Keynes noted in the General Theory that, according to Gesell's proposal, "currency notes (though it would clearly need to apply as well to some forms of at least bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure. According to my theory it should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment." And although Keynes found "the idea behind stamped money sound", he nevertheless conceded that there would be difficulties in the implementation of this scheme:

But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes - bank-money, debts at call, foreign money, jewelry and the precious metals generally, and so forth...there have been times when it was the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest; though under Gesell's system this possibility would have been eliminated by land nationalisation. (John Maynard Keyes, General Theory, London, 1936, Chapter 23)

I briefly discussed Gesell's ideas because his books would make excellent bedtime reading for Comrade Obama. I doubt, however, that the Commissar can indulge in much reading time since he has embarked on micro-managing the economy. Also, as Keynes himself admitted, there are enormous problems associated with the "stamping system", as well as with the "hat system" explained above by Mankiw, because savers would turn to other forms of "money" such as precious metals, non-ferrous metals, diamonds, paintings, stamps, cigarettes (see also below), metal coins, ecstasy pills, cocaine, prepaid cards, etc. But back to Mankiw!

Mankiw: If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates - interest rates measured in purchasing power - could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend...

Yes, real interest rates could be strongly negative, as was the case in the 1970s, which generated high inflation and high nominal GDP growth rates but a collapse in bond prices (see Figures 1 and 2). Currently, Mr. Mugabe maintains in Zimbabwe by far the lowest interest rates in the world in real terms. But who is lending him money? What about capital spending and consumption in Zimbabwe? Go and look for yourself, Professor Mankiw! But there is no need to travel that far. After all, it is far too uncomfortable for an academic at Harvard. Closer to home - in the US - there is sufficient evidence that consumption as a percentage of the economy fell in the inflationary environment of the late 1960s and 1970s when interest rates in real terms were mostly negative.

Mankiw: Ben S. Bernanke, Fed chairman, is the perfect person to make this commitment to higher inflation. [MF: I am in full agreement on this point.] Mr. Bernanke has long been an advocate of inflation targeting. In the past, advocates of inflation targeting have stressed the need to keep inflation from getting out of hand. But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative...

I have a far simpler solution for creating inflation (for which I should obtain a Nobel prize in economics) than the half-baked measures proposed by Gesell, Mankiw, and his students, in order to create "more demand for goods and services, which leads to greater employment for workers to meet that demand". The government could issue to each US man, woman, and child free vouchers for different goods and services, which would have a three or six months' expiry date.

There are 310 million Americans. The government could issue 310 million vouchers to be exchanged for a new car, 100 million vouchers to be exchanged for a $500,000 home, a billion vouchers for a visit to an amusement park, a trillion vouchers each for Prozac and attendance at a sporting event, and so on. AIG and Citigroup would be in charge of making a market in these vouchers, so if someone didn't wish to buy a car he could exchange the But since these vouchers would have an expiry date they would unleash a huge consumption boom, which would temporarily lift the prices of everything and, therefore, achieve the objective of the US economic policymakers of creating inflation and negative real interest rates. (An even simpler solution would be to remove all taxes for two years, or simply to send each American a cheque for a million dollars, but the impact on spending would not be as powerful as with my voucher system.)

car voucher for cigarette vouchers or any other voucher.

With my voucher system, the current interventionist government could even target the bailout of some specific industries that are currently ailing. For instance, it could issue 310 million vouchers, each of which could be exchanged for the purchase of a new car; whereas it would not issue vouchers for goods where demand remains strong - namely, for guns, cocaine, ecstasy, prostitutes, and porno magazines. And if some protectionist flavour was desired - since this would really stimulate domestic capital spending and employment - the government could issue a disproportionately larger quantity of vouchers for the purchase of domestic goods than for foreign goods.

And who would pay for the vouchers that businesses would receive from consumers? Nobody! The Treasury Department could issue bills, notes, and bonds to pay businesses for the tendered vouchers, and have the Fed buy them all. But would nobody really pay for my voucher system? The objective of my voucher system would be fulfilled, which is to create inflation, but at the cost of a tumbling US dollar and collapsing bond prices, as was the case in the 1970s (see Figures 3 and 4).

I may add that a collapsing dollar might lead to a "little too much inflation"-even for the Bernankes and Mankiws of this world! The astute reader will naturally ask what will happen when the economic stimulus arising from the vouchers ends, since they are issued with an expiry date. The answer is very simple: the same thing as occurred after 2007 when the stimulus from easy monetary policies and strong debt growth (inflation) ended: demand collapsed.

