This is a strange and beautiful crisis. For the last century, at times of change and instability, nervous investors have traditionally piled their money in two directions, into Treasury Bonds, and into cash. This time, the fortifications underlying the entire financial system are straining beneath the weight of change, the weight of American and European debt, and the rise of China, Brazil, India and Russia. From The Economist’s resident cartoonist, KAL:


And the most common response to these wild and whirling winds of change — as I expected, and totally paradoxically — is money flowing into the asset class that has just been downgraded, the US Treasury, slashing yields by half a percent. Why? Because it is the most widely traded and the most liquid asset in the world. Put money in Treasuries — goes the common logic — and you will get your money back. The United States Treasury cannot, will not default. Why? The answer has been spoken explicitly in the past few days, most prominently by former Federal Reserve Chairman Alan Greenspan:

The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default

Sadly, Chairman Greenspan is shamefully wrong. The United States is defaulting. Printing money is default by debasement, and investors — in both cash and Treasuries — are having their wealth inflated away. How does default-by-debasement gnaw away at wealth? The answer is through the phenomenon of negative real interest rates. If interest rates become negative, holding onto cash means purchasing power falls. From Wikipedia:

Real Interest Rate = Nominal Interest Rate − Expected Inflation

So are interest rates really negative? It depends how we measure inflation. A huge aspect of my economic case is that — really — there is no such thing as a uniform inflation (or uniform inflation expectations), because there are different rates for different people, different communities and different strata of society. For welfare-recipients on a fixed income, food and fuel make up a much higher proportion of their income, leading to a much higher inflationary rate. For large corporations importing vast quantities of goods from China, inflation is undoubtedly lower. But no matter who you are, the rate of inflation is high enough to yield a negative real rate on cash.  On Treasuries, this is not necessarily true. But real rates on Treasuries are undoubtedly close to zero, if they are not negative.

Of course, that is the point of the zero interest rate policy: it is designed to spur holders of cash and Treasuries out of merely holding onto wealth, and instead into more productive ventures. The ostensible goal of the Federal Reserve’s policy, at this stage is to gradually increase productivity, output and unemployment and kick the can down the road for long enough to be able to get the burden under control. This is why Bernanke has called for further fiscal stimulus. The problem is that the “can” is now a giant wall of interconnected, ever-growing debt, and every “kick” of monetary easing, and of fiscal stimulus is having less and less effect. In this environment, cash and Treasuries cannot be king, because cash and Treasuries are being deliberately throttled (even as the market deludes itself by pushing them to ever-greater heights).

What is king? It is a strange paradox, and transformation. Investors seeking security in dollars and Treasuries will be sorely disappointed, and gradually investors will start to seek alternatives. Ultimately, the UN and G20 may step in to create a new and truly international reserve currency, which may or may not be successful. But, until then — as the credibility of all governments stumbles — only currencies backed by things other than government will strengthen. Gold, silver, oil, food, energy and water.