The huge growth and level of debt in our society cause much concern amongst investors world-wide. Will high debt lead to inflation or depression? What is the right investment strategy to protect or increase investors' assets in the future ? Is it a good strategy to buy gold and gold mining companies to fend off possible crisis? This report highlights the background of investing in our current environment of high public and private debt.

US debt grew fourfold in real terms over the last 30 years. In 1999 US dollars this represents a figure of US$18 trillion. Nearly all of US Gross Domestic Product (GDP) growth in the last few years stems from credit expansion. Population demonstrated a significantly slower growth rate than debt increases.

In many cases, debt itself is neither deflationary nor inflationary as high liabilities also imply high assets in an economy. It is just the dynamics and the psychology which will lead to inflation or depression. The crucial point is that as long as money savers and lenders think their money is safe, they will not ask for the money - allowing debt to grow ad infinitum.

When the crucial point is reached where money savers/lenders get nervous, they will ask for the return of their money. Consequently, we will see a devaluation/higher interest rates, inflation,... This is exactly the point why policy makers are so keen to talk up currencies, play down trade deficits and inflation and oil price increases. It is more an issue about credibility than the level of debt. For example, a high gold price would also undermine this credibility. This also explains governmental obsession to keep the gold price down through central bank manipulation. The situation is especially meaningful for the US economy - as savings are mostly outside the country and the US government has to convince foreign savers to hold their dollars.

Think what happened in Asia two years ago. Only in consequence to money lenders requesting for the return their money (and this was pure psychology, because fundamentals did not change very much as the recent recovery of these countries shows), were the local currencies devaluated and interest rates raised...

A second example is the Great Depression of 1929. The US Fed actually increased money supply after the Crash. Yet consumers just did not want to spend money as they were worried about their economic situation. Only a severe drought in the summer of 1933 (caused a spike of inflation - mostly of food), was the fear about future economic conditions replaced by the fear of the value of the money. Yin and Yang, day and night, summer and winter, greed and fear, this is what also drives the inflation/currency/debt/depression scenario.

Let's consider Japan today. The Land of the Rising Sun has increased its money supply. And although the Nippon government increased its debt dramatically, interest rates and inflation remain at record lows. Yet the consumers refuse to spend their money - as they fear the uncertainties of the future. It is also interesting that especially in Japan, there is a unique social element in consumer spending behaviour. Japanese demographics are strongly dominated by older people, who have a stronger penchant to allow savings to accumulate. Yet, in the case of a severe crisis, senior citizens are more likely to panic as they have less possibilities to recover their losses in the future.

Therefore, the money supply will relentlessly increase as central banks have need to support economies loaded with debt, until something happens that turns fear into greed. When this occurs, people will readily spend their savings, because they are now worried about the value of their money. This will necessarily increase inflation, creating an inflationary upward spiral…as idle money comes out of the mattresses.

We call it money velocity (GDP/Money Supply). Velocity increases when inflation and interest rates rise. During the Germany's hyperinflation of the 1920's, the money supply was quite low, yet velocity was very high. Traditionally, higher the velocity begets higher inflation. Between January 1922 and July 1923, prices skyrocketed six times as much as nominal money -- thus reducing the real money supply by 82 per cent (Bigg, Fisher, Dornbusch, Economics 1994). So, hyperinflation actually occurred even in the face of a declining money supply. When interest rates and inflation rise, the costs of holding money increase (the flight from money), people are motivated to increase spending (i.e. consumption). Although this is an extreme example, it shows quite simply how the mechanism works.

Imagine a dam. As long as the water (i.e. money) is retained in the reservoir (i.e. reluctance to consume), the dam will continue to fill infinitely (money supply and credit). If some event triggers an outflow (spike of inflation or currency devaluation), the dam will burst, allowing the water to empty in a very short time. This is exactly what happened in Asia two years ago.

There is just one cardinal function of debt level: it increases volatility. The higher the debt load, the higher the risk and impact of a severe crisis - when savers/lenders lose their patience through a confidence crisis provoked by currency devaluation and/or inflation.

As industrialised countries experience a period of low inflation, low interest rates, high stock prices and decent economic growth, this view seems to be exaggerated. We are now at a stage, which many people perceive as very comfortable. Yet this is exactly what the high volatility reflects. What is overlooked now is that we are not in an equilibrium, we are at an extreme. The other side of the coin of this extreme side of volatility is that mining and oil companies, some developing countries went through extreme depressions over the last years.

If the tide turns in industrialised countries, this "comfortable" scenario can quickly change into high inflation, high interest rates, and devaluing currencies.

To demonstrate the high volatility, I have plotted the real US money supply over the last 30 years. It is impressive to see how big the swings were in recent years. This will certainly have an impact on the real economy in the next few years. The first decade shows relative stable monetary growth until the first outburst of credit expansion occurred at the beginning of the seventies. This led to high inflation, high interest rates, high volatility and low stock prices during the second half of the seventies. The situation somewhat calmed, as Asian countries re-invested their export dollars into dollar denominated securities, which enabled further debt growth. This high growth for money restarted in the mid-eighties, followed by strong monetary growth at the beginning of the nineties, which peaked at an incredible rate of nearly 13 percent last year. The lows are lower and the highs are higher.

Regarding monetary expansion we are nearly at the same situation as at the beginning of the seventies: The huge upward movement for commodities in 1973 started first with a sharp decline for commodities, sharp increases of money supply and low interest rates and high economic growth. Money growth accelerated as savers were willing to buy securities world-wide in a certain deflationary scenario. We all know what followed: the sharp increase in the oil price and other commodities triggered a spending frenzy, high volatility and high inflation.

Today, the main difference I can see is the higher leverage. The lows for commodities are unprecedented. Also interest rates are at record low in some countries (Japan). This in turn will also lead to a much higher upward movement in precious metals and commodities, when the tide turns.

Given the difficult scenario, the investment strategy is clear: The high leverage and increasing volatility makes it important to have excellent timing for investment decisions. The best time for investing in gold has been a peak of monetary growth: 1973, 1977,1986 and 1992 have been excellent years for investing in gold. The current monetary growth has already reached a very high level, which suggests the most opportune time for investing in gold, other precious metals and mining companies looms on the horizon. If money supply is limited through devaluation, declining demand for stocks and bonds will ensue. This will be the signal to go into gold and commodities. We are already at the beginning of this trend.

As the monetary peak is so high and comes so late, gold and other commodities have been hard hit. This is just a reflection of its high volatility. Nevertheless, the high monetary peak also makes the case for an almost unprecedented sharp and high recovery for precious metals and commodities.

I look forward to receiving your comments

Dr. Heinrich Leopold
21 January 2000

hleopold@ibm.net