Five Steps to Take Before Economic Collapse

. . .To understand where we are now, you have to start with a clear understanding of money and credit. Most normal people never have to think about these ideas. But. . .during a financial crisis. . .you won't have any idea what's really happening unless you understand a few basics of economics. Please bear with me while we cover a few fundamentals. Understanding these concepts will make it easy for you to see how much trouble we're in right now.

Credit is money that's been borrowed. In a healthy economy (one with sound money, like gold), credit is limited to savings. That only makes sense, doesn't it? How could you borrow something that someone else hasn't already put aside for the purpose of lending?

Of course. . .saving is hard. Most people would prefer to have the benefits of credit without the effort of saving. And that's what they vote for in democracies. Thus, we have modern economics, which is based on a simple lie: That you can safely expand credit in excess of savings.

But, of course, you cannot create wealth from a printing press. Doing so causes price inflation, asset inflation, a credit collapse—or a mix of all three. Everyone knows this. And yet it seems the entire global political class remains dedicated to pretending otherwise.

When credit is expanded far enough in excess of savings, you get a collapse. It happens every time. It shouldn't surprise anyone. Sooner or later, creditors look around and begin to ask themselves a critical question: Can these debts really be financed? Will I ever get my savings back? If credit has been expanded radically beyond savings (as it has in the U.S.), the answer is invariably no. That's what S&P was warning about two weeks ago. And that means credit will be harder and harder to get in the U.S.

Currently, the total-debt-to-GDP ratio in the U.S. is almost 400%. (Total debt is the combined federal, state, municipal, corporate, and individual debt in the U.S.) Crushing debt loads have already destroyed the real estate market and led to an economic decline. For now, the government has stepped up to replace the private borrowing and spending. As a result, we're now spending close to half our GDP merely on interest and government taxes. This simple fact should give everyone a reason to worry about the future of our country. Spending half your production each year on the government and interest payments doesn't leave much to live on or invest for the future.

In Europe, the problem is a bit different. . .and slightly more technical. Most of the debt in Europe is held by the big banks, not the sovereigns. Look at just two French banks, for example. Credit Agricole and BNP Paribas have combined deposits of a little more than 1 trillion euro. But they hold assets of 2.5 trillion euro. Those assets equal France's entire GDP.

And those are only two of France's banks. Right now, the tangible capital ratios of these banks have fallen to levels that suggest they are probably bankrupt—like UniCredit in Italy and Deutsche Bank in Germany. BNP's tangible equity ratio is 2.85%. Credit Agricole's tangible equity ratio is 1.41%. (UniCredit's is 4.42%, and Deutchse Bank's is 1.92%).

These banks have long been instruments of state policy in Europe. They've funded all kinds of government projects and favored industries. Making loans is far more popular with politicians than demanding repayment for loans. As a result, these banks are left with nothing in the kitty to repay their depositors. If there's a run on these banks (and there will be), how will they come up with money that's owed? No one's saying. (But I'll tell you in a moment. . .)

The numbers are similar across most of Europe's biggest banks. And the money that's owed is staggering. The reason the market fears these debts so much is that there's no clear mechanism to increasing the money supply enough to paper them over, as there is in the U.S. As strange as it may seem, investors prefer the U.S. Treasury market precisely because they know there's nothing to stop the Fed from buying as many Treasury bonds as the market wants to sell. On the other hand, in Europe, there's no guarantee whatsoever that the European Central Bank (ECB) will continue to buy the sovereign bonds—and there are even rules that explicitly forbid the ECB from financing bank bailouts.

What's the end game? How will this huge mess be sorted out? The essential problem is there's too much credit and too little money. So a lot more money is going to be created. Let me explain why I'm so sure this will happen. . .

Twice in the last week, I've heard someone describe gold as "just another fiat currency." James Altucher said this in our discussion about golddiscussion about gold on Yahoo Finance (which followed our previous debate.) And I also heard some clown on CNBC make the same claim. To these folks, gold is in a bubble because it's become so overvalued against the other fiat currencies. It's amazing to me how little knowledge there is on these topics. Gold isn't a fiat currency at all. In fact, it's the only form of money that's not a fiat currency.

I enjoy offshore fishing. I have a relatively modest center-console fishing boat. I like it because it's really fast and I can get across to the Bahamas quickly, which is my favorite place to fish. But to get there in a reasonable amount of time, I need calm water. My wife is always surprised that I can tell the surface conditions of the ocean just by looking at the sky. I know because the ocean is the mirror of the sky. While you might not be able to "see" the waves in the sky, waves are caused by wind. You just can't see the wind.