But that should be of no great concern to the Mankiws of this world. The government could then issue new vouchers with a higher face value and in higher quantities. So, whereas my initial voucher program would have issued 310 million car vouchers with a face value of $40,000 each, the government could now issue 400 million car vouchers with a face value of $100,000 each. Now, some of my readers may think that I have lost my mind, but macroeconomically there is very little difference between my voucher program, which guarantees to stimulate demand and bring about inflation immediately, and the way the Treasury has recently expanded the fiscal deficit and the Fed has increased its balance sheet (see Figure 5). My vouchers stimulus runs out when the vouchers expire, and the Treasury's and the Fed's stimuli run out when these esteemed institutions stop increasing them! But my point is that if a government is determined to create inflation and negative real interest rates, there is really nothing standing in the way of its doing so.

Naturally, both voucher and money stimuli lead to enormous economic and financial volatility. In this respect, I urge my readers to read R.A. Radford's "The Economic Organisation of a P.O.W Camp", in Paul A. Samuelson, John R. Coleman, and Felicity Skidmore (eds), Readings in Economics (McGraw-Hill, 1952). (For those people who have little time to read, this is a superb book about economics and contains brief contributions by economists such as Malthus, Marshall, Boehm-Bawerk, Taylor, Hayek, Tobin, Friedman, Samuelson, Schumpeter, Ricardo, Bastiat, Rostow, Kuznets, Burns, Eckstein, Keynes, and Kindleberger, and many more.)

Radford describes how in a prisoner's camp during the Second World War cigarettes became the principal "currency" and how prices compared to cigarettes fluctuated widely. The Red Cross would make weekly deliveries of cigarettes to the P.O.W. camp and prices would subsequently fluctuate largely as a function of the quantity of cigarettes delivered. When plenty of cigarettes were delivered the prices of other goods would increase; conversely, when the supply of cigarettes was scarce, prices would deflate. Radford concluded that "the economic organisation described was both elaborate and smooth- working in the summer of 1944. Then came the August cuts [in the delivery of cigarettes by the Red Cross - ed. note] and deflation. Prices fell, rallied with deliveries of cigarette parcels in September and December, and fell again. In January 1945, supplies of Red Cross cigarettes ran out and prices slumped still further: in February the supplies of food parcels [to a lesser extent, food also was used as medium of exchange - ed. note] were exhausted and the depression became a blizzard. Food, itself scarce, was almost given away in order to meet the non-monetary demand for cigarettes."

Radford never won a Nobel Prize for his observations about the economics of a P.O.W. camp, but they taught me far more about relative and absolute price movements than did economists at Ivy League schools. When supplies of cigarettes (money) increased relative to food items, prices for food rose more than for cigarettes; and when supplies of cigarettes fell, food prices fell more than prices of cigarettes. In other words, the successful P.O.W. camp hedge fund traders had to constantly adjust their investment position between cigarettes (money) and food (assets), depending on their relative supplies. This is the investment environment I expect for the foreseeable future.

Dr. Marc Faber
for The Daily Reckoning Australia

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A friend of mine, Michael Berry, whose missives I always read, could not have phrased this better than in "Importance of the Individual", a recent report in which he quotes Milton Friedman (whose views I fully share in this particular instance) in an interview with Phil Donohue.

According to Berry, "On February 11, 1979 Milton Friedman took 2-1/2 minutes to explain the critical importance of the individual and choice in the free enterprise system to a doubting Phil Donohue. I wonder what Dr. Friedman would say 30 years later about our current predicament and the role government is assuming in our lives? The individual's freedom and ability to choose and take risks to create value are, of course, all important life elements and a cornerstone of our country.

"Individual ability to choose and take risk is being suppressed. It is increasingly evident that it is the government that is defining risk and the taking of risk. The sanctity of Moral Hazard has now been repeatedly breached by both recent administrations. We must guard these life elements jealously. Please take time to ponder the Friedman interview.

"Unfortunately in the current partisan atmosphere in Washington the role of the individual and that of individual risk taking is being suppressed. When the President of the United States uses the 'Bully Pulpit' to criticize institutions for not 'playing ball' (Chrysler debt holders) and forces a CEO to resign (GM's Wagoner), when a Treasury Secretary and Chairman of the President's Economic Council team up to run an auto company (General Motors), and when no institution is too large to fail (the other side of individual risk taking) something is seriously amiss. Under the guise of saving the economy, there is a not so stealthy encroachment on the rights of the individual. No one is noticing.

