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Raising Interest Rates Could Cause ‘Wonderland Economy’ to Collapse

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Bank of England chief economist Andy Haldane dug through thousands of years of historical data and found interest rates now sit at the lowest levels in some 3,000 years.

short and long term interest rates

Wonkblog economic affairs reporter Matt O’Brien places the historic state of interest rates in vivid perspective in a Washington Post op-ed:

This is the best time to borrow money in recorded history…Now, it is true that rates almost got all the way down to zero during the Great Depression, but they have gotten all the way down there today. Indeed, interest rates are all-but-zero in the United States, the United Kingdom, the euro zone and, for the past 16 years now, Japan. Those are economies that, in nominal terms, make up more than half of the global economy.”

O’Brien goes on to provide some in-depth analysis of what got us here, focusing on the basic economic principles relating to the supply and demand for money. He pinpoints an “aging economy” that requires less investment, and explains how and why the demand for money has dropped worldwide:

When people get scared, say, when a housing crash almost brings down the entire financial system, they don’t want to borrow money or lend money or do anything else with it. They just want to hoard money. The problem, though, is that if nobody is spending, then the economy will shrink — which will only make people want to put their money in super-safe places, like government bonds, rather than taking any kind of risk. Interest rates, in other words, will fall even more.”

O’Brien goes on, arguing the fact that we essentially have a “global crisis” exacerbates and magnifies the problem.

Of course, O’Brien and other mainstream economics reporters view these low interest rates as a good thing – something to take advantage of. We can borrow and that means we can consume. As O’Brien puts it, “It turns out Polonius was wrong. You should be a borrower right now.”

But he leaves something extremely important out of his interest rate analysis focusing on the supply and demand of money. It all seems reasonable in a free-market for money. But this isn’t the world we live in. Central banks manipulate and control interest rates, and they have, in-fact, actively held them down at these artificial levels for years.

Why?

Because raising rates would likely prove absolutely disastrous. Casey Research analyzed the bond market and reported looming warning signs already evidenced by an increasing spread. In other words, investment-grade yields are rising, while Treasury yields are falling.

So what?

The Wall Street Journal explains the problem:

Wider spreads mean that investors want more yield relative to Treasurys to own bonds from U.S. companies. It can signal that investors are less confident about companies’ business prospects and financial health, though other factors likely also are at play…That would be the first time since the financial crisis in 2007 and 2008 that spreads widened in two consecutive years. The previous times were in 1997 and 1998, as a financial crisis roiled Asian countries, and a few years before the dot-com bubble burst…”

This is simply the bond market reacting to years of “easy money.” Casey Research calls this the “wonderland economy:”

Years of near-zero interest rates have warped prices of nearly everything. But the recent bond market action is a sign that ‘Wonderland’ is starting to crack.”

In his October Investment Outlook, founder of Pacific Investment Management Bill Gross said while creating this wonderland, zero percent rates have actually done more harm than good.

Low or zero interest rates it seems do wonders for asset prices and for a time even stabilize real economies, but they come with baggage and as zero or near zero becomes the expected norm, the luggage increasingly grows heavier.”

Note the key words: expected norm.

Central bankers have created an environment where they basically have to leave interest rates at these artificially low levels forever, or risk a major economic meltdown as the bubbles they’ve created burst.

In an interview on Fox Business last August, Former Federal Reserve Chairman Alan Greenspan sounded this very warning, noting interest rates have never been kept this low for this long, and that the policy is creating a huge bubble in bonds. While this could correct itself slowly, history demonstrates it will likely pop quickly, with devastating effects for financial markets.

Remember this: normal interest rates for reasonably good debt have always been in the 4-5% annual rate for millennia. We have data going back to ancient Greece, and interest rates were not all that significantly different then than now. And we have daily data going back to 1694 with the Bank of England.

“The reason this is the critical issue is it’s telling us the interest rates we’re looking at in history is almost certainly built into human time preference. It’s inbred. That means we’ve pressed the interest rates well below normal for a protracted period of time. The danger is they will begin to come up to where they’ve always been in millennia. [This is] not good [for the financial markets].”

All of this dovetails with what Peter Schiff has been saying all year. The Federal Reserve has painted itself into a corner. As much as it may want to, the Fed simply cannot raise interest rates.

Other recent economic news backs up Peter’s view, including a dismal jobs report on Friday, that he analyzed in depth.

Simply put, allowing interest rates to realign with historical levels would prove disastrous. For all the talk about the Fed beginning the process of bringing rates up, this is highly unlikely. In fact, as Peter has argued, we will more likely get another round of quantitative easing.

Historically, economic dynamics such as these bode well for gold. You can read more about future of the US economy and the gold market in Peter’s special report, Why Buy Gold Now? Download the free report HERE.

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