While many economists and market watchers have failed to notice, we have entered a new chapter in the short and checkered history of central banking. This paradigm shift, as yet unaddressed in the textbooks, changes the basic policy tools that have traditionally defined the sphere of macroeconomic decision-making.

The job of a central banker is supposed to be the calibration of interest rates to achieve the optimal rate of growth for any particular economic environment. It is hoped that successful decisions, which involve perfectly timed moves to raise rates when the economy overheats and lower them when it cools, would bring consistency and stability to the business cycle that many fear would be dangerously erratic if left unmanaged. That’s the theory. The practice is quite different.

Over the past thirty years or so, interest rates have been lowered far more often than they have been raised. This makes sense. Bankers, being human, would rather err on the side of good times not bad. They would rather leave the punch bowl out there a little too long than take it away too soon. Over time, this creates a huge downward bias. But things have really become distorted over the past eight years, a time period during which interest rates have never gone up. They just go down and stay down.

Back in the early years of the last decade, Alan Greenspan ventured into almost unknown territory when he lowered interest rates to 1% and left them there for more than a year. But in today’s terms, those moves look hawkish. In the wake of the 2008 financial crisis, Ben Bernanke brought interest rates to zero, where they have remained ever since.

But old habits die hard, and economists still expect that rates can and will go back to normal. They assume that since the economy is now apparently on solid footing, the period of ample accommodation is over. In reality, we have built an economy that is now so leveraged that it needs zero percent interest rates just to tread water.

Based on statistics from the Bureau of Economic Analysis, from 1955 to 2007 Fed Funds rates were on average 230 basis points higher than average GDP growth (5.7% vs. 3.4%). But from 2008-2013, Fed Funds rates have been less than half the rate of GDP growth (0.44% vs. .92%). Rates lower than GDP, in theory, should stimulate the economy. But instead we are stuck in the mud.

Twenty-odd years ago the textbooks still seemed to work. A recession hit in 1991, which brought GDP close to zero. In response, the Fed cut rates by more than 200 basis points (from 5.7% in 1991 to 3.5% in 1992.) As expected, 1992 GDP rebounded to a reasonably healthy 3.6%. But the rate cuts did little for asset prices. In that year the S&P 500 crept up just 4.4% and the Case-Shiller 10-City Composite Index of home prices actually fell almost 2% nationally.

Compare that to 2013. With Fed Funds still near zero, GDP actually fell to 2.2% from 2.3% in 2012. But asset prices were a different story. Stocks were up 26% and real estate up 13.5%. It would appear that interest rates have lost their power to move GDP and can now only exert pressure on asset prices. As a result, rates are no longer the main attraction in central banking. The real action takes place elsewhere.

The Fed and other central banks have made the active purchase of financial assets, known as quantitative easing, to be there main policy tool. QE is a more powerful drug than interest rates. It involves actual market manipulation by the purchases of bonds on the open market. Whereas zero interest rates could be compared to a general stimulant, QE is a direct shot of adrenaline to the heart. When the next recession comes, the syringe will likely come into greater use.

Since 1945 the U.S. economy has dipped into recession 11 times. The average length of the recoveries between those recessions was 58.4 months, or just under five years. The current “recovery” is already 73 months old, or 15 months longer than the average. How will the Fed deal with another contraction (which seems likely to begin within the next year or two) with rates still at or very close to zero? QE appears to be the only option.

Given that reality, the big question is no longer whether the Fed will raise or lower rates, but by how much they will ramp up or taper off QE. When the economy contracts, QE purchases will increase, and when the economy improves, QE will be tapered, and may even approach zero for a time. But interest rates will always remain at zero or, at the least, stay far below the rate of inflation. This will continue until QE loses its potency as well.

Mainstream economists will be quick to dismiss this theory, as they will say that policy is now on course for normalization. Although economic growth in 2013 was nothing to write home about, the set of indicators that are normally followed by most economists, point to a modest recovery, exuberant financial markets, and falling unemployment. But if that is the case, why has the Fed waited so long to tighten?

The truth is the Fed knows the economy needs zero percent rates to stay afloat, which is why they have yet to pull the trigger. The last serious Fed campaign to raise interest rates led to the bursting of the housing bubble in 2006 and the financial crisis that followed in 2008. This occurred despite the slow and predictable manner in which the rates were raised, by 25 basis points every six weeks for two years (a kind of reverse tapering). At the time, Greenspan knew that the housing market and the economy had become dependent on low interest rates, and he did not want to deliver a shock to fragile markets with an abrupt normalization. But his measured and gradual approach only added more air to the real estate bubble, producing an even greater crisis than what might have occurred had he tightened more quickly.

The Fed is making an even graver mistake now if it thinks the economy can handle a measured reduction in QE. Similar to Greenspan, Bernanke understood that asset prices and the economy had become dependent on QE, and he hoped that by slowly tapering QE the economy and the markets could withstand the transition. But I believe these bets will lose just as big as Greenspan’s. The end of QE will prick the current bubbles in stocks, real estate, and bonds, just as higher rates pricked the housing bubble in 2006. And as was the case with the measured rate hikes, the tapering process will only add to the severity of the inevitable bust.

So while the market talks the talk on raising rates, the Fed will continue to walk the walk of zero percent interest rates. The action has switched to the next round of QE. In fact, since none of the Fed’s prior QE programs were followed by rate hikes but by more QE, why should this time be any different? The most likely difference will be that eventually a larger dose of QE will fail to deliver its desired effect. When that happens, who knows what these geniuses will think of next. But whatever it is, rest assured, it won’t be good.

