Government debt paper is debt paper. Money — gold — is money.

By now, everyone knows that S&P downgraded the debt of the USA from their top rating, AAA, to their second-highest grade, AA+. Most of the commentary has been of the pin-the-blame-on-the-donkey variety. For all most people know, this is the collapse of the currency and the financial system and their biggest concern is that Obama may not win the 2012 election. If this were truly the collapse, I submit for your consideration that we will all have bigger things to worry about!

So, I thought I would look at this from a different angle. My conclusion is simple. On the one hand, there is no question that the US dollar will collapse. This is not only inherent in any irredeemable paper money, but also the inevitable result of any government and financial system that runs perpetual and accelerating deficits. But this is not what S&P is considering! If it were, they would re-rate all dollar-denominated debt at their lowest level. They would then look at the dollar derivative currencies (e.g. eur, gbp, yen, etc.) and realize that a derivative cannot survive the destruction of the underlying currency. So they would do the same to the sovereign debt of the issuers and all debt denominated in those currencies. Then they would lay off their staff, awaiting the return of gold-denominated bonds.

Dollar collapse aside, consider that in 1913, when Wilson created the Federal Reserve, a dollar was worth roughly 1/20 ounce of gold. In 1933, Roosevelt devalued the dollar to 1/35 of an ounce. In the 1960s, the US government was obliged to give up more and more of their gold hoard to “defend” this level, because by then the real value of the dollar had fallen well below 1/35 ounce. We can’t know how much it had fallen because the government interfered with the process of price discovery.

After Nixon officially defaulted on the gold obligations, the dollar’s collapse accelerated. By 1981, the dollar was worth 1/600 ounce (ignoring the spike into what turned out to be a mania). Today, the dollar is worth less than 1/1700 ounce of gold.

I am not aware of anyone who thinks that the government will get the dollar’s fall under control. Any Keynesian or Monetarist will even tell you that it’s good for the dollar to fall. And we Austrians are saying that not only is it bad, but it’s happening and it’s accelerating.

If the S&P rating was intended to account for the value of the currency that the debtor uses to repay its bonds, then how could S&P give the USA an investment-grade at any time under any circumstances? If the dollar is losing 5 to 15% of its value per year, this represents a significant default over the duration of a 10-year bond!

And, for that matter, the same dilemma would apply to corporate bonds, municipal bonds, etc. Obviously S&P does not look at the dollar, and its constant propensity to fall, as part of its rating process.

To summarize my points so far, the dollar has been steadily eroding for 100 years, and this is a trend that those in charge defend as being good and necessary. And the dollar will collapse under the weight of unpayable debts. This is the fatal flaw of an irredeemable debt-based currency, and the end is in sight if not imminent (see Permanent Gold Backwardation: Why a “Crack Up Boom” Is Inevitable).

In this light, the S&P downgrade is meaningless.

On the other hand, in the world of the irredeemable currency, what does it mean for a bond to be paid back? It means that the debt is transferred from one party to another party. If a corporate bond is repaid, the corporation redeems it using dollars (i.e. Federal Reserve Notes). Dollars are the liability of the Fed. The debt is simply transferred. First, the corporation owes you. Then the Fed owes you.

This is an insane system, but at least there is an arms-length transaction between unrelated parties. It is possible to discuss default, attempt to qualify (if not quantify) the risks of default, etc. Default or non-default: these are the only two possible outcomes for the bond at maturity. One of them will occur, and which one occurs is of utmost importance to the bond buyer. The goal of the ratings agency (assuming repeal of the 1970’s era law making them work for the bond issuer) is to assess the risks of a bond being paid or not.

However, Treasury bonds are payable in Federal Reserve Notes which are backed by … Treasury bonds. It’s circular, it’s a check-kiting scheme, and it’s a Ponzi scheme.

There is no risk that there won’t be Federal Reserve Notes to pay the bond holder. Both the bonds and the notes that are used to pay them off are inextricably tied! The point I am making here is that the very concept of “rating” such bonds is meaningless. There is no objective (or otherwise) standard of measure to use in rating them.

It would be like asking how much gold is an ounce of gold worth? How many dollars is a $100 bond worth? These are tautologies.

This is just one of the perverse “unintended” consequences of trying to use irredeemable paper currency. Government debt paper is debt paper. Money (gold) is money. The two are the same, like oil and water are the same.

The world needs to return to a proper, unadulterated gold standard including bonds redeemable in gold. And this must include repealing the laws that grant a cartel to the three ratings agencies (S&P, Moodys, and Fitch), so investors can hire any firm to help them with due diligence on the bonds they buy.

The dollar valued in terms of gold:

Behind this pithy graphic is a serious issue. How do we measure value?

The paper currencies are (at best) elastic. Using a dollar to measure value is like using a rubber band to measure length.

Most people accept the Monetarist notion of using consumer prices to deflate the dollar. But consumer prices are subject to myriad and diverse forces (e.g. ever-improving efficiency; fewer labor hours and less land are needed to produce a ton of wheat today than in 1911).

Using consumer prices to “adjust” the price of gold would be like lining up a bunch of gummy bears next to the reference meter rod (under glass in Paris, it’s made of a platinum-irridium alloy). Be careful to estimate the fraction of a bear at the end.

Gold is the objective measure of value. This is because its stocks to flows (ratio of inventories to annual mine production) is higher than any other commodity by far. Despite ever-growing inventories throughout the ages, its value held up.

This is true for the dollar also: its value should be measured in gold. 100 years ago, the dollar was worth 1/20 ounce. Today, it is worth about 1/1800 ounce.

This graph is for all of those calling a “top” in the gold “bubble”.

The dollar hasta bounce. Gotta. Inevitable. Right?

For months, even before the end of QE2, analysts and prognosticators have been saying the Fed will have to do another QE and another, endlessly. These folks were surprised when it didn’t come last month, and predicted confidently that it would come this month especially because Bernanke extended the September meeting to two days. I said then, and I still believe it, that QE3 will come, but not as quickly as most people think (or hope).

So today, the Fed gave us, in addition to their normal pap about “downside risks” and “exceptionally low rates” forever, two new policies: (1) they will sell $400B worth of Treasurys of 3 years or shorter maturity, and buy $400B worth of Treasurys with 6 to 30 year maturity; and (2) the Fed will reinvest the proceeds when mortgages it owns are paid.

The markets became very volatile after the announcement. When the dust settled, we had S&P down 3%, every currency, including the yen, down substantially on the day (much less from the day’s highs around 3:30 p.m. EDT), copper down hard, crude, and even gold and silver down, down, and down. Copper and the precious metals continue to sink as I write this.

Obviously, the Fed’s decision disappointed and underwhelmed market participants. It has become a cliché to say that there is a “Bernanke Put”, i.e. he won’t let stocks fall. One commenter said that today’s decision moved the Put farther out of the money.

I don’t think that the Fed cares about the stock market, in particular. I think it cares about its member banks interests, in this case their balance sheets.

The Fed might care about the stock market if it is a means to its ends, as in the following chain. If stock prices rise, then investors feel wealthier. If they feel wealthier, then they buy homes and invest in businesses and commercial real estate. If they buy and invest, this firms up asset prices. These are the assets on bank balance sheets, so firming up the prices will bolsters said balance sheets.

So today the Fed threw the stock market under the bus, or at least allowed it to go under the bus. Let’s look at what the Fed did in lieu of more outright printing.

The simpler of the two policies is: the Fed will reinvest the money it gets from mortgages that are paid or prepaid. This is nothing more than the Fed saying they will continue to hold their balance sheet at its current size. They do not want to withdraw liquidity. One theory says this paves the way for Treasury to announce a giant refinance for everyone. We shall see.

“Operation Twist” as the financial blogosphere has been calling it is simple in its mechanics. Sell short duration, and buy long duration, Treasurys. I don’t believe they will sell anything. They surely do not want the interest rate on the short end of the yield curve to rise, much less for the yield curve to invert. But perhaps demand is so strong that they haven’t had to manipulate short end anyways for months? I don’t know and they aren’t saying.

By plowing money into the 6-30 year maturities, they will push up bond prices there. Since the interest rate and the bond price are a see-saw, mathematically and rigidly related, this will push down the rate of interest on 6+ year bonds. The Fed thinks that this will spur more borrowing and lending. The theory is that with lower rates, businesses will make a case to borrow for new projects– however, they have many reasons not to. And, investors will be forced to take more risk to earn a decent yield. Maybe, but I remain doubtful.

It will, however, have other consequences. Such as the following:

1. The spreads between municipal or corporate bonds to Treasurys will widen. Yields on munis/corps will go down , but not as much as Treasurys (there isn’t a growing risk of sovereign defaults as with munis).
2. Bond speculators (is there any such thing as a genuine saver who has been buying 30-year bonds to hold for three decade?) will be rewarded with capital gains.
3. The capital that goes to bond speculators comes out of the capital accounts of the bond issuers. It’s a zero-sum game. When interest rates rise, bond speculators lose and bond issuers gain. When rates fall, the opposite.
4. One of the banks’ (illicit) source of risk-free profits is reduced. Yield curve arbitrage, borrowing short to lend long, will become less profitable.
5. Where bond issuers have access to the markets to “roll” their liabilities, the new payments will be lower. In theory this would allow them to borrow more (which is what the Fed intends). In practice, we shall see. Certainly governments will borrow more, as there is little or no personal downside to the politicians who make such decisions.
6. Any borrowing that only makes sense because the interest rate was further reduced is, almost by definition, malinvestment. Such borrowings will not be paid back. Car buyers would do well to consider the total cost of ownership over the life of that 84-month 15% interest loan with the balloon at the end and “affordable” payments. The same is true with government and corporate borrowers: there are other considerations than monthly payment.
7. Assuming any business does borrow at the new, lower rate, it will have a permanent competitive advantage over its competitors who borrowed at the old, higher rate. The new borrower will either be able to produce the same good at lower cost (due to lower debt service) or be able to attract customers to the new restaurant, hotel, resort, cruise ship, shopping mall, etc. Customers love higher ceilings, lavish landscaping, opulent gilding dripping from the marble columns, etc.
8. Thus capital destruction will continue and accelerate.
9. The process of halving of interest rates will continue. It is just as damaging to go from 1.5% to 0.75% as it was to go from 12% to 6%.
10. Debt accumulation will continue.
11. All, of course, until it cannot continue.