. Mortgage Credit was already expanding at double-digit rates when Dr. Bernanke introduced his intellectual basis for the government printing press and helicopter money. The subsequent decade, replete with a historic Credit boom and bust, has seen radical monetary policy doctrine become the mainstream. But didn’t the policy experiment fail miserably?

Accommodating gross mortgage Credit excesses in the name of system reflation is one of the greatest blunders ever committed in monetary management. The Fed has not been held accountable – either in terms of a seriously flawed analytical framework or the associated policy mistakes. Instead, the Bernanke Fed has become only more radical and domineering in the markets. Public confidence and trust in the Federal Reserve have suffered mightily, yet this has thus far had no impact. Importantly, the power players in political circles and the securities markets have benefited tremendously, ensuring ongoing support for the Fed’s controversial reflationary policy course. The financial mania has reached the point where the completely unreasonable is accepted as perfectly reasonable.

The housing Bubble was obvious, or at least this has become the commonly held view. As someone who chronicled the Bubble on a weekly basis for a number of years, I have a clearer view of how things went down. There was actually tremendous hostility for Bubble analysis. I was “lunatic fringe.” The analysis that the GSEs, mortgage insurers and sophisticated Wall Street debt structures were part of a historic episode of “Ponzi Finance” did not resonate. And the more conspicuous the mortgage finance Bubble became, the more elaborate the arguments against the Bubble thesis.

Chairman Greenspan became fond of arguing that housing markets were local and, hence, the notion of a national housing Bubble was misguided. I often wondered if the king of all economic data ever took a glance at the Fed’s Z.1 “flow of funds” report. The Greenspan/Bernanke Fed fashioned “white papers” and such explaining how it was impossible to recognize a Bubble until after it burst. To them, the proper and prudent policy course was to avoid the risk of intruding on prosperity and functioning markets, being ready instead to implement a “mopping up” strategy in the event such measures were ever required. It was the ridiculous bordering on negligence.

When it comes to Credit and Bubble analysis, the Fed has proven itself incompetent. After the Fed-induced steep yield curve from 1991 to early-1994 fomented a destabilizing speculative Bubble, they should have focused keenly on how their policy measures were inciting leveraging and speculation. After the 1995 Mexican bailout further emboldened speculative excess and fomented the catastrophic Bubble throughout SE Asia (and beyond), policymakers should have been fixated on the risks associated with destabilizing “hot money” flows, derivatives and a ballooning global “leveraged speculating community.” After the LTCM fiasco, the danger was conspicuous. It was also conspicuously apparent that the LTCM bailout and the Federal Reserve market backstop were instrumental in inciting the tech Bubble. And the Fed’s response to that burst Bubble was integral to the scope of the mortgage finance Bubble. As obvious as this chain of cause and effect has been, the Fed dogmatically refuses to have any part of such analysis.

I have seen overwhelming support for the “global government finance Bubble” thesis. Fiscal and monetary policy has been out of control for going on four years now. And with parallels to the mortgage finance Bubble, the more prolonged the Bubble period the more dismissive the crowd becomes to the notion that they might be participants to a manic Bubble. That’s ok. As an analyst of speculative Bubbles, I am well aware of the nuances. Objectively, it is possible to recognize Bubble dynamics in real time. Realistically, however, it is the nature of things that this analysis will be dismissed and disparaged. As I’ve written in the past, “Bubbles tend to go to unimaginable extremes – and then double!” I am comfortable with the analysis that we are in the late stage of a historic global financial mania.

Let’s talk a little Bubble analysis. First of all, most that use the term “Bubble” are implying an imminent bursting. I subscribe to a different analytical framework. The baseline assumption, especially in today’s extraordinary global financial and policy backdrop, is that Bubbles will enjoy momentum and longevity. Anchorless global finance and incredible policy activism will tend to support ongoing (compounding) excess. My thesis further holds that the global government finance Bubble is the “granddaddy” – the crescendo Bubble that will conclude this Credit cycle. Students of previous monetary experiments and manias appreciate that authorities will commonly resort to increasingly desperate measures in order to bolster waning confidence. This week I recalled reading accounts of how John Law devalued hard money coinage that was competing with his “Mississippi Bubble” paper monetary scheme in a last chance gambit to force players to stick with his faltering Credit instruments.

Most Bubble analysis focuses on valuation: “A Bubble is created when prices move beyond that which is supported by underlying fundamentals.” Again, my framework is altogether different: A Credit Bubble is about a mispricing (under-pricing) of finance. This mispricing supports the over-issuance of debt instruments. And, importantly, Credit Inflation is self-reinforcing, in that the associated increase in purchasing power bolsters the fundamental factors central to the bullish premise. Credit excess begets Credit excess. Tech stocks always looked cheap compared to earnings growth rates, and the greater the mania in tech-related equity and debt securities the greater the capacity for industry expansion to justify ever increasing industry price-to-earnings ratios and stock prices.

