Tipping Over Into A Deflationary Blackhole

In my six year search for an explanation of the troubles facing the economic system I have just come across what may be the most important essay in understanding our deflationary destiny.

Some of the most relevant excerpts are included below.

Keep in mind that this was written over 10 years ago; before 9-11, before the housing bubble, and before the "war on terror".  It is proving to be prophetic.

by Antal E. Fekete - Professor Fekete.com
Originally published December 07th, 2001

Economists and the financial press have failed to sound the alarm as a - so far unprecedented - curse hit the world: the rate of interest in Japan started plunging to zero. While the public is kept in the dark, authorities are trying desperate measures, including the encouragement of and subsidy to the yen-carry trade, in the hope to relieve the downward pressure on the rate of interest in Japan through the sale of Japanese bonds - to no avail. The yen carry-trade is the very mechanism whereby the deflationary tumor metastasises across the Pacific. What it does is merely to shift the downward pressure on the rate of interest from Japan to the United States. From this vantage point, the gold-carry trade is also highly deflationary as it also contributes to the downward pressure. The world has been hit by the greatest deflationary iceberg in economic history, and the captains of the international monetary system are busy rearranging the deck-chairs, telling passengers that the boat is unsinkable.
A reliable indicator of deflation is the rate of interest falling towards zero. It can be compared to a blackhole the attraction of which is hard to escape and from where (just as from Hades) no one has ever returned. Why is a zero-bound rate of interest such an unmitigated disaster? Because, as we shall see, it makes the (present value of) debt go to infinity - just like gravitation becomes infinitely large inside of a blackhole of the physical universe.

There are, in fact, two blackholes in the economic universe: blackhole #1 is the infinite-interest blackhole (runaway inflation), and blackhole #2 is the zero-interest blackhole (runaway deflation). When gold was put beyond the pale just 25 years ago in 1976, little did the world realize that it was firing the policeman in charge of cordoning off blackholes. By 1980 the world had a close brush with runaway inflation as the dollar was tottering at the brink of one of the blackholes. Many ad hoc explanations were concocted, from the machinations of the gnomes of Z├╝rich to the malice of Arab sheiks. Nobody raised the question whether the firing of the policeman may have had something to do with the disaster. The scare passed when the Soviet Union showed signs of disintegration and the successor states of the Evil Empire, like a dry sponge, started absorbing dollars with abandon. The people of these countries were lapping up dollars at the trough as if they were imbibing the elixir of life which had for so many years been denied to them. This meant a stay of execution for the dollar which appeared doomed only a few short years before. But neither the economists' profession, nor the top brass at the Fed was interested in taking advantage of the remission to initiate an inquiry into the wisdom of having put into abeyance the monetary clauses of the United States Constitution half a century earlier. Instead, they joined the enthusiastic crowd at the Currency Circus watching with fascination Clown #1, the dollar doing fancy footwork dancing away from blackhole #1, while neglecting to pay attention to Clown #2, the yen waltzing around blackhole #2.
Of course, the rate of interest can never be exactly zero. Likewise, it can never be infinity either. We are in the habit of rounding figures. But just as we never round to infinity, we should never round to zero either. For example, if the rate of interest is 0.01%, one must not round it to zero. It could get halved a dozen times or even a hundred times, and will still not be exactly zero. Yet each halving would mean that the debt burden got doubled, causing ever more bankruptcies and punching ever greater holes in the balance sheets of banks.

The see-saw of interest rates and bond prices
The fact that the yield and the price of a bond are in inverse relation is well-known to security analysts, although it is often puzzling to laymen. Even professionals may occasionally think that it is merely a statistical law. Well, it is not: it is a mathematical law that does not bear exceptions. A related common mistake is to think that the see-saw of the rate of interest and the bond price is limited by the face value of the bond, which cannot be exceeded by market value no matter how far the rate of interest falls. The fact is that the face value of a bond does by no means or manner limit its market value. Any given value, however high, is theoretically possible, provided that the rate of interest is low and maturity is far enough. The mathematical apparatus to prove this is given in the Excursus. The mathematics becomes quite simple for perpetual bonds (consols in British parlance). A perpetual bond with face value A has no maturity, but it pays interest in perpetuity at a fixed rate a. If the market rate of interest isb, and the market value of the perpetual bond is B, then the mathematical relationship between the variables b and B is given by the attractive formula:
Aa = Bb = constant

