Excerpts from Peter D. Schiff's The Real Crash.


The Fed needs to stop fueling inflation and start sucking dollars back out of the economy. It also needs to let interest rates rise. When the Fed does these two things, Washington’s free ride will end — it will no longer be able to borrow at near zero interest. As a result, Congress will have to slash spending, fix our entitlements, and generally shrink government.

Throughout the 1990s, the Federal Reserve injected tons of money into the economy, which fueled a stock bubble, focused particularly on dot-com companies. In 2000 and 2001, when the Stock Market turned down and unemployment started to creep up, that was a correction. Assets that had been overvalued (such as stocks) were returning to a more appropriate price. The dot-com and Stock Market bubble had misallocated resources, and while investment was fleeing the overvalued sectors, inevitably the economy shrunk and unemployment rose while wealth became more rationally allocated around the economy. Readjustments in the economy involve short-term pain, just as the cure to a sickness often tastes bitter. Short-term pain, however, was unacceptable to the politicians and central bankers in 2000 and 2001. Federal Reserve Chairman Alan Greenspan manipulated interest rates lower. This made borrowing cheaper, inspired more businesses to invest, and softened the employment crunch. But the economy wasn’t really getting stronger. That is, there weren’t more businesses producing things of value. As there were few good business investments, all this cheap capital flowed into housing. As housing values skyrocketed, Americans were getting richer on paper. This made it seem as if things were okay. In other words, Greenspan accomplished his goal of forestalling any significant pain. By the same token, he also kept the economy from healing properly, which would have laid the foundation for a stronger and lasting recovery. When market realities started to bear down on the economy, and the housing bubble popped, with the broader credit bubble right behind, the government was running out of things to artificially inflate. So the Fed and the Obama administration decided to pump money desperately into government.

Just as the housing bubble delayed the economic collapse for much of last decade on the strength of imaginary wealth, the government bubble is propping us up now. The pressure within the bubble will grow so great that the Federal Reserve will soon have only two options: (a) to finally contract the money supply and let interest rates spike — which will cause immensely more pain than if we had let this happen back in 2002 or 2008; or (b) just keep pumping dollars into the economy, causing hyperinflation and all the evils that come with it. The politically easier choice will be the latter, wiping out the dollar through hyperinflation. The grown-up choice will be the former, electing for some painful tightening — which will also entail the federal government admitting that it cannot fulfill all the promises it has made, and it cannot repay everything it owes. In either case, we’ll get the real crash.

The Fed’s manipulation of interest rates not only artificially boosts the housing market, it also boosts all borrowing and indebtedness. Without the Fed, our indebtedness and consumption would both be much lower.

The Troubled Asset Relief Program (TARP), the stimulus, the auto bailouts, and the inflationary actions of the Federal Reserve all treat the symptoms of our 2008–2009 downturn. It’s all superficial. Government can slow the fall of housing prices, and so our politicians make sure that it does. For example, Obama has used TARP to keep people in their homes — often only delaying foreclosure and thus making homeowners even poorer. Fannie Mae and Freddie Mac ramped up their subsidies, thus keeping demand for homes higher than it would be. The Federal Housing Authority is subsidizing mortgages to the point that people are once again putting down zero percent — this applies upward pressure to home prices, slowing their fall. But falling housing prices are part of the cure. Inflated prices are part of the disease.

Along the same lines, government can keep interest rates low, and so it does. But low interest rates contributed to the disease. High interest rates are part of the cure that we need. Again, government makes sure that we never get the cure.

Falling prices and wages are another cure the government won’t let us swallow. Washington does everything it can to prevent falling prices. Mostly, this means (1) Keynesian stimulus to drive up demand for goods and services, and (2) inflating the money supply. Falling prices would be a cure, and so government pumps up prices. In other words, the market is trying to cure the economy, and the government won’t let it. The government’s "cure" for the market’s cure is more imaginary wealth. Government doesn’t exactly pull this imaginary money out of a hat, but it does create it out of nowhere. Where did the $700 billion to bail out Wall Street and Detroit come from? That money was created by the Federal Reserve. Literally, the Fed just credited banks with money. Those dollars didn’t come "out of" anywhere. The Fed simply declared that more dollars existed. The stimulus? None of that was paid for with tax dollars. All of that money was borrowed. That means the U.S. Treasury sold bonds and treasury bills, and then spent all the money it borrowed. Because the federal government runs a deficit, every year it is borrowing more. Everyone who owns U.S. debt today knows that if they redeem their bond or cash in their T-bill, the government will pay for it by borrowing again. So every dollar with which our government tries to save banks, create jobs, and keep interest rates low comes either through (a) inflation (new dollars that dilute the value of existing dollars) or (b) revolving debt.