"This is not, 'Change We Can Believe In.' It is 'change we must be wary of.' Where is Milton Friedman when we really need him? Think carefully about the following interview which was conducted 30 years ago. Another read of Friedman's 'Free to Choose' is in order for all. We pray that Washington will not stray too far."

Phil Donohue: When you see around the globe the mal distribution of wealth, the desperate plight of millions of people in underdeveloped countries. When you see so few haves and so many have-nots. When you see the greed and the concentration of power. Did you ever have a moment of doubt about capitalism? And whether greed is a good idea to run on?

Milton Friedman: Well first of all tell me, is there some society you know that doesn't run on greed? You think Russia doesn't run on greed? You think China doesn't run on greed? What is greed? Of course none of us are greedy. It's only the other fella that's greedy. The world runs on individuals pursuing their separate interests. The greatest achievements of civilization have not come from government bureaus. Einstein didn't construct his theory under order from a bureaucrat. Henry Ford didn't revolutionize the automobile industry that way. In the only cases in which the masses have escaped from the kind of grinding poverty that you are talking about, the only cases in recorded history are where they have had capitalism and largely free trade. If you want to know where the masses are worst off, it's exactly in the kind of societies that depart from that.

So that the record of history is absolutely crystal clear, there is no alternative way, so far discovered, of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.

Phil Donohue: Seems to reward not virtue as much as the ability to manipulate the system.

Milton Friedman: And what does reward virtue? You think the Communist commissar rewards virtue? You think a Hitler rewards virtue? Do you think... American presidents reward virtue? Do they choose their appointees on the basis of the virtue of the people appointed or on the basis of political clout? Is it really true that political self- interest is nobler somehow than economic self-interest? You know I think you are taking a lot of things for granted. And just tell me where in the world you find these angels that are going to organize society for us? Well, I don't even trust you to do that.

Well, for sure you won't find any angels at central banks around the world and in the economics faculties of universities. I needed quite a stiff drink after reading a Wall Street Journal article by Harvard Professor Gregory Mankiw, who advocates creating negative real interest rates through inflation and seems to have great sympathy for the outright expropriation of savers. Professor Mankiw needs no introduction. His great intellect was revealed on February 1, 2000, dead ahead of the NASDAQ collapse, when he expressed the view in the Wall Street Journal that "when you look at the mistakes of the 1920s and 1930s, they were clearly amateurish. It is hard to imagine that happening again - we understand the business cycle much better."

The mindset of the US Federal Reserve and of a very large number of economists is perfectly reflected in the views of Mankiw, according to whom, "It May be Time for the Fed to Go Negative" (see Wall Street Journal of April 19, 2009). For the ease of the reader I have added some comments, which will be noted in italics and with a 'MF'.

Mankiw: With unemployment rising and the financial system in shambles, it's hard not to feel negative about the economy right now. The answer to our problems, however, could well be more negativity. But I'm not talking about attitude. I'm talking about numbers [MF: He means negative interest rates]... What is the best way for an economy to escape a recession? Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services - and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

There is no clear evidence that interest rate cuts stimulate lasting employment gains, because "lower interest rates encourage households and businesses to borrow and spend." If an industry is plagued by overcapacities (the oil and mining industry in the 1980s and 1990s), lower interest rates (interest rates fell throughout the 1980s and 1990s) are irrelevant. (The same applies for autos now.) In addition, interest rate cuts that encourage households to borrow and spend may not help employment in the country that implements such policies (the US after 2001) but instead in another country (China), where production costs are lower and where a large pool of savings is available for capital spending. (Also, it is not consumption that creates prosperity but capital formation.) To his credit, Mankiw recognizes this problem. He writes:

Mankiw: The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them...

So why shouldn't the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3%? At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less. Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10%. That move would free the Fed to cut interest rates below zero.

People would be delighted to lend money at negative 3%, since losing 3% is better than losing 10%. Of course, some people might decide that at those rates, they would rather spend the money - for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn't a flaw - it's a benefit. [MF: I think that most people would choose to invest in another country where savings wouldn't lose 3% per year.]

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell's concern about cash hoarding suddenly seems very modern.

Silvio Gesell (1862-1930) was a rather obscure economist, but a cult formed around his more outlandish socialist and land nationalization ideas. He was the author of Die Reformation des Münzwesens als Brücke zum Sozialen Staat (The Reformation of the Monetary System as a Bridge to a Social State - read "socialism").