Best Selling author Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital. His podcasts are available on The Peter Schiff Channel on Youtube

Catch Peter’s latest thoughts on the U.S. and International markets in the Euro Pacific Capital Summer 2014 Global Investor Newsletter!

Are Government Bonds Really ‘Safe’?

One of the striking ironies of our modern economy is that government bonds are considered safe-haven investments, while gold is a “barbarous relic” to be avoided at all costs. Since the 2008 financial collapse, the bond market has been on a tear, thanks to the Federal Reserve’s endless interest rate suppression. This has only served to reinforce the traditional notion that government bonds are “safe.”

Meanwhile, the financial media argues that gold is no longer relevant to today’s investors. They conveniently ignore the fact that gold has been a safe-haven for thousands of years, while government paper has only been around for a handful of decades.

However, government bonds fall short of traditional investment goals. A look at the history of government-issued bonds in the 20th century reveals terrible performance. Applying this historical knowledge to our current economic climate, and bonds don’t stand a chance when compared to time-tested gold bullion.

Government Bonds – An Abysmal Track Record

When making any sort of investment – whether in government bonds, real estate, or gold – a prudent investor aims to not only earn interest on the principal, but also to get the entire principal back. This is Investing 101. In fact, with safe-haven investments, capital preservation is the primary objective and any additional gain is just gravy. So an obvious way to judge the effectiveness of a supposed safe-haven asset would be to look at how well it preserved capital investment in its past.

When it comes to paying back the principal on its debt, governments have an ugly – and lengthy – history. Today I will highlight just that period in history that most closely resembles our current “Great Recession” – the Great Depression following World War I.

The League of Nations – the precursor to our modern United Nations – issued a report showing 62 sovereign states had been loaned a total of $149 billion by 1936. By the end of that year, 27 of the 62 governments were in default on both the interest and the principal on those loans. That is a failure rate of over 40%.

If you look at loans that just the United States made to other nations, the default rate gets worse. Of 40 sovereign states that the American government issued loans to following the First World War, 23 defaulted on their debt obligations. That is nearly a 60% failure rate! Had you been alive then, your chances of seeing any of your principal back on government debt were worse than a coin flip. I wonder what category that falls into over at Moody’s or Standard & Poor’s?

The most notable country at the time to default on its obligations was Great Britain. Its currency, the pound sterling, was the world’s reserve currency. Great Britain’s inability to pay its debts in full after World War I was a precursor to the pound losing its privileged role.

To be fair, governments have a near flawless record when it comes to paying the interest on their debt. But this returns us to the primary notion of using safe-havens for capital preservation. Who in their right mind would lend money to someone who only agrees to pay back a fraction of the principal? That’s not lending, that’s charity.

Are We Any Safer Today?

Snap back to today. The US government has borrowed more than it ever has before, with more than $17 trillion in debt. Consequently, the Federal Reserve’s balance sheet has ballooned to the unprecedented figure of nearly $4.5 trillion. About $2.5 trillion of that is in government Treasury notes, while $1.7 trillion is in mortgage-backed securities.

This represents a huge systemic risk to the liquidity of the entire financial system. The government lacks both the resources and the will to pay back this debt. As we’ve just seen, history shows this lack of will to be the norm, not the exception. This proves true even if your currency is the world’s reserve currency, as was the case with Great Britain.

The United States’ current position is not so dissimilar. Just as Great Britain entered World War II in a vulnerable economic condition, so is the US gearing up for yet another costly offensive (they don’t use the word war anymore) in Iraq. WWII put the final nail in the coffin of the British pound, and perhaps the US government’s military adventurism in the Middle East will do the same for the dollar.

The numbers don’t lie and the conclusions are obvious. When it comes to actually receiving the full principal of one’s loan, government debt is one of the most speculative investments an individual can make.

Welcome to the Monetary Madhouse

Today we live in the monetary madhouse erected by our central banks. Distortion and irregularity prevail, not clarity and stability. Instead of private investors looking for win-win profit opportunities in a free market for money and credit, we have central banks using “forward guidance” to dictate where capital should flow. Today’s bond market and the giant balance sheet of the Fed are a direct result of their intervention.

Nearly all government bonds are bought based on rate speculation and rarely held to maturity. What does that mean? These bonds are traded without a care given to whether or not they will see a dime paid back in principal. The bond market relies almost entirely upon making money based upon changes in the interest rate.

Let that sink in for a minute.

In any other market, the lender is highly concerned with whether or not the interest and the principal will be remunerated in full. The lender would not part with his funds if repayment of the principal were not guaranteed.

This is not the case with government. The government can borrow like no other. It maintains the illusion of solvency by only paying the interest on its debt and rolling over old debt obligations by issuing new debt as a replacement. This means the merry-go-round of debt keeps on spinning but nothing ever gets paid. This is more than enough to make any credit manager’s head spin.

Government debt is simply not a safe play in today’s markets. It’s either speculative or it’s suicidal. On the other hand, there is no speculation about gold. The yellow metal’s value has remained relatively stable for thousands of years without a government’s promise. Gold is no “barbarous relic” – it’s our financial salvation.

About Dickson Buchanan

Dickson Buchanan is Director of International Development and a Precious Metals Specialist at Euro Pacific Precious Metals. He received his MA in Austrian Economics from King Juan Carlos University in Madrid, Spain, and is currently enrolled in the doctorate program. Dickson joined the Euro Pacific Precious Metals team in 2012 after returning from his economic studies abroad. This article first appeared on Peter Schiff’s Gold Blog on September 17, 2014. To learn more about Peter Schiff’s gold & silver dealer, visitwww.europacmetals.com.