The Fed is creating money that banks are then lending to the Treasury to pay for ever-expanding government. The same artificially low interest rates that made it easy to buy a house in the last decade are making it easy for the government to borrow in this decade. Of course, the government isn’t borrowing for investment, it’s borrowing for consumption. That means Uncle Sam is simply going deeper into debt, and the only way we’re going to pay off our current loans is by borrowing again.

Much government spending goes to government-favored technologies, which do not add value to the economy, such as subsidized wind turbines or solar panels. Republicans and Democrats alike have increased subsidies for whatever they consider to be cutting-edge technology. These subsidies create very narrow booms: some solar-panel maker gets rich, or some company that makes windows expands and adds another plant. Politicians point to these successes as proof that their subsidies help the economy. But these subsidy-induced booms actually hurt the economy. The tax credits and handouts draw rational businessmen to invest in technologies that don’t really add value. If these technologies were valuable, they wouldn’t need subsidies in order to draw investment. Government turns these useless or inefficient technologies — like ethanol, or solar power — into profitable undertakings. Every dollar invested in these unproductive activities is drawn away from something that people would value more — and that would be able to grow on their own. This makes us poorer.

Politicians refuse to allow the short-term pain that the cure entails. They’re like a doctor who won’t give a patient any bitter medicine, or like a rehab counselor who won’t let the addict go through withdrawal. The politicians might be behaving rationally — that is, acting in their own political interests. If people face higher interest rates, smaller 401(k)s, falling wages, or foreclosure, they get upset. Presidents, governors, and congressmen know they will get blamed. So, like an Enron executive trying to hide losses off the books so that shareholders are happy, Congress, the White House, and the Fed take short-term gain, even though the price is long-term pain.

Those who lend to the U.S. government these days don’t expect that tax revenues will pay them back — they know they will get paid back with more borrowed funds. Once would-be creditors begin to see the risk in this Ponzi scheme, they’ll start demanding a higher risk premium. In other words, Uncle Sam will need to pay higher interest rates on its Treasury Bonds.

While tightening money supply, skyrocketing interest rates, and slashing of government services and spending will cause immense economic pain, it will be the right thing to do. With high interest rates and tight credit, borrowing will slow down. Slowly, people will start to pay down their debt. High interest rates will also incentivize savings. Those savings will eventually become investment capital — the foundation for new enterprises. A shrinking government, of course, will open up the economic playing field for market actors, who will invest in what’s promising rather than what’s politically favored. The process will simply be the delayed — and more painful — cure that should have come in 2001 or 2008. It will be the crash we should have had in 2002 or 2009, but it will be worse, because the imbalances are now greater as a result of the extra debt the government has accrued for itself and induced in financial institutions and individuals.

Instead of this scenario of excruciating tightening, politicians could opt to try to cover up reality one last time by pumping even more dollars into the economy. Need to pay off the national debt? Fine, just print more money, and pay it off with that money. Need to pay for unsustainable entitlements like Medicare and Social Security? Fine, just print more money, driving up nominal wages and thus tax revenue. Of course, the real value of these benefits would collapse, but maybe politicians could maintain a pretense of keeping up benefits. Some politicians might prefer this route, because it could deflect some blame: they could blame businesses and service providers for raising prices (even though the price hikes would be a necessary and natural response to inflation). For example in 2011, as oil prices rose as a result of the inflation created by the Fed, Ben Bernanke and President Obama blamed the rise on oil speculators, and commissions were convened to investigate the wrongdoing. But this path leads to hyperinflation, which will be even more economically destructive for the average American.