The same thing is true about the price of gold and the stability of fiat currencies. Gold is the mirror of the world's paper currency system. The price of gold doesn't reflect the intrinsic value of the metal—which is almost unchanging over time. It reflects the relative value and volatility of paper currencies.

The people who are arguing that gold is overvalued are not looking at the right numbers. They ought to be looking at Europe's banks. They ought to be looking at the amount of short-term obligations that are sitting on the U.S. Treasury's books. The price of gold is reflecting the likelihood that the world's sovereign nations decide to bail out Europe's banks and paper over the U.S. Treasury debt. Here's how it will happen. . .

Two great depositories of the world's bad debt are Europe's banks and the U.S. Treasury. Europe's banks will need trillions of euro (yes, trillions) to regain safe capital ratios. And the U.S. Treasury will need trillions of dollars to refinance its upcoming repayment schedule. Both will be accomplished by the actions of the U.S. Federal Reserve. Step one will be the extension of swap lines to the ECB by the Federal Reserve, which will allow the Fed to buy between $2.5–$5 trillion worth of "riskless" ECB notes. These notes will allow the ECB to bail out Europe's banks, which will in turn begin to buy U.S. Treasurys to repair their capital ratios.

The big unknown in this scenario is whether or not the Germans will approve this massive inflation. I can't know whether they will go along or not. But several of their biggest banks need a bailout, which leads me to believe they will eventually get on board. Whatever the final details, the goal is clear—a massive increase in the size of the Federal Reserve's balance sheet and a correspondingly huge increase in the world's money supply. And that's what you're seeing when you look at the prices of gold and silver.

How will we get from here to there exactly? I can't know. It may be done piecemeal, one quantitative-easing program and bank bailout at a time. Or it might happen with some kind of grand new compromise—a kind of Bretton Woods II solution. But just remember where we must end up. . .Europe's banks have to be recapitalized. And the U.S. Treasury has to be refinanced. The only way to accomplish this that has any chance of being approved by the democracies in question is via the printing press.

That's why I continue to warn about inflation. That's why I continue to advocate buying gold and silver. That's why I'm bearish on stocks (especially bank stocks). And that's why I think it's prudent for you to take steps to safeguard your property and your family—especially if you live in a big city. The population won't be ignorant of what's happening. The message will be clear: Governments and bankers have the right to steal from the whole world via inflation. That will probably inspire the crowds to do the same.

What should you do?

Step one: Make sure you have at least a year's worth of living expenses set aside in gold and/or silver. Haven't bought any yet? Sorry about that. Insurance gets mighty expensive once you can see the hurricane coming. Buy it anyway.

Step two: Make sure you and your family are relatively safe from the threat of violence. People used to make fun of me for saying this until they saw what happened in London. It will happen here, too.

Step three: Hedge your portfolio by shorting stocks or buying puts on some of the companies I've been identifying as vulnerable for months and months.

Step four: Get liquid. If there's a real bank crisis, you'll want to have plenty of cash on hand. Even though the U.S. dollar is likely to be devalued by 30%–50%, you might still need cash for a few days if the ATM network or the credit card network is turned off, which it might be.

Step five: Try buying into a farm co-op or other independent supply of fresh food. I know, this sounds a little crazy. Likewise, I suggest you stockpile critical medications. It's better to be safe. And prices for critical drugs would soar if there were any disruption to global supplies.

In closing, let me say that I hope none of these terrible things happens. Perhaps the crises of U.S. sovereign debt and Europe's rotten banks will have a better outcome. I simply can't figure out how we can get out of this mess without a huge inflation—but I'm certainly open to other ideas.

Yes, we could do the right thing, which would be to repudiate our debts as unaffordable and restructure our obligations. But I can't recall the last time any democracy took this path—it's far too honest. No politician is going to willingly take the blame.

Nor do I think these problems can be kicked down the road much longer. Confidence in the system is falling apart. Venezuela, for example, exited the modern financial system last week. It sold all of its Treasurys and recalled its gold from vaults in London. Yes, I know, it's only Venezuela. But other nations will follow. Central banks all around the world are buying gold, not dollars. That's a trend that's going to escalate. Quickly. I believe it's only a matter of time before a large Treasury auction completely fails, as our creditors simply become unwilling to lend. And when that happens, then a huge inflation will be our only way out.

Crux Note: Porter recently published a new "End of America" video. . .If you haven't seen it yet, be sure to click here.

Porter Stansberry
The Daily Crux