By MoneyMorning.com.au
In 1971, President Nixon abandoned the US dollar’s link to gold.
From that point on the world was on a US dollar standard. The US dollar floated freely and other currencies floated against, or were fixed to, the US dollar.
For the first time in history the world was operating without any semblance of a monetary anchor.
The result? An explosion of debt, or credit creation.
The chart below chart shows ‘total credit market debt owed’ in the US. As you can see it began nudging higher during the 1960s before starting on its parabolic way after the link to gold was ditched in 1971.
The expansion of US debt markets represents an expansion of global liquidity. Or, an expansion of global debt.
That’s because the US dollar replaced the role of gold in the international financial system. Now, investors considered the dollar ‘as good as gold’.
But, unlike gold, the production of US dollars is limitless.
Before World War I, the world was on a classical gold standard. That was when currency values were defined by their weight in gold.
Today we use a ‘floating currency’ system. That means all currencies ‘float’ in value against each other. In contrast the gold standard was a fixed currency system.
When recession threatened the US economy, the Federal Reserve tried to avoid it and lowered interest rates. They wanted to encourage spending by encouraging people to take on more debt. Which led to more US dollar printing.
All this money printing is the exact opposite of how the gold standard applied its stabilising influence.
And because of monetary policy used by the Fed and other major central banks, they were able to resist every economic correction.
At the same time, central bankers transformed into central planners. They were able to heavily influence the cost of credit.
So within this supercycle there emerged a smaller cycle of expansion, recession and recovery. If you look at the chart, you’ll see there were fewer recessions (shaded areas) after 1980 than in the 1940s and 50s, which were under a stricter currency regime.
This desire by politicians to engineer the economy and soften the impact of recession caused the spectacular debt growth shown in the chart. The value of all outstanding US debt is now around US$54 trillion. It represents all household and business debt, state and local government and federal government debt, as well as financial sector debt and foreign borrowing in the US.
There are a few things I want you to think about when it comes to your investments.
Using debt to fund a real asset – one that produces cash flow – is good debt.
But when the amount of outstanding debt grows to such levels that it swamps the amount of real assets in an economy, things get ugly.
If you have a look at the chart again, you can see that debt growth continued its parabolic trajectory during the 2000s. This growth fuelled the US housing market bubble, but did nothing for the stock market.
Now, despite the bursting of the US housing bubble, total debt continues to grow.
The problem is that the debt growth is now almost exclusively Federal Government debt. This is the most unproductive debt of all.
The politicians and central bankers are doing what they have always done during the credit market supercycle. They are trying to avoid recession by creating more debt.
But this time is different.
Monetary policy is weak because the private sector is already too indebted.
And financial interference merely keeps the credit market from imploding. It does nothing to create productive investment.
However, lower interest rates – the central bankers ‘cure-all’ – to encourage debt is no longer a recession fix. And gone are the days where strong expansion would follow a shallow recession.
Instead, you should anticipate a weak expansion to come from a deep recession.
So thinking in terms of how things used to be in days of the ‘supercycle’ is pointless.
What you now need is an investment strategy for a cycle in reverse… The debt vacuum.
How do you deal with the end of the global supercycle in credit creation?
There are four things you can do to preserve your wealth and grow it.
Focus on preservation.
1. Get out of debt.. Mortgage debt, margin debt, and personal debt. Pay it back. Sell assets if you have to. The days of asset price appreciation from debt are over.
2. Have large cash balances as a part of your investment portfolio. You need to be flexible. Holding cash when interest rates fall has an opportunity cost. That is, what are you forgoing by holding cash?
3. Hold precious metals – both physical and equities – in your portfolio. They have taken a hit lately, but I firmly believe precious metals will benefit as the debt supercycle comes to an end
4. Look to add defensive, income-producing equities to your portfolio. This is something I focus on in Sound Money. Sound Investments and will continue to in 2012 as the monetary system breaks down.
After a 40-year experiments with floating currencies, linked to an anchorless reserve currency, the system has hit a wall.
You’re investing in unprecedented conditions. In fact, no one has been here before.
Use 2012 as the time to preserve your capital, reduce debt and accumulate precious metals.
Greg
Editor, Sound Money. Sound Investments
Publisher’s note: Greg Canavan is the editor of Sound Money. Sound Investments – a premium investment advisory focusing on finding companies that trade below their “real” value. But buying stocks is only half the deal. It’s also important to know what and when to sell. In this special report, Greg explains which four investments you should sell NOW, and why. Click here for details…