The crash and what follows will be beneficial. For one thing, this crash might finally bring about tax cuts. Government will be forced to shrink, thus freeing up more space in the economy for entrepreneurs. Maybe when the debt is paid down, we can keep government small. Also, those who have saved, and who have low debt and hard assets, such as farmland, gold, or natural resources, will benefit from a contracted money supply. The contraction will clean out the malinvestment and government bloat.

The Fed sets interest rates, it controls the money supply, it is effectively the main lender to the United States Government, and the lender of last resort to the banks, and it is the core of the Bush-Obama bailout machine.

During the 1990s, every time there was an economic problem — like the “Asian Contagion,” the Russian debt default, the collapse of Long-Term Capital Management, the Orange County default, or worries about Y2K — the Fed stepped in with more cheap money, in an effort to postpone any kind of correction. A look at money supply data is striking. In April of 1995, there was barely more than $3.5 trillion in circulation, counting all currency and bank accounts (this number is known as M2). In the next eleven years, the money supply would double. By the middle of 2011, we were pushing $9 trillion in money supply. When the big pump began in mid-1995, this new money had to find a place to go. The Fed was keeping interest rates artificially low, thus discouraging savings. So, the new money went into the Stock Market. The average close of the Dow Jones Industrial Average in May 1995 was under 4,500. Four years later, it was above 11,000. Most notoriously, the money poured into dot-com stocks. The Nasdaq, the epicenter of the dot-com boom, began in 1996 at 1033. In March of 2000, the Nasdaq broke 5,000. By 1999, the ongoing inflation (increase in the money supply) led to noticeable price increases. From December 1998 until December 2000, the Consumer Price Index (CPI) rose by 6.8 percent(3.4 percent annually). And the CPI doesn’t totally reflect higher costs of living. Gasoline prices rose about 50 percent in eighteen months around then.

Alan Greenspan wasn’t the only one in 2001 who thought we needed people to spend more money. At this time, President Bush gave his "go out and shop" exhortation. Well, how do we get people to shop? Cheap money and low interest rates that encourage indebtedness and discourage savings. Thus began the Federal Reserve policy of perpetually cheap money — continued inflation of the money supply and near-zero interest rates. So the Fed brought the rate down to 1.0 percent by the middle of 2003.

The money supply continued to grow unabated, and so, once again, we had excess money and a disincentive to save. The Stock Market again swallowed much of that, and stock prices again began to rise. However, this time around, the real action was in real estate. Housing became the prime place for excess speculation and paper wealth. The Fed created the excess capital that then went in search of somewhere to go. So, why a housing bubble, and why not, say, a car bubble or a tulip bubble? Some of it was just market forces — crime was on the way down, and rich people were moving back into cities, driving up center-city prices. But much of it was government policy. Politicians in both parties decided that government should promote home ownership. Democrats focused on helping poor people own homes by making mortgages easier to get. Republicans spoke of an "ownership society" that would promote personal responsibility. Bankers and realtors, two of the most powerful interest groups in Washington, both agreed, and they helpfully pointed out ways the government could subsidize mortgages. The biggest subsidy for buying a home is the tax deduction for mortgage interest. If you rent your home, none of your rent is deductible. If you buy your home outright, your costs are not tax deductible. But if you borrow in order to buy your house, all of the mortgage interest — which is a majority of the monthly payment for many homeowners — is tax deductible.

Franklin Roosevelt created the Federal National Mortgage Association during the Great Depression in order to stimulate home buying ("FNMA" became "Fannie Mae"). In 1968, Congress privatized Fannie, and a couple of years later, created a competing agency, the Federal Home Loan Mortgage Corporation, or Freddie Mac. These agencies buy mortgages from lenders. You can imagine how this opens up the mortgage market. Without someone buying up mortgages, a bank is limited in how many loans it can make — after all, even with fractional reserve banking and loose reserve requirements, your loans still need to be backed up by some amount of assets. But once you have Fannie and Freddie buying mortgages, there’s no limit. Bank of America can lend money to a homebuyer and then sell the mortgage to Fannie. Bank of America now has its cash back and can lend it out again — a loan the bank will then off-load. Now, there’s nothing wrong with mortgage securitization in itself — it’s financial innovation which is a bit risky, but that’s what finance is about. The problem with Fannie and Freddie is that they knew that while their profits were real — and huge — their risk was not real. More precisely, the politically connected bigwigs who ran the halls at these GSEs knew that if their companies ever lost money, the taxpayers would bail them out. Fannie Mae was able to borrow at lower interest rates because lenders realized that taxpayers would bail them out. Near-zero borrowing costs allowed Fannie and Freddie to buy up massive amounts of mortgages, and to buy up riskier mortgages. If Fannie and Freddie would buy a loan, there was no reason not to issue it. The net effect of Fannie and Freddie was to drive down lending standards and interest rates. Had there been no government-subsidized secondary mortgage market, selling mortgages would have been harder for banks, and so lending standards and interest rates would have been higher.