Throughout the mortgage finance Bubble, the expansion of mortgage debt led to inflating home prices. And the greater the number of housing transactions the greater the growth in household equity extraction and consumption. GDP and corporate profits surged, ensuring higher stock prices and heightened demand for houses and mortgage Credit. For the most part, home prices at the time didn’t look dangerously extended compared to boom-time fundamentals (i.e. surging household net worth, income growth, stock prices, GDP prospects, etc.). And the meager risk premiums on mortgage-related finance seemed to be justified by minimal Credit losses, robust housing price trends and prospects for ongoing prosperity. Home prices only go up.

The bottom line was, however, that multi-Trillions of finance were mispriced based on faulty market perceptions. In the end, faith that Washington (the Fed, Treasury, Congress, Fannie, Freddie, Ginnie, the FHLB, FHA, etc.) would never tolerate a housing bust proved instrumental in the market’s mispricing of the debt underlying the historic Bubble. Government intervention, market misperceptions, mis-priced finance, self-reinforcing over-issuance and seductively inflated fundamentals are Credit Bubble hallmarks.

At this point, only a lunatic would take issue with the market premise that the Fed and global central bankers would never tolerate a problem in the Treasury or agency debt market. In a replay of mortgage finance Bubble dynamics – with only greater ramifications and inevitable consequences – the perception of ongoing government market intervention is allowing the self-reinforcing issuance of Trillions of debt at the most meager of risk premiums. Systemic risk rises exponentially, as the price of government finance is pushed to the floor.

It has reached the point where the Fed (along with fellow global central banks) has completely abrogated the market pricing mechanism – and with it the capacity for the self-regulation of debt issuance through higher borrowing costs. Why on earth would we expect Washington politicians to take deficit reduction seriously? And, to be sure, the massive expansion of newly created purchasing power is bolstering fundamentals, including consumption, economic output, corporate profits, stock prices, and household net worth. Strong markets, in particular, underpin the view that future growth will provide a backdrop conducive to Washington getting its fiscal house in order. There are many facets to the Bubble.

The Fed committed yet another major error this week. The worsening European crisis last year created a major artificial bid to perceived “safe haven” Treasury (and related) securities. This amounted to a major loosening of financial conditions for the commanding sector of U.S. Credit expansion. The Fed should have recognized how this dynamic had created heightened Bubble risk throughout our government debt markets (Treasury, agency, MBS, muni, etc.). Instead, the Fed has administered gas to the fire – along with pronouncing that it’s content to stand gas can in hand for some years to come. The Bernanke Fed has created a backdrop further supportive of speculative leveraging – and global risk market speculation more generally. Worse yet, our central bank is determined to punish savers into submission.

Responding to the Fed announcement, Treasury, agency debt and fixed income prices rose; U.S. stock prices rose; gold, energy and commodities prices rose; and emerging debt, equity and currency prices rose. The dollar was one of the few losers. Forgive me for believing the Fed secretly fears a stronger dollar. And forgive me further for contemplating a scenario where the Fed’s incessant market circumventions backfire.

Let’s contemplate LTRO 1&2-induced bullish market sentiment meeting disappointment at the hand of faltering European economic performance – and European debt markets finding themselves, there we go again, re-pricing risk higher. At some point, might global investors perhaps find a highly governed U.S. Credit market more appealing than dealing with the whims of ungovernable debt markets in Europe and elsewhere? And forgive me one last time for thinking that the invincible hand of the Federal Reserve – along with unfathomable global central bank liquidity creation – further bolsters boom and bust dynamics and heightens the risk of further rounds of global de-leveraging and de-risking. If it looks like a Bubble, smells like a Bubble…

If nothing else, we’ve learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it’s a very real threat, and if and when it ends we should nonetheless be guarding against its return — which means that there’s a very strong case both for a higher inflation target, and for aggressive policy when unemployment is high at low inflation.

The bottom line is that the Fed almost surely won’t, and very surely shouldn’t, start raising interest rates any time soon.

But does it make sense that by means of more inflation the US economy could be pulled out of the liquidity trap?  

The Origin of the Liquidity-Trap Concept

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Thus, spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

Consequently, a vicious circle sets in: the decline in people’s confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates.

Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby reestablishing the circular flow of money, so it is held.

In his writings, however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further.

This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings. As a result, people’s demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply.

Keynes wrote,

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. [1]

Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending can be on all sorts of projects — what matters here is that a lot of money must be pumped, which is expected to boost consumers’ confidence. With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby reestablishing the circular flow of money.

Do Individuals Save Money?

In the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure. When people spend more of their money, this is seen that they save less.

Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed that they save more. Observe that in the popular — i.e., Keynesian — way of thinking, savings is bad news for the economy: the more people save, the worse things become. (The liquidity trap comes from too much saving and the lack of spending, so it is held.)

Now, contrary to popular thinking, individuals don’t save money as such. The chief role of money is as a medium of exchange. Also, note that people don’t pay with money but rather with goods and services that they have produced.

For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange. Again, money is just employed to exchange goods and services.

To suggest then that people could have an unlimited demand for money (hoarding money) that supposedly leads to a liquidity trap, as popular thinking has it, would imply that no one would be exchanging goods.

Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note: people demand money not to accumulate indefinitely but to employ in exchange at some more or less definite point in the future).

Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer. The state of the demand for money cannot alter the amount of goods produced, that is, it cannot alter the so-called real economic growth. Likewise a change in the supply of money doesn’t have any power to grow the real economy.

Contrary to popular thinking we suggest that a liquidity trap does not emerge in response to consumers’ massive increases in the demand for money but comes as a result of very loose monetary policies, which inflict severe damage to the pool of real savings.

Liquidity Trap and the Shrinking Pool of Real Savings

As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and nonproductive activities. Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than the amount it releases. This excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings.

This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. (The shrinking pool of real savings exposes the commonly accepted fallacy that the loose monetary policy of the central bank can grow the economy.)

Needless to say, once the economy falls into a recession because of a falling pool of real saving, any government or central-bank attempts to revive the economy must fail.

Not only will these attempts not revive the economy; they will deplete the pool of real savings further, thereby prolonging the economic slump.

Likewise any policy that forces banks to expand lending “out of thin air” will further damage the pool and will reduce further banks’ ability to lend.

The essence of lending is real savings and not money as such. It is real savings that imposes restrictions on banks’ ability to lend. (Money is just the medium of exchange, which facilitates real savings.)

Note that without an expanding pool of real savings any expansion of bank lending is going to lift banks’ nonperforming assets.

Contrary to Krugman, we suggest that the US economy is trapped, not because of a sharp increase in the demand for money, but because loose monetary policies have depleted the pool of real savings. What is required to fix the economy is not to generate more inflation but the exact opposite. Setting a higher inflation target, as suggested by Krugman, will only weaken the pool of real savings further and will guarantee that the economy will stay in a depressed state for a prolonged time.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies.

India has agreed to pay the price of crude oil it imports from Iran in gold, which makes it the first country to drop the US dollar for purchasing the Iranian oil. According to a report published by DEBKAfile news website, unnamed sources have stressed that China is also expected to follow suit.

India and China take about one million barrels per day (bpd), or 40 percent of Iran’s total exports of 2.5 million bpd and both of them have huge reserves of gold.  

The report added that by trading in gold, New Delhi and Beijing enable Tehran to bypass the upcoming freeze on its Central Bank’s assets and the oil embargo which the European Union’s foreign ministers agreed to impose on Monday, January 23. The EU currently buys around 20 percent of Iran’s oil exports.

On the other hand, experts say the vast sums involved in these transactions are expected to boost the price of gold and depress the value of the dollar on world markets.

“An Indian delegation visited Tehran last week to discuss payment options in view of the new sanctions. The two sides were reported to have agreed that payment for the oil purchased would be partly in yen and partly in rupees. The switch to gold was kept [in the] dark,” the report stated.

India is Iran’s second largest customer after China, and purchases around USD 12-billion-a-year worth of Iranian crude, or about 12 percent of its consumption.

Delhi is to execute its transactions, the report said, through two state-owned banks: the Calcutta-based UCO Bank, whose board of directors is made up of the Indian government, the Reserve Bank of India representatives, and Halk Bankasi (Peoples Bank) — Turkey’s seventh largest bank which is owned by the government.

US President Barack Obama signed into law, on December 31, 2011, new sanctions which seek to penalize other countries for importing Iran’s oil or doing transaction with Islamic Republic’s Central Bank.

Foreign ministers of the European Union also imposed sanctions on Iran’s oil imports over the country’s peaceful nuclear program during their Monday meeting in Brussels.

The sanctions involve an immediate ban on all new oil contracts with Iran and a freeze on the assets of the country’s Central Bank within the EU.

Tehran has warned that the embargo will have negative consequences, such as increasing the oil price.