In fact, I had forgotten about him until Mankiw brought him up, but I remember well how my history teacher in high school - who also had a socialist tick, but was an outstanding historian - discussed him at length in the context of socialism and land reforms through expropriation. (Right throughout the course of history, this has never worked. Also, Gesell's tax on cash had more to do with soaking the rich than stimulating consumption.)

In 1919, Gesell was called to take part in the Bavarian Soviet Republic by Ernest Niekisch. The Republic offered him a seat on the Socialisation Commission and later appointed him as the People's Representative for Finances. Fortunately (for the world), his term of office lasted only seven days. After the bloody end of the Soviet Republic, Gesell was held in detention for several months and was later acquitted of treason. Unfortunately, he never had the opportunity to read George Orwell's Animal Farm - published in 1945 - which refuted most of his arguments for a "social state".

Regards,

Dr. Marc Faber
for The Daily Reckoning Australia

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In fact, I hesitate to make any forecast because I am faced with the following dilemma: Yes, as Ed Yardeni argues, we are in a recession; and yes, as Ian Scott of Lehman Brothers thinks, corporate profits could conceivably decline by as much as 45% if the United States were to slip into recession. But equally, as these economists and strategists argue, the stock market could move up despite poor economic growth and declining corporate profits. This scenario is particularly likely if the Fed pushes the Fed fund rate towards zero and if "extraordinary" monetary measures are implemented with increasing intensity - and also by non-U.S. central banks, which is now increasingly likely.

After all, anything is possible in a land of plenty (at least of dollars, deficits, and unfunded liabilities) in a country where one out of every 100 adults is behind bars (a total of 2.32 million); where the fear of its legal system is such that - according to a survey of 180 in-house counsel working in five European countries - lawyers working for European businesses would prefer to face a major dispute in Russia or China than in the U.S.; where stock car auto racing is the most popular spectator sport (the National Association for Stock Car Auto Racing holds 17 of the top 20 attended sporting events in the United States); where the movie 10,000 BC, described by critics as a "bombastic bore" and "sublimely dunderheaded", opened in early March at No. 1 with box office earnings of US$35.7 million, ahead of College Road Trip with US$14 million (to be fair, it was also No. 1 in Mexico); and where almost three years into an economic recovery (June 2004), the Fed fund rate was still at 1%!

Yet, I have my doubts about forecasts of the S&P 500 going above 1600 by year end, and of the Dow Jones being at between 18,000 and 20,000 within a year (see above) because, in my opinion, the credit cycle has turned down for good - and when this happens, all asset prices and the economy tend to perform poorly. It would also be extremely surprising if the financial problems that we are now confronted with, which have been fermenting for at least 15 years, were to be solved almost overnight by Mr. Bernanke & Co.! Equally, it would be the first time in my experience that the stock market had made a major low with so many commentators assuring us that a "low" is in place. Not to mention above-average valuations!

Lastly, if money moves out of money market funds into riskier asset markets such as equities, it is likely that interest rates will increase and contain a sharp stock market advance. I therefore maintain my very negative stance towards long-term Treasury bonds.

While I concede that sentiment data is very negative for the near term and so, from a contrary point of view, is supportive of an intermediate low, investors seem to be very complacent and far too optimistic about future corporate profits. A recent Merrill Lynch Fund Manager Survey found that 53% of U.S. fund managers thought a recession in the next 12 months to be "unlikely", up from 35% in February!

For now, I still think that a likely outcome is a "water torture" bear market α la 1973-1974, during which the downtrend was continuously interrupted by sharp countertrend rallies. A rally towards 1450 on the S&P is possible. In mid-March, commodities began to sell off sharply. This is an ominous sign, as it indicates either that the credit crisis is spilling over into asset classes other than equities or that global economic growth will disappoint, or a combination thereof. Last month, I suggested that some "preventive selling of industrial commodities, steel, and iron ore companies might be advisable".

I would like to reiterate here that in an environment of relative tightening of monetary conditions, commodities (including oil and art prices) should also correct meaningfully. This doesn't change my long-term favourable view about the performance of commodities relative to U.S. financial assets. Should oil prices decline, the prime beneficiaries will be airlines. AMR, Thai International, Singapore Airlines, and Lufthansa could be bought for a short-term trade.