Some like to point out that subprime was the real problem and that Fannie and Freddie did not guarantee subprime loans. While that is technically true, they were the biggest buyers of these loans in the secondary market. In fact, without their lavish appetites, far fewer subprime loans would have been originated. Not only did their demand help fuel originations, but it helped legitimize the investment merit of the securities. However, in a nod to Fannie and Freddie defenders I will acknowledge that the primary culprit behind subprime was the Fed. Without ultralow short-term interest rates, the low teaser rates that made subprime loans initially "affordable" never would have existed. In addition, ultralow interest rates and the excess trade deficits they fueled drove global demand for higher-yielding dollar assets. Because the private sector originated subprime loans without any official government backing, many like to blame capitalism, or more specially Wall Street greed, for the problem. But take the Fed and Fannie and Freddie out of the picture, and subprime would have been a trivial part of the mortgage market.

Fannie Mae and Freddie Mac were the most important players in driving the Fed’s excess capital into housing, but other policies helped, too. The Community Reinvestment Act (CRA) was one. The CRA has changed plenty over its thirty years, but the general thrust was always the same: it empowered federal regulators to pressure banks to make more loans to low-income people. George W. Bush pushed his "ownership society," too. Bush spoke at a black church in Atlanta in 2002 about "the American Dream," meaning home ownership. The president named some of the new homeowners he had just met and said, "What we’ve got to do is to figure out how to make sure these stories are repeated over and over and over again in America." To this end, he proposed the American Dream Downpayment Act to help folks buy homes even if they couldn’t afford the downpayments. The law, passed in 2003, provided grants of up to $10,000 to cover downpayment, closing costs, and some home repair for first-time homebuyers of below-average means. Of course, the tax preferences above drove the housing market, too. Housing prices soared. At the same time, the American Dream was hijacked. Instead of referring to the upward mobility made possible by American capitalism, it was redefined to mean getting rich just by buying a house and extracting equity as it magically appreciated.

When bubbles are built upon foundations of massive leverage, the bust brings real destruction. Consider the guy who took out an adjustable rate mortgage in 2005 to buy a big house with a very small downpayment. When his home value dropped 30 percent, not only his on-paper net worth suffered. His rate adjusted in 2010, and he couldn’t refinance because his house was underwater. If he sold his house, he wouldn’t be able to get enough money to cover his outstanding mortgage and the bank would take all his savings. Banks also took a hit, when everyone realized the trillions investors and banks had spent on mortgage-backed securities were worth a fraction of what they were supposedly worth. All the financial institutions that had been providing credit to the economy were suddenly in trouble, and couldn’t lend like they used to. Those businesses that depended on credit for their day-to-day operations were in trouble. The Stock Market fell. From an October 2007 peak above 14,000, the Dow Jones Industrial Average staggered down to 11,000 before the collapse of Lehman Brothers in September 2008. In the next month, the Dow fell below 8,500, eventually bottoming out at 6,626 in early 2009. That’s a 53 percent drop. Housing prices collapsed. The June 2006 Case-Shiller index was 189.93. In March 2009, the index hit 129.2. That’s a 32 percent drop.

