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The Credit Market Debt Bubble and the Role of Gold.

by strudy1

Historical data shows the economy has required increasing amounts of credit to produce a given amount of economic growth.

The chart below shows the total amount of credit market debt owed in the US. Total credit surged to a record high of US$54.6 trillion (in the first quarter of 2012), from close to zero when records began in the early 1950s. Initially credit growth remained subdued. But during the 1970s it picked up…and never looked back.

total credit market debt own

 

Source: Sound Money. Sound Investments.

 

I recently read The New Depression, the Breakdown of the Paper Money Economy by Richard Duncan.  What piqued my interest was Duncan’s analytical focus on the major role that credit plays in modern economies.

According to Duncan:

‘…on average from 1952 to 2007, inflation adjusted credit expanded by 5 percent a year while real GDP expanded by 3.3 percent a year. The ratio of GDP growth to credit growth was thus 66.4 percent over that period.

That ratio has been declining over time; more and more credit has been required to generate economic growth. Between 1981 and 2007, that ratio was 54.5 percent. And between 2001 and 2007, it was only 35.8 percent. This suggests there has been a diminishing return on credit. And, it suggests that a growing amount of credit has been misallocated.’

The other observation Duncan makes is that:

‘…there were only 12 years during which credit expanded by less than 2 percent, and in every instance except one, 1970, such weak credit growth was accompanied by a recession, either in the same year or in the following year.’

Please read that sentence again. It’s saying that historically, system credit growth of less than 2% almost guarantees a recession. Now consider the following stats.

In 2010, credit grew 0.4%…

In 2011, credit grew 1.6%…

Based on first quarter 2012 figures, credit grew 0.6%…

Yet the US has avoided recession since the downturn of 2008–09. In 2010, the economy grew 4.2%. In 2011, it was 3.9%. Annualising first quarter 2012 figures, the economy grew 2.3%. (These are nominal figures and therefore do not take inflation into account. All figures from the Fed’s Flow of Funds report.)

How Credit Market Growth is Creating a US Recession
 This relationship between credit growth and economic growth is unprecedented. I therefore think it is unlikely to last. The message is that a recession lies ahead for the US economy.

And that’s before we even take into account the ‘fiscal cliff’ the US economy is headed for. The fiscal cliff refers to legislated spending and tax cuts that are due to come into effect in 2013. These legislated fiscal changes will improve the government’s finances by around $560 billion.

If you’ve been paying attention, you’ll know the last thing the US economy needs is for government credit to contract at the same time as the private sector cuts back. If that happens, a very deep recession awaits.

I’m certain most people don’t realise the gravity of the situation, and I’mabsolutely certain the Congress, which has the power to change the legislation, doesn’t realise either. The ‘fiscal cliff’ issue is only likely to create more uncertainty and market volatility in the second half of 2012.

Here’s why…

If the tax hikes and spending cuts go ahead, the US falls into a deep recession. If Congress repeals them, the US will quickly come up against the debt ceiling, which currently stands at $16.4 trillion. Total US government debt outstanding is currently around $15.8 trillion.

This means there will be another congressional fight over raising the debt ceiling. After much debate, Congress will raise the ceiling — again — and then the ratings agencies will fall over themselves to reduce the government’s credit rating.

If the situation plays out this way, and I think it will, I’m tipping it will mark the peak in this long, 30-year+ bond bull market. A sharp sell-off need not ensue right away, but with the US government intent on prolonging a broken credit system by throwing more and more debt at it, supply will soon start overwhelming demand…and prices will fall (meaning yields will rise).

The Role of Gold
Where does gold come into play in all this?

Let’s go back to Richard’s Duncan’s book to provide some perspective:

‘The US credit market can be thought of as an inverted pyramid. Back in 1968, an edifice composed of $1.3 trillion in credit balanced on a small foundation of gold valued at $10 billion. Then in March that year, Congress changed the law so that dollars no longer had to be backed by gold.

Over the decades that followed, no more gold was added to the base, but another $50 trillion of credit was piled on top. In 2008, with nothing real to underpin it, the entire debt superstructure began to collapse upon itself.’

As you’ve seen, by creating new debt, the government is trying to avert this collapse. It is my view that the government’s attempts to reinflate the credit markets will result in Duncan’s inverted pyramid becoming top heavy. Seeing the end of the credit based economic system, capital will flee down into the safety of the pyramid’s base. It will fall into gold.

That’s because physical gold is outside the ‘system’. When this happens gold will be worth thousands of dollars an ounce. More accurately, paper based credit will collapse in value when compared to gold.

This will either happen gradually or immediately. By this I mean thephysical gold market could freeze up (due to their being no sellers at the prevailing price) which would force a weekend revaluation to a much higher price. A higher gold price would help ‘re-set’ the system by reducing the value of debt.

Gold is the only asset in the financial system that does not have a corresponding liability. It can therefore be re-valued much higher without an offsetting increase in system liabilities.

Greg Canavan

Editor, Sound Money. Sound Investments.

This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.