The trend over the past few years has been a relative underperformance of U.S. assets versus foreign stock markets - especially emerging stock markets, a weak U.S. dollar, and strongly rising prices for precious metals and other commodities. This broad trend could change for the intermediate term (three to six months). As indicated in last month's report, U.S. equities have begun to outperform the MSCI World Index and I expect this outperformance to last for a few months. This doesn't necessarily imply that U.S. equities will rise, but should they decline further then it will probably be by less than we would expect to see in foreign markets.

Gold remains my favourite asset class, but I wouldn't rule out a decline in prices to below US$800 before the next upward leg gets under way. As Ron Griess observes, the gold price has tended to bounce off the 300-day moving average - currently at US$741. The U.S. dollar may have reached a selling climax in mid-March and I expect a rally, which may have some legs as dollar shorts will be quick to cover their positions.

Regards,

Marc Faber
for The Daily Reckoning Australia

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The above observation was penned by Johann Wolfgang von Goethe and may be very prescient in today's economic and financial conditions.

Let us assume that the unthinkable happens: China's economy slows down sharply, or even contracts - and there are reasons why it could. Commodity prices slump and bring about economic hardship in the resource-producing countries of the world. In turn, these countries' imports of capital and consumer goods from Europe and Japan decline.

We would then have the perfect setting for a global economic contraction with dire consequences for corporate earnings and asset prices.

Now, I concede that this scenario is not very likely to occur. However, on a recent visit to Dubai, I could see how it might unfold. I have been travelling to the Middle East since 1977, and I experienced first-hand the oil boom of the late 1970s and the collapse in equity and real estate prices when oil prices fell in the early 1980s. About three years ago, on a visit to the Middle East, I felt that the gigantic
equity boom would come to an end.

In 2006, most of the Middle Eastern stock markets declined by 50% or more, though the economies didn't suffer. Yet, over the last three years, it has seemed to me that there is something not quite right about the enormous construction and economic boom that Dubai and other Middle Eastern countries are experiencing. (The world's tallest buildings are going up there....) What if oil prices were to decline? But why would oil prices decline? Obviously, oil prices would decline because of diminished demand for oil from China and other rapidly growing emerging economies.

But why would demand for oil from China slow down or decline? Obviously, because of an economic recession! The assumption that the Chinese and other emerging economies will continue to expand rapidly may prove to be very deceptive. In recent years, the US has experienced a credit boom and China has had a capital spending boom. Both could come to an end at about the same time! I also wish to stress that there is enormous connectivity between all the world's economies and that it would be wrong to assume that the present financial crisis, whose epicentre is the United States, couldn't be followed by financial and economic crises elsewhere.

Also, if the Dubai boom was an isolated event, I wouldn't be particularly concerned. But everywhere I travel I am left with the uncomfortable feeling that the current boom is surreal and unsustainable. The INDABA - the annual conference for natural resources professionals - which I attended earlier this year in Cape Town, has become a huge circus reminiscent of the consumer electronic shows held in Las Vegas in the late 1990s.

And whereas I have a relatively positive view of commodities, I doubt that all these mining executives (predominantly promoters and liars) will make as much money as they hope to, simply because exploration and mining development costs are soaring. Every major city around the world is also experiencing a huge condo and office construction boom, and in resort areas there are enormous developments of secondary homes.

Should the financial sector contract, as I believe will occur for several years, will all these new offices find tenants? I also wonder if all the condo and second home buyers are aware of the maintenance costs of their units and that in over-supplied markets prices can decline sharply.

Lastly, I think that investors fail to appreciate fully the process of deleveraging after a period of accelerating credit growth. In a credit-driven economy, a deceleration of credit growth will depress all asset prices and tip the economy into recession. In this respect, I am particularly surprised that analysts still expect S&P 500 earnings per share to increase to above US$110 in 2009.

Over the past few months, I have discussed corporate profits a number of times and shared with my readers my concern that we are in the midst of an earnings bubble, which has been driven largely by an explosion of financial sector earnings.

Richard Berner, chief economist at Morgan Stanley, recently published an excellent study entitled "Downside Risk for Corporate Profits", in
which he opines: "I think the earnings outlook will disappoint.

"The US economic outlook has darkened and fading operating leverage, dwindling pricing power, and deteriorating credit quality will squeeze margins. Despite the benefit of a weaker dollar, slower growth abroad seems likely to tame the overseas earnings boom" (Morgan Stanley Research North America, US Economics, March 17, 2008). In

Berner's view, "the combination of slower growth and high operating and financial leverage in Corporate America made a contraction in earnings unavoidable even if the economy skirts recession". (He is referring here to the corporate earnings decline in the fourth quarter of 2007.) "Lower marginal but higher fixed costs have increased operating leverage. Corporate America's ability to exploit that leverage propelled earnings to record levels when growth was healthy. Strong increments to revenue went straight to the bottom line.... But leverage - both operating and financial - works both ways. Slower growth means that operating leverage is working in reverse, with decreases in revenues going right to the bottom line."