Remember the prime directive that transcends party lines at the Fed, in Congress, and the White House: minimize short-term economic pain at any cost. Never was this directive on display as clearly as in 2008. In March, the Fed bailed out failed bank Bear Stearns. In July, Congress passed housing bailouts. In early September, the federal government took outright ownership of Fannie and Freddie (since then, according to Congressional Budget Office numbers, taxpayers have poured $310 billion into the two GSEs). In mid-September, the Federal Reserve, with no authorization from Congress, created brand-new Enron-like special-purpose entities to buy an 80 percent stake in insurance giant AIG. This was an attempt to bail out a collapsing financial sector. It wasn’t enough. By the end of the month, Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson had formulated the mother of all bailouts, which they named the Troubled Asset Relief Program, or TARP. At first, we were told the TARP would allow the Treasury, using money created out of thin air by the Fed, to buy up mortgage-backed securities and other financial assets whose value couldn’t be ascertained. The idea was to prevent a "disorderly" unwinding of troubled financial institutions, with debt and other financial instruments going at fire-sale prices, thus destroying the market prices of the assets on which other banks were sitting.

The reality, unsurprisingly, was something far bigger. The Bush and Obama administrations used TARP in all sorts of creative ways, like buying up auto companies and creating "Public-Private Investment Partnerships," paying banks to reduce the principal of underwater homes, and other innovative ways of injecting the government into the economy. Most important, though, was the way the string of bailouts fit the government pattern: prevent the economy from correcting itself. Once again, rather than let an inefficient allocation of resources shake itself out, politicians and central bankers decided that the right cure for a drinking binge was "the hair of the dog that bit you." That is, when confronted with a crisis caused by government-created moral hazard, cheap money, and central planning, Washington responded with more moral hazard, even cheaper money, and heightened central planning. Since July of 2007, the Fed has increased the money supply by 23 percent. Bernanke has been buying bonds from big banks as quickly as the Treasury can sell them to the banks, keeping interest rates absurdly low, and thus discouraging saving.

Federal spending rose from $2.66 trillion in fiscal year (FY) 2007 to $3.82 trillion in 2010. Because tax revenues actually went down, the new federal spending was all borrowed money (the 2011 deficit was about $1.65 trillion). The national debt held by the public — a disgrace under George W. Bush at $4.82 trillion in 2007 — skyrocketed to about $10 trillion in 2011. Remember, this wasn’t accidental on the part of the Fed and the federal government. It was an intentional plan: Keynesian stimulus, punctuated by Obama’s $800 billion stimulus bill and the Fed’s giant "quantitative easings" (episodes of pumping money into the economy).

The problem with our banking system has not been too little regulation, but too much. To curb excessive risk taking, we do need more "adult supervision," as Obama put it, but that supervision should come not from government officials, but from creditors and customers. So, the big-government types are correct that our financial system is dysfunctional, and that this dysfunction is the key destabilizing factor in our economy. But the solution isn’t more regulation, or even "smarter regulation." To fix our financial sector and make our economy more stable, we need something far more drastic: an actual free market. Government needs to stop telling banks what to do and stop bailing them out when they fail. No regulator will ever be as effective as the threat of failure.

The single most destabilizing factor in our financial sector is the "Too Big to Fail" mind-set. The FDIC’s moral hazard is a minor problem compared to the belief that the Fed and Congress will come swooping in to save big banks — or at least their creditors — if anything bad happens. There’s no doubt today that Wall Street and big banks, high on cheap money from the Fed, were taking extra risks during the last decade on the assumption of bailouts, including the FDIC, Fannie Mae, and the sort of extraordinary saves by the Fed we saw at Bear Stearns, AIG, and, eventually, the TARP. The bank executives taking the risks saw all the signs: politicians’ rhetoric and government policy made it clear that the government was in the business of propping up housing. If banks bet big on housing, would Washington really let them fail? Washington is sending the same message today, with President Obama still using the TARP inorder to bail out underwater mortgages, and the FHA underwriting 3.5 percent down payment mortgages. In fact, the FHA has basically taken over the subprime market now that the private sector will no longer touch it. In 2006 FHA insured only 3.3 percent of total mortgages. During 2010, the Federal Housing Authority (FHA) insured 40 percent of all new mortgage originations. By the end of that year, 20 percent of the entire mortgage market was FHA guaranteed. The private sector lost so much money making subprime loans that it abandoned the practice completely. The government then saw an opportunity to corner a market no private firm wanted any part of — making risky loans to people unlikely to repay them. My guess is the FHA will soon need a massive federal bailout, perhaps as early as 2012, as a result of the huge losses that will result from its reckless lending practices. At least the private sector learned from its mistake. The government adopts them into official public policy.

