How the US Empire Simply Digs a Deeper Hole

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It is worth considering what’s eating away at the US Empire these days. There are many reasons for America’s powerful rise. But we would say having the dollar as the world’s reserve currency is THE major reason for US economic, cultural and military dominance.

Being able to produce paper and swap it for real goods and services is an incredible economic advantage. It means your creditors allow you to keep running up the tab and you seemingly never have to settle.

But at some point you do. The actual point, or settlement date, depends on how you play your cards and how long you can game the system.

The way we see it, by keeping up the pretence that you’re running a ‘sound’ monetary system…by allowing the odd recession and by maintaining interest rates that slightly rewards savers while still benefitting spenders…you can keep the game going for a long, long time.

But the US threw that game plan out the window back in 2000. Then they went outside and kicked it into the kerb in 2008. Now the great US empire has a diseased heart. It’s formerly great capital markets no longer pump blood around the economy the way they once did.

It is the flagrant mispricing of credit that is bringing the US down. As we mentioned yesterday, an interest rate is a price signal provided by savers and borrowers. But it is also more than that. It is a signal of credit quality.

When you deposit your funds in a bank you receive interest. That interest rate is your reward for giving the bank your money…for becoming a creditor of the bank. Of course the bank lends your money out…and promises to pay you back if you need it. But in receiving interest you’re implicitly taking on the bank’s credit risk.

If you don’t want to take on credit risk, you buy physical gold. That’s why gold pays no interest. It is no one else’s liability.

The absurdity of a centrally managed financial system is that as credit quality weakens across the board, the central bank tries to drive interest rates lower, supressing the signal of deteriorating credit. In the early days of a crisis, the private sector falls for this false signal and the risky company or country gets access to even more funds, rewarding profligate behaviour.

But at some point the ‘settlement date’ arrives. Greece’s arrived in 2010. Ireland and Portugal’s followed soon after. Creditors finally saw the writing on the wall. Interest rates in those countries are now so high (to reflect their high risk) that they needed bailout funds to avoid collapse.

Despite heroic (we use the term loosely) and constant efforts to avoid contagion, Spain and Italy’s ‘settlement dates’ are fast approaching. Spanish government 10 year bond yields are back above 6%. Italian government bonds are at 5.56%, up from 4.84% in early March.

Getting back to the US, we think it’s at the stage where the private sector has fallen for the false signal of lower rates = good credit quality. It’s practically giving money to the US government. The 10 year US bond yield is 1.78%, below the official inflation rate. Right now everything seems fine. It’s what will happen in a couple of years that’s the big concern.

By maintaining zero interest rates and repeatedly resorting to quantitative easing, US central planners think they’re keeping the game going. But they’re really digging a hole for themselves. And at some sudden future point, the ‘market’ will bury the dollar’s reserve status in it.

Regards,

Greg Canavan
for The Daily Reckoning Australia

From the Archives…

The Physical Gold Market – From the Weak to the Strong
2012-05-18 – Greg Canavan

Why JP Morgan is Playing the Same Old Rigged Game
2012-05-17 – Eric Fry

Why Greece Can’t Afford to Stay in the Euro
2012-05-16 – Dan Denning

A Big Oops at JP Morgan!
2012-05-15 – Dan Amoss

Preparing For China’s Growth Slowdown With The ‘Energy Hub’ Portfolio
2012-04-14 – Dan Denning

From the Archives…

The Physical Gold Market – From the Weak to the Strong
2012-05-18 – Greg Canavan

Why JP Morgan is Playing the Same Old Rigged Game
2012-05-17 – Eric Fry

Why Greece Can’t Afford to Stay in the Euro
2012-05-16 – Dan Denning

A Big Oops at JP Morgan!
2012-05-15 – Dan Amoss

Preparing For China’s Growth Slowdown With The ‘Energy Hub’ Portfolio
2012-04-14 – Dan Denning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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