Gold up $10 an ounce yesterday. The Dow up 40 points. Meanwhile, the most watched stock index in the world, the S&P 500, closed at a new all-time closing high of 1,890.9.

In yesterday’s Diary, we revealed economist and author Richard Duncan’s outlook for the months ahead. You noticed, surely, that it corresponds with our own, at least to an important point.

Duncan’s key insight is that asset prices – in particular stock prices – have come to depend on excess “liquidity” in the economy.

(We put liquidity in quotations, because it is not clear how fluid QE money really is. Our colleague Chris Hunter has pointed out that excess reserves can’t be spent in the economy… nor can banks multiply them into more loans – an issue of some debate around our offices. Still, there is no doubt in our minds that the S&P 500’s new record high is largely down to QE.

As long as the quantity of this liquidity exceeds the economy’s uses for it (principally borrowing by the federal government and corporations) stocks have a tendency to go up. When liquidity levels fall stocks tend to fall, too.

Duncan anticipates that liquidity will dive in the last quarter of this year (with less available cash and credit than the economy needs). If they haven’t sunk already, stocks will go down to where they belong.

But the Fed has taken a blood oath to keep the credit bubble expanding to the end of time… or until it blows up… whichever comes first.

And Janet Yellen has recently revealed herself to be a remarkable personage for a central banker. (She is, after all, a disciple of the infamous Yuri Pavlovovich!) She will not stop or sidestep the trap; she will walk right into it… recklessly blundering into the biggest financial disaster of all time.

Ex Nihilo, Nihil Fit

Ah yes… you might as well know. There’s more to Duncan’s macro views – a lot more.

In 1964 – half a century ago – the US had a total debt load (private and public) of $1 trillion. Today, the economy carries a debt load of $59 trillion.

Did the size of the economy also grow 59 times? Is our bigger, more prosperous economy now able to support $59 trillion of debt… or more? Hardly.

In 1964, annual US GDP was $656 billion. Let’s see… today it is about $17 trillion. Divide $17 trillion by $656 billion and we find that GDP has gone up 26 times – not even half as much as the debt.

In other words, each unit of today’s economic output supports more than twice as much debt as it did 50 years ago. Put another way, twice as much of what you see today – cars, hamburgers, houses, flat-screen TVs – owes its existence to transactions that have been completed. There is a day of reckoning for every debt-fueled purchase. And if interest rates rise, the coming settlement could be extremely painful.

Normally, and naturally, the amount of credit in the world is limited by the amount of savings. You can’t lend someone something you don’t have. And if you don’t save money, you can’t lend it to someone else.

But a reduction in required reserves balances for banks… and a shift to an elastic currency (in 1968)… made it possible for banks to create credit ex nihilo (out of nothing) without putting any meaningful amount of money aside as reserves. (By 2007, US banks held $73.2 billion in reserves and vault cash against assets of $11.9 trillion… for a liquidity ratio of just 0.6%.)

If credit growth had just kept up with GDP growth, it would now measure about $26 trillion, not $59 trillion. In a credit deflation, the difference would have to disappear. Ex nihilo it came. Ad nihilo it will go. That $33 trillion worth of spending and asset prices would go poof.

The Next Great Depression

And that is exactly what you should expect when the credit bubble pops.

The Great Depression saw GDP fall by more than 40%. The next great depression should see an even bigger drop. Unemployment reached 25% in the Great Depression. The next depression could see even more jobs lost. In the Great Depression a large percentage of the US population was still semi self-sufficient – with gardens, chickens, hogs and extensive home preserves. Today, few people could support themselves from home, even for a few days.

As the Austrian School economists warned us: Any credit in excess of actual savings is a fraud. It produces a fraudulent boom, which must be followed by a bust. Eventually, the phony credit must go back whence it came. Central banks can delay it. They can’t avoid it.

Today, the world economy relies on this never-ending credit expansion in the US. Without it, China’s economy would collapse along with the US economy. The US stock market would be chopped in half – at least. In short, it will be one godawful mess.

But Duncan goes further: A credit deflation would also knock the wind out of government finances. Social security, education, welfare programs, military spending – all would be substantially impaired.

“In all probability,” says Duncan, “our civilization would not survive it.” He believes a serious credit deflation would bring “chaos, starvation and war.”



Editor’s Note: Are you ready for the next great depression Bill sees coming? Do you have an investment plan in place to deal with a demise of the dollar-based monetary system? If not, we recommend you read the free report our senior analyst, Braden Copeland, has put together. It explains in detail the coming collapse… and the simple steps you can take to protect what’s yours. Find out how to protect your savings here.

Market Insight:

Burns Returns?
From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

It’s hard to keep a straight face these days when Janet Yellen talks about the plight of the unemployed in America.

Her idea – and the idea that the fate of the world’s largest economy now largely relies on – is that higher inflation will bring about more jobs.

This is plain batty. We’re stunned that there isn’t more criticism of it in the mainstream press… which seems to have swallowed the Fed’s twisted logic hook, line and sinker.

It’s true that higher inflation helps out debtors… and fuels speculation in stocks and real estate by reducing the real value of their liabilities. But it does so at the expense of savers – particularly retirees – who face pitiful yields on money market accounts, CDs and bonds.

And anyone with even a passing understanding of the history of monetary policy knows that keeping interest rates ultra low for long periods doesn’t always turn out as intended (with lower levels of unemployment).

As you can see from the chart above, of the Fed funds rate minus the annual CPI under different Fed chairmen, the last time the Fed tried this trick was in the 1970s under the chairmanship of Arthur Burns.

Instead of leading to full employment, as planned, this period of negative real interest rates was followed by stagflation – hardly a model for success.

It remains to be seen what the unintended consequences of the current dose of negative real interest rates will be… but we know we don’t want to be unhedged when we find out.

That’s why we continue to like gold, as “disaster insurance,” as well as other tangible assets you can stub a toe on… such as real estate. Both tend to perform well in periods of high inflation.