So how do you abolish bailouts? You start by abolishing the FDIC and dissolving Fannie and Freddie. But what about implicit bailouts? You can’t pass a law blocking them because there is no law promising them. It’s just how Congress or the Fed reacts when an actual crisis arises. The first step would be to stop propping up the giant banks and investment banks. People often assume big banks are a creation of capitalism. Instead, they are the creation of government. First, regulation always acts as a barrier to entry by adding to overhead. This punishes smaller banks and keeps out new entrants, allowing the bigger guys to proceed with less competition. Size provides only one sort of benefit for big banks: political favor. This is why Bank of America can borrow much more cheaply than a smaller, sounder bank. This is one reason Goldman Sachs is able to draw institutional clients. In other words, through implicit bailouts and regulations, government creates this class of superbanks. Without bailouts and with less regulation, banks wouldn’t get so big that they pose "systemic risk."

If you look back at the TARP, Bear Stearns, Fannie Mae, and Freddie Mac, you begin to see the same culprit at the scene of every crime. It’s the Federal Reserve Bank of the United States. The only way to create a stable financial system is to force banks, investors, and creditors to bear their own risk. The only way to make them bear their own risk is to end bailouts once and for all. And the only way to end bailouts once and for all may be to dissolve — or at least permanently weaken — the Fed.

You can think of paper money originally evolving as a warehouse receipt at a gold storage facility. In other words, wealthy people probably wouldn’t want to keep gold lying around their houses, and so gold-storage vaults came to be demanded. Since gold is a commodity, and Mr. Smith’s one hundred-oz bar is identical in value to Mr. Jones’s one hundred-oz bar, the gold vault doesn’t need to put Mr. Smith’s name on his gold bar. Instead, the vault — or bank — gives him a certified receipt for 100 ounces of gold. Any time he wants, Mr. Smith can go to the bank, hand in his receipt, and pick up his gold. Maybe he only wants a bit of his gold, so he walks in with a 100-oz certificate, and walks out with 10 ounces of gold and a certificate for 90 ounces. Alternatively, he can give his gold certificates to the tailor in exchange for a new suit, and the tailor can go get some gold, or he can use it to buy something else. Soon, the banks start issuing standard smaller-denomination notes (put in 100 ounces, and get ten 10-oz gold notes). Now these warehouse receipts — or bank notes — have become a money substitute, called "currency". However, currency must not be confused with money itself. The introduction of money substitutes represented another advance in money. Paper money, backed by gold or any other commodity, is much more convenient. Paper money is much lighter, and uniform, convenient denominations are much easier to divide. But with the added convenience comes new opportunities for fraud. When people begin getting used to paper money, they can easily confuse it with a store of wealth in itself. At that point, governments can get away with removing any backing from the currency, and can print as much as it wants. It’s called fiat currency, and it gives government unlimited power to pilfer. It’s a total fraud. The ultimate destroyer of the U.S. dollar was the Federal Reserve System, which was supposed to be the guardian of the currency. The original idea of the Fed was a good one: providing a uniform currency backed by gold. But once again, government officials, given the power to manipulate money, couldn’t resist it. They cheapened the dollar badly. Within a few years of the Fed’s birth, it began injecting fiat money into the economy. Woodrow Wilson increased the monetary supply to help pay for World War I, and soon afterward, the Fed inflated again, in an effort to help Europe’s recovery. The 1920s inflation (which pumped up the real estate and Stock Market bubbles that sparked the Great Depression) was fueled by "credit reserves." In other words, the Fed loaned out money backed by absolutely nothing — it was money created out of thin air. After decades of doing this sort of thing, the U.S. government eventually went all-in: President Richard Nixon on August 15, 1971, unilaterally abolished the gold standard. He declared that the Fed would no longer redeem dollars with gold. Officially, now, the dollar was backed by nothing. It’s important to repeat the real way in which the Fed makes money. Big U.S. banks all keep their money at the various Federal Reserve Banks — they are the banks’ banks. So, Bank of America, Chase, Citibank, and so on all have accounts at the Fed. If the Fed wants to buy something from Bank of America — say a U.S. Treasury, or somemortgage-backed securities — the Fed simply credits B of A with the new money. This doesn’t lower the amount of money the Fed has. New dollars have simply come into existence. The Fed isn’t spending money. It’s creating money. Under this system, the dollar is now worth only whatever the dollar will buy. Whereas paper currency backed by gold or some other commodity always had an intrinsic value, the only value the U.S. dollar has is whatever value others attach to the U.S. dollar at a particular moment in time. And there is no fixed supply of dollars, meaning the supply is whatever government says it is. This is called fiat money.