Berner's two principal concerns about US corporate profits relate to "operating leverage" and the fact that the "strength of overseas earnings" is about to be "challenged". Operating leverage is at present far higher than in the 1990s, which, according to Berner, could mean that "a deeper recession, especially one that spreads abroad, would promote a much more serious profit squeeze."

Berner shows that overseas earnings have increased from 15% of overall earnings 20 years ago to 31.5% at present, as "growth abroad - and the higher oil price that comes with it - are powerful engines for US earnings". I may add that a weak dollar is another extremely powerful driver of overseas earnings as a percentage of total earnings. Also, that "growth abroad - and the higher oil price that comes with it - are powerful engines for US earnings" supports my view about the extreme connectivity we now have between economies in the global economy.

According to Berner:

"[T]here's also a darker side to earnings from abroad. I worry about the potential for a vicious circle in transatlantic earnings. The US earnings downturn is already spilling over into weaker earnings abroad, especially in Europe. NIPA data show that US earnings remitted abroad in last year's third quarter declined by 7% from Q3 2006. No doubt such weakness was a factor in our European strategy team's recent earnings downgrade; they expect a 16% plunge in European earnings this year compared with the consensus forecast of a 7% increase. The impact of the US earnings downturn on Europe likely will be significant: US direct investment data suggest that about 2/3 of our payments abroad go to Europe.

"Such payments, which are earnings of US affiliates of foreign companies, crashed in the last recession - from a peak of $66 billion in Q1 2000 to a loss of $24 billion in Q4 2001. And for European companies the strength of the euro is a massive headwind: A 13% appreciation of the euro has magnified the earnings downturn in euros for European companies' US affiliates [as it has magnified US overseas earnings - ed. note). Together with tighter financial conditions, I'm concerned that weak earnings at European companies could contribute to a sharp deceleration in capital spending and in European growth. That would complete the circle, because it would also hurt US earnings abroad. About half of those overseas earnings originate in Europe."

I have pointed out above that there is now a much higher economic and financial connectivity in the world than has previously been the case. However, I have to confess that I hadn't thought about, and fully appreciated, how weaker US growth, manifested as declining profits in the United States, would affect the affiliates of foreign companies, which in turn would lead to lower US overseas earnings. Richard Berner's analysis is very perceptive! Also, I doubt that European stock markets have fully discounted the 16% plunge in 2008 European corporate earnings that Morgan Stanley has estimated!

Berner concludes his exposé of US corporate profits with the following - very politely phrased - remarks:

"Against this backdrop, what's really perplexing is that Wall Street analysts don't think that a weak 2008 will cast doubt on the vigor of next year's results. On the contrary, in what I think is fundamentally flawed logic, they have maintained the level of their 2009 estimates where they were, so that downward revisions to 2008 earnings actually boost the 2009 growth rate. Street estimates for 2009 S&P 500 earnings growth have been revised up to 15.5% from 14.7% at the beginning of January. By comparison, we expect a 5.9% increase in 2009 after-tax economic profits that would leave the level below that in 2007."

As an aside, a friend of mine, a very savvy and keen observer of economic and financial trends who doesn't mince his words, calls what the Street has done with 2009 S&P earnings estimates "criminally insane". I agree. After all, illusion is one of the most pervasive realities of life!

Marc Faber
The Daily Reckoning Australia

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• The Profits Depression

At the same time, the sharp decline in the yield of ten- and 30-year Treasury bonds and the collapse of lower-quality bond prices seem to indicate that a bad deterioration in US and world economic conditions is about to occur. Since, according to Philip Isherwood, equities tend to perform poorly when volatility is high, cash and bonds would seem to be a good alternative. But, stating his case in favour of US equities on CNBC, a US money manager made the comment that "money in cash is also at risk". This is certainly true for bank deposits, CDs all structured products, and even money market funds, because the return of capital is uncertain. In the case of Treasury securities, "money is also at risk" but for different reasons.

In the case of Treasuries, the return of capital won't be a problem for now, but I suppose that with a yield of less than 2% on two-year, 3.7% on ten year, and 4.5% on 30-year Treasury