Debt to GDP Ratio Will Return to Normal

And what about gold? Dr. David Evans of www.goldnerds.com.au sent us this note earlier this week. He was responding to our truth-telling note earlier in the week that called the current recovery out as a fraud.

He writes that, "During the credit boom, from 1995 to 2007, the debt-to-GDP ratio rose quite a lot, to all-time record levels, eclipsing the 1920s by considerable margins. In our current system, money is created by debt: new debt creates more money. During that period the broad money supply in the US generally grew at about 8% per year, and in Australia about 10% (peaking at 23% year on year to January 2007). That extra money was spent in the real economy, thereby raising the GDP by about 1 - 2% per year. About 10 - 25 GDP points were artificially added by borrowing from the future (borrowing brings forward consumption from the future to the present)."

"Now here is the thing. With the ending of the credit bubble (and it will end eventually, despite any stimuli), the debt-to-GDP ratio will return to normal, pre-bubble levels. People won't carry abnormally large debts unless asset prices are rising quickly, so the debt-to-GDP level cannot stay permanently elevated. Reduced debt reduces the money sloshing around the economy: retiring debt destroys money, in our current system. So as the debt-to-GDP ratio returns to normal, that 10 - 25% of extra economic activity brought from the future by extra debt will now be removed from the GDP.

"The main economic issue of today is how fast the 10 - 25% reduction in GDP is going to take place. We could do it quickly in one year, with a sharp short depression. Force bad debts out into the open, those who are broke go bankrupt, and everyone starts over in a dynamic economy. Or we could drag it out indefinitely like Japan after its bubble popped in 1990, but pay the price of a moribund economy with hidden unresolved debts. Or we could go for something in-between, maybe giving back 1 - 2% of GDP per year for the next 12 years.

"So far policy makers have tried to postpone the GDP decline by simulating to keep the bubble going a bit longer. History suggests they can pretty much be relied upon to keep trying to put it off, and eventually reach for the printing press and inflation to lower the real value of debts (most voters are borrowers, not lenders) and disguise the reduction in real GDP (with enough inflation, no one will be sure).

"In the 1970s, after the smaller credit bubble of the 1960s, the formula was to run about 10% inflation from 1973 to 1979 before radically raising interest rates to bring an end to the inflation in 1980. Seven years of 10% inflation halves the real value of debts. Of course, all this will bring the nature of debt-and-fiat money into question, and the price of gold and silver relative to other items will probably increase dramatically (they went up 20-fold in the 1970s).

As Dr. Evans points out, if the gold price repeats its 1970s run, knowing which Aussie gold stocks have the lowest production costs will come in very useful. Goldnerds does a great job of helping you suss out who the low-cost producers are.

In the meantime, as one reader wrote in this week, don't forget the cash. The Aussie dollar is enjoying its moment in the sun as the most attractive currency in the G-20. The interest rate differential and rising commodity prices ad to its allure. But cash itself as part of your preparation for further economic turbulence is always a good idea. Don't forget it! Until next week...

Dan Denning
for The Daily Reckoning Australia

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