The Fed shouldn’t be allowed to create money out of thin air. We need to return to the gold standard. Every dollar the Fed issues should be backed by a fixed amount of gold. Everyone holding a dollar should be able to redeem it for gold on demand. And the Fed should be barred from issuing "credit reserves" — or money backed by nothing. In other words, we need to restore the original Federal Reserve Act as it existed prior to 1917.

America’s solvency is built on the shaky foundation of low short-term interest rates. The only way we can pretend to pay our bills is by borrowing the money required to do so at near-zero percent interest rates. I say pretend, because if you have to borrow money to repay your debts, you aren’t repaying anything. However, the pretense can only be maintained so long as rates remain low and our creditors cooperative. As previously discussed, I believe that the U.S. Treasury is running a giant Ponzi scheme. The national debt always goes up. Even during the Clinton years when the budget was supposed to be in surplus the national debt rose every year. When a Treasury Bond matures, the government sells another one to pay it off. When an interest payment comes due the government borrows the money required to pay it. This is precisely the same way that Bernie Madoff ran his investment business. It "worked" great for a while, until too many people wanted their money back.

What happens when America’s creditors want their money back? For now the U.S. is able to finance its deficits largely by selling T-bills. It does this because T-bill rates are much lower than T-bond rates. This helps make our current deficits smaller. The risk is that when rates eventually rise, future deficits are much larger. Politicians, however, are doing what is politically expedient rather than what is financially sound. This is the same mistake homeowners made with adjustable rate mortgages. They traded lower initial payments for higher future payments. The problem was that once those higher payments kicked in many borrowers could not afford to make them. The predictable result was default. As the dollar falls, eventually even the CPI-measured inflation rate will rise to unacceptable levels. Then our creditors will no longer be willing to lend us money at such low rates. When that happens it’s not just interest payments that will be due, but principal payments as well. For example, given the short maturity of our debt, it’s very possible that in any given year, over $5 trillion in debts will mature. Since that is more than twice annual tax receipts, where will the money come from to pay it? The answer generally given is that we will not have to pay it, as we will simply borrow the money. But what if we can’t? What if our creditors do not want to roll over low-yielding debt in a high inflationary environment? This book is called The Real Crash for a reason. This is the reason. The idea that America can borrow forever, without ever having to pay any of the money back, is absurd. Inherent in that assumption is that the rest of the world is willing to lend without ever getting its money back.

For years before the Greek debt crisis erupted, the Greeks enjoyed record low-interest rates. As such they were able to feign solvency just as America does now. Servicing the debt was no problem as long as rates remained rock bottom. But rock bottom rates rested on the false premise that the Greeks were actually good for the money. Low rates in America rest on the same false paradigm. Once this premise was challenged the Greek house of cards collapsed. Greece could not roll over maturing debt at the same low rates, and it lacked the revenue to pay higher rates. As this became apparent the process fed on itself, and a crisis quickly emerged. The main difference between Greece and America is that Greece cannot print euros. However, the fact that the Fed can print dollars will be of little consolation to our creditors. It may provide a certain degree of comfort now, but that will change once the pain of dollar depreciation sets in.

There is simply no way American taxpayers can repay the money the federal government has borrowed. That means our creditors are going to take huge losses. There are really only two questions left unanswered. The first is what form those losses will take. Either our creditors will not get all of their money back, or the money they get back will buy much less than they expect. So either we default, or we allow inflation, but honest repayment isn’t an option. Given a choice between the two, default is by far the better choice, even for our creditors. The second question is one of timing. Will we default to avoid a crisis or in reaction to one? Will we default on our own terms or on those imposed upon us by our creditors? I would argue that the sooner we default the better, and that the terms will be more favorable when we are the ones proposing them.