Kontent Review

I have to confess that I did hesitate for a long time before deciding to commit to paper the following observations, as they will undoubtedly cause some confusion, given the views I have expressed in earlier reports. However, there are times when, within a long-term view, short-term considerations become more significant. From a longer-term perspective, I still maintain that central banks — especially the US Federal Reserve — will have no other option than to print money and that, therefore, in the long run, asset prices will continue to increase — at least in nominal terms.

US MZM has soared as a percentage of GDP in recent years and, as in the case of Japan, has created a huge monetary overhang. And while monetary conditions have tightened relatively in both Japan and the US, because money supply is no longer expanding as a percentage of GDP, looking at credit growth there can be no question that monetary polices are still expansionary. I am grateful to Kurt Richebächer for having recently pointed out that, in the US, in the fourth quarter of 2005, non-financial credit expanded at a new annual record rate of US$2,445.7 billion.

According to Richebächer, this compares with US$1,710.5 billion in the second quarter of 2004, at the end of which the Fed started its rate hikes. Financial credit increased US$1,224.4 billion, as against US$932.7 billion in the second quarter of 2004. In aggregate, overall financial and non-financial credit growth accelerated over this period of rate hikes from US$2,643.2 billion in the second quarter of 2004 to US$3,670.1 billion in the fourth quarter of 2005. In percentage terms, borrowing and lending increased a staggering 38.9%.

According to Richebächer, “the fact to see is that all the rate hikes were undertaken in [the] complete absence of any monetary tightening. Plainly, the Fed has readily provided any bank reserves that the financial system has needed to maintain its credit expansion. It is a farce of monetary tightening. For all of 2005, total credit expanded by $3,340 trillion, to $40,230 trillion, up more than $500 billion from 2004's record $2,818 trillion increase. For comparison, annual total credit growth averaged $1,237 trillion during the 1990s. Trying to capture the dynamics, we compare the credit expansion with the simultaneous increase in real and nominal GDP. Well, in real terms, it was up $378.9 billion in 2005, and in current dollars, 751.4 billion.”

So, in order to generate nominal GDP growth of US$751 billion, in 2005, total credit market debt had to increase by US$3,340 trillion — 4.4 times faster than GDP. Now, as is the case for the current account deficit, which hovers around 7% of GDP at present, the optimists will say that debt growth that is four times larger than GDP growth is sustainable. This may be the case for now, but the point is that, in the 1950s and 1960s, debt and GDP grew at about the same rate, with the result that in 1980, when Paul Volcker tightened meaningfully, total credit market debt was “only” about 130% of GDP.

Then, in the 1980s, debt grew at about two-and-a-half times GDP, in the 1990s at about three times GDP, and now at more than four times. In other words, as GaveKal Research pointed out, in order to sustain the asset bull markets and the economic expansion, debt growth will have to accelerate soon to initially five times GDP, later to six times, and if we extrapolate the trend that has prevailed since the 1960s, eventually to more than 20 times GDP.

Similarly, the current account deficit, which grew from 2% of GDP in 1998 to around 7% of GDP, would have to triple to around 20% of GDP in the next five to seven years in order to sustain the growth rates in foreign official dollar reserves (global liquidity) and economic growth around the world, if the recent trend is extrapolated. Also not forgotten is the US saving rate, which declined from an average of 9% in the 1970s to less than zero at present and turbo- charged the economy. If the stimulative economic impact of a declining saving rate is to be maintained, the saving rate will eventually have to be at around –10%.

Now, you don't need to be an economist with a Harvard education to see that these trends are not sustainable in the long run. However, it is my belief that the Fed, and other central banks which are at least as agile at printing money as the Fed is, will try to postpone the hour of truth by a renewed massive liquidity injection when the next recession arrives. So, my concern remains the same: before the final debt crisis hits, we might see very high rates of inflation — most likely hyperinflation, with all asset and consumer prices soaring (amidst falling real incomes)."