Last week the United States debt to GDP ratio quietly hit 101% for the first time, moving us solidly over the 100% mark (hit on January 30th of this year) and bringing us ever closer to countries like Greece (168%), Italy (121%), Ireland (108%), and Japan (233%). (Numbers from 24/7 Wall St.)

We’ve been talking about Fractional Reserve Banking over the past few weeks because it holds the key to understanding the global financial markets and in particular, the global sovereign debt crisis and what these debt levels truly mean for the future of our global financial system.

I am spending so much time on this because it is critical to understand the “big picture” before diving into the specifics of “how to sell a put option” or “how to evaluate real estate” or “how to buy a corporate bond”.

If you don’t have a solid grasp of the “big picture” (the “yin” as we call it), you are destined for failure and likely to get crushed (even if you are an absolute master of a specific technique…the “yang”).

Hopefully you now have an understanding of what our current “money” is (debt), how it is created (by issuing more debt and then propagating that debt throughout the financial system through fractional reserve banking), and how this massive money creation dilutes the value of all of the other “money” in existence.

And hopefully this knowledge makes it easier to understand what is really happening “behind the scenes” in Europe, China, Japan, the UK…(heck, throughout the entire globe right now!) so that you can translate financial news articles into “plain” English (or your language of choice) and understand the implications, such as:

  • “China Reduces Reserve Requirements in Effort to Encourage Lending” (translation: “China is creating more ‘money’ through the ‘magic’ of fractional reserve banking and debt), or
  • “US Debt to GDP Hit 101% today with the latest issuance of $32 billion in two-year bonds” (translation: “The United States just created more ‘money’ through the ‘magic’ of fractional reserve banking and debt), or
  • “Dollar Rises Versus Euro, Yen as Bernanke Comments Damp Easing Speculation” (translation: “Japan and Europe are expected to create more ‘money’ through the ‘magic’ of fractional reserve banking and debt in the immediate future than is the United States due to a comment made today by Ben Bernanke”)

Are you beginning to see a pattern? The entire Western world is engaged in a process of “money creation” via debt (the only question is who is doing it faster…this is discussed well and extensively in James Rickards’ excellent book, Currency Wars), and when more ‘money’ is created like this, it reduces the value of all of the other ‘money’ in existence, just like we saw in our example with you, John, Steve, and Sarah.

This is the primary reason why “smart money” investors have been slowly moving their money to “hard assets”—things with real, intrinsic, tangible value such as precious metals, farmland, timber, commodities, and well-located real estate—for the past decade.

The prices of all of these tangible assets have been rising not because they are suddenly inherently more “valuable” (although this is true in some cases as demand increases for a certain asset or the supply is reduced, etc.), but because the value of your money is decreasing…the same $10 that used to buy you five gallons of gas in 2000 and 10 or 15 gallons of gas in 1950 now buys you only 2.5 gallons of gas in 2012.

In fact, the value of the U.S. dollar as compared to gold (used as money throughout history since the earliest civilizations) has declined by 98% since 1900:

USD versus Gold 1900 - 2012

US Dollar Has Lost 98% of its value since 1900; Chart Courtesy of Priced in Gold

(For more details on various items “priced in gold”, check out Charles’ site at www.pricedingold.com)

And the amount of money we have “floating around” in our system continues to rise, year after year…at last count the M1 money supply of the U.S. (and this is the narrowest, most restrictive measure of money in our system, including only the most liquid forms of currency such as checks, traveler’s checks, and other deposits against which checks can be written) was $2.2 Trillion:

M1 Money Supply

M1 Money Supply; Chart courtesy of ShadowStats.com

The only thing preventing us from experiencing more pronounced inflation is banks’ ability and desire to lend…if banks cannot find enough qualified borrowers to loan out this new money to and/or if there are massive loan defaults as happened in the subprime mortgage fiasco, then this “inflationary ‘magic’ of fractional reserve banking” doesn’t work.

So now you have a tool to decide for yourself whether to expect massive inflation in the years ahead (if governments and central banks continue to print ‘magic’ money via fractional reserve banking), or deflation (if banks either cannot or will not lend the new money out, thus actually decreasing the supply of money), or some type of “muddle along” scenario (a combination of the first two leading to a somewhat flat money supply—not too much new money created, and not too much destroyed).

You can now amaze your friends at the dinner table (or bore them…) 🙂 with your outstanding understanding of inflation and deflation and the various global economic forces at work!

My belief is that we cannot avoid massive inflation in the near future, although “near” may take a year or two to arrive (just because something is “inevitable” doesn’t mean that it is necessarily “imminent”, as my mentor Doug Casey is so fond of saying).

I can certainly imagine a scenario where we muddle along as we are now for a bit longer, much like Japan’s “lost decade” (or rather, lost two decades, although hopefully ours won’t be that long!) before experiencing massive inflation, but I don’t see how we can have a massive deflation unless the situation in Europe completely implodes and there are runs on all of the banks and massive loan defaults…

But even then, much like the recent financial crisis of 2008/2009, the governments and central banks would inevitably respond by “emergency measures” like multi-trillion dollar bailouts (remember TARP…) and massive monetary support, because letting everything collapse into massive deflation is politically impossible—there would be even more riots in the streets than there already are and governments would get overthrown—something they will fight to the death (literally, you’ve seen the pictures and videos…) to prevent from happening.

(Incidentally, that last sentence and the worry that governments and central banks will not be able to “save us all” is one reason why many savvy “smart money” investors are creating foreign “escape pads” such as Doug Casey’s La Estancia de Cafayate and Simon Black’s Resilient Community.)

So my big picture analysis and forecast is for eventual massive inflation, and that is how I am investing….but that’s just me…how about you?

What do you think?

To your financial success,
— Kung Fu Girl

P.S. Enjoy this “extra” day today….you get a bonus day this year to make all of your dreams happen and achieve your goals! Don’t waste this precious gift…go get ‘er DONE!