By Sean Hannon, CFA, CFP, of Covestor.com

Contracting credit should be an aspect of the business cycle. As the economy grows, credit expands, investments are made and price levels rise. Eventually, we reach a point at which prudent lending standards prevent further credit expansion, borrowing stagnates and economic growth either moderates or declines.

During the decline, certain borrowers will experience hardship and default on their loans. If, during the expansion, debt levels remained moderate and loan standards prudent, defaults would be limited and economic damage contained.

Our current crisis is much different. As the credit bubble expanded earlier this decade, household debt grew from 60% of GDP to 97% of GDP. Similarly, household debt as a percentage of disposable income (measured as income after taxes) grew from 89% to 127%.

Normally, high debt levels would force prudent lending standards as the risk of loss is elevated. Instead, the credit bubble was inflated as investor demand for extra yield and the belief that asset prices only increase caused many lenders to loosen underwriting standard and create subpar loans.

As many homeowners find themselves with negative equity, the rationale for owning a home shifts and their choice is to walk away. Normally, we see economic stress cause people to lose a home they would rather keep. Currently, we have seen people willing walk away from homes prior to a true downturn in the economy. This has caught many lenders off guard and has led to tightening of credit to nearly all clients. Thus today's borrowers suffer for yesterday's mistakes.

With the access to credit eliminated and debt levels high, individuals find few options to expand consumption. If consumer spending drops, economic growth also drops. So what are the alternatives? Because the economy is dependent upon borrowed money to grow, we must rely on the one entity with the ability to borrow and spend -- the federal government.

While I rarely advocate increasing deficits, the current economic picture requires extreme measures. With individuals and companies locked out of the credit markets, the risks are massive. As we have seen in the last six weeks, financial markets are awakening to these risks, and the results have been brutal. With the focus on the Treasury's most recent band aid, the Dow Jones Industrial Average (Dow) has dropped below 10,000 while volatility continues to soar. Buying bad assets may help eliminate uncertainty, but it does not guarantee that credit markets unclog and lending continues. Instead, we need more drastic actions to stem asset deflation.

Our infrastructure has fallen into disrepair and needs updating. An expansion of both education and health care services would be easily justified to the American people. Tax incentives for research and development would increase employment and innovation. Combined, the federal government would be using its borrowing capacity as a way to reinflate the economy, raise asset prices and increase our standard of living.

Normally, I would never advocate inflation to cure our economic ills. These are not ordinary times. Given the size of the problems and the effect it is having, failing to take an inflationary path will lead to, at best, a deep recession and increase the possibility of a severe depression that will affect the entire country and thus, the world.

If I am correct about the need and intent of the government to inflate the economy, the investment implications are many. In an inflationary environment, Treasury bonds will suffer. Currently, the two-year Treasury pays 1.45% and the 10 year Treasury pays 3.49%. The initial steps of an orchestrated increase in inflation will be led by a Federal Reserve interest rate reduction. When it occurs, you should expect Treasury yields to decline further. At that moment, I would exit these positions as increasing inflation will erode the value of the bonds.

The largest beneficiary of increased inflation will be hard assets and related companies. Gold offers the purest exposure, but all commodities should do well. Equities that either supply commodity producers (i.e. -fertilizer companies such as Potash ( POT) or currently possess abundant commodity reserves (i.e. - oil companies such as XTO Energy ( XTO) should see their shares perform well. Real estate should begin to bottom and then eventually outperform.

As the presidential election is near, keep a close look at the economic plans presented by the candidates. It is my belief that in order to prevent another Great Depression greater and more painful than the one in our past -- because so much more wealth is at stake and the population of our country has increased -- our government must spend on infrastructure, health care and education. A portfolio focused on these areas should yield excellent results.
At the time of publication, Hannon was long XTO. Positions may change so click here to view their current portfolio. Sean Hannon has their investment record verified by Covestor.com. Visit Covestor.com to track the real investments of thousands of proven self-investors live for free.

If you liked this article you might like

The Great Inflation Is Coming

The Great Inflation Is Coming

Covestor: Time to Buy Coca-Cola

Covestor: Time to Buy Coca-Cola

Covestor: Why I'm Bullish on Oil

Covestor: Why I'm Bullish on Oil

State Street Not Too Big to Fail

State Street Not Too Big to Fail

First Solar Ready to Shine

First Solar Ready to Shine