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In one of my recent articles, 29 hyperinflations in the last 100 years, I discussed the probability of hyperinflation or high inflation in the foreseeable future. I had linked the probability of hyperinflation with surging money supply in that article. This article also discusses the prospects of high inflation with a gradually diminishing impact of debt on GDP growth.

To build on my case, I would be using the total credit market debt outstanding in the U.S. in different periods and assess its impact on GDP growth during the same period.

From 1960 to 1980, the total credit market debt increased by USD3.9 trillion. In the same period, the GDP increased by USD2.4 trillion. In other words, one dollar of debt had an incremental impact of 61 cents on the GDP.

From the year 1980 to 2000, the total credit market debt increased by USD20.7 trillion. The GDP in these 20 years increased by USD9 trillion. Therefore, one dollar of debt had an incremental impact of 44 cents on the GDP.

Coming to the most recent decade, the total credit market debt from 2000 to 2011 increased by USD27 trillion while the GDP increased by USD5.2 trillion. The impact of debt on GDP growth during this period has witnessed a sharp decline. For every one dollar of debt, the incremental impact on GDP was just 19 cents.

It can be easily concluded that more and more of debt is gradually having lower impact on the GDP. The more important point is to figure out the reason for the diminishing impact of debt on GDP growth.

In my opinion, the primary reasons are -

With a gradual shift from a production to a consumption based economy, the debt has been put to use in consumption than capital investment. This diminishes its impact on GDP growth.

With artificially low interest rates (negative adjusted for inflation) for a large part of the last eleven years, debt has been put to use in regions where superior returns can be generated (outside the United States).

The Federal debt increase during these eleven years has been largely directed towards defence spending and bailouts.

Further, in my opinion, the impact of debt on GDP growth will continue to decline in the future. The primary reasons for this conclusion is -

With near zero interest rates, dollar carry trade is a trend and it does not benefit the local economy where the ROI will be relatively lower than some emerging economies.

The focus of the government is on boosting consumption rather than on saving and capital investments. As such, the impact of new debt on growth will be minimal and most of impact will be on price increases.

After the financial crisis, households are deleveraging and the corporate sector has also acted rationally. The private sector is the dynamic sector of the economy. As this sector avoids significant leveraging and focuses on stability, growth will be muted. On the other hand, the government sector expansion might not have a significant impact on GDP growth and can lead to crowding out of the private sector investment.

Are we heading towards zero hour?

Zero hour will be when additional dollar of debt has no impact on GDP growth. The increase in debt just leads to price increases. I do believe that we are heading towards zero hour in the next 5-10 years. Sluggish economic growth will result in continued government spending (largely misdirected). Also households might keep deleveraging while the government sector more than offsets that.

The implications of zero hour would be rapid asset price increases as additional debt just creates inflation.

Many would argue that there are no hints of inflation. On the contrary, we are staring at deflation. There are three important things to look at -

Excessive government spending and rapid money supply growth has a lagging impact on inflation.

If one just considers the reported CPI numbers, there will never be inflation in the U.S. I believe if any household in the United States calculate their annual inflation, the number would not be less than 5%.

Inflation is being exported to other parts of the world as banks and financial institutions speculate in risky asset classes globally. If the entire dollar were just circulated in the U.S., inflation would have gone through the roof.

Investment Options

Considering the scenario discussed, there is no doubt that investors need to have hard assets in their portfolio. I have been recommending gold (GLD) and silver (SLV) not only as investments, but also as honest currencies.

Agricultural commodities will rise on demand supply mismatch issues and also due to rising fuel prices and weakening currencies. The US Agriculture Index Fund (USAG) and PowerShares DB Agriculture ETF (DBA) can be considered for long-term exposure to agricultural commodities.

Equities tend to do well in times of inflation and exposure to U.S. (SPY) and global equities is a better option than exposure to government bonds (which might enter into a long-term bear market soon).

Source: Inflation To Rise With Diminishing Impact Of Debt On GDP Growth