For example, if the rate of interest b gets halved, then the market value of the bond B must double (and conversely). Moreover, if b plunges to zero, then Btends to infinity. While there are no perpetual bonds around any more, the formula is still relevant, because it provides a reasonable approximation for the relation between the market value of long-term bonds and the rate of interest. Furthermore, the longer the term the better the approximation (for a 30-year bond the error in percentage terms would still be single-digit).
Wrong way to report debt
Another reason why the formula Aa = Bb is relevant is the fact that it can be used to calculate the present value B of the total debt A in a country as a function of the rate of interest b (a > 0 is immaterial.) In this case it has the force of an exact formula rather than an approximation, because the existing debt of virtually every country today may be assumed to be perpetual debt. By no rational calculus can it be expected that it will be retired through the normal process of repayment (that is to say, without wiping it out either through default of through currency depreciation). We may verbalize our formula as follows:Every time the rate of interest in a country is cut into half, the (present value of the) total debt in that country doubles. In particular, as the rate of interest is plunging to zero, the (present value of the) total debt is galloping to infinity.

What makes people walk away from their dream-home?
Most of us have never had the opportunity to serve as the CEO of an enterprise and have little appreciation of business problems connected with falling interest rates. For those who had to face the problems connected with the financing of the family home the following example may be more meaningful in showing how deflation can make innocent people suffer.
You bought the house of your dreams, putting down 50% of the purchase price, your entire life-savings, which is now your equity, financing the other 50% with a conventional mortgage at 6% interest. Now deflation comes and the same mortgage is offered at 3%, half of what you have to pay. The bank refuses to renegotiate the mortgage as it is flooded with similar requests. You shrug and say: "So what? I like my home and stay put. I don't care that my equity has been wiped out. Those are just numbers."
Brave talk! But now you see "house for sale" signs cropping up around you and hear talk that houses don't move even at half of the appraised value. The situation is now this: you carry twice the debt on a house the market says is worth only half of what you have paid for it. For a moment you think that you want to walk away from your dream home, because it makes no economic sense to pay that much per month for shelter when you could rent a nice apartment for a fraction of debt servicing. But throwing away your life-savings is just too painful to contemplate.
However, you are a confirmed optimist and say: "Let's just tough it out and wait for the turnaround that the President says is just around the corner". Your house is now your coffin, and you are lying in it. They threaten to drive in the nails when your salary is unexpectedly reduced by half. Then you climb out of your coffin and, broken-hearted, walk away from your dream-home, because you prefer life to death.

Avalanche alert!
Deflation is a term loosely applied to the phenomenon of general money scarcity in the economy. Hardly ever is the question asked just what it is that makes money scarce. Here is the answer to that crucial question. Money is made scarce by bond speculation. The bond market acts like a gigantic vacuum cleaner running amok. It siphons money away from every nook and cranny of the economy. The money is channeled into bonds serving as chips in the hands of the speculator with which they make their bets.
A vicious circle is hereby set into motion. The scarcity of money calls for central bank intervention. The open market purchases of bonds by the central bank drive up bond prices making the profits of bond speculators soar. Thereupon bond speculators get bolder and start pyramiding, using easy money made available by the banking system, thanks to the intervention of the central bank. Money becomes scarce again, and the central bank is called upon to act once more. And so on it goes.
We use the term "bond market" and "bond speculation" in the broadest sense, as a generic term embracing not just bond trading and speculating in the narrow sense of the word, but also trading and speculating in derivatives based on bond and interest rate futures, options and swaps. Even gold leasing comes under this heading, as the short position in the gold market is offset with a long position in the bond market. It is an extremely dangerous development that the bond market in the broadest sense is snowballing exponentially, as new players jump on the bandwagon and the old ones pyramid. Even the blind can see the explosion of derivatives. It is an avalanche that will ultimately kill the innocent and unsuspecting people who live down there in the valley

My view:

Professor Fekete was visionary when he saw the dangers of ZIRP (zero interest rate policy) in Japan 10 years ago.

He saw the monetary infection of this Japanese policy spread to the United States years before Bernanke dropped rates to near zero.

He foresaw the collapse of the housing market with prices 50% off peak values.

He foresaw the rapid build up of government debt.

Now we see the desperation of the Japanese to keep their parasitic banking system afloat lead to global consequences we are still discovering.

Nearly every western democracies have ZIRP today as deflation tightens its grip around the throats of arrogant central bankers, politicians, and the ignorant public.

By choosing to borrow money (though the bond market) from future generations for present consumption in social programs, military excursions to far away lands, and 
unproductive building projects, we have created the most massive asset bubble in global history.

Once again it is helpful to reflect on Exter's Inverse Liquidity Pyramid:

At the bottom is the only substance known to man capable of extinguishing the raging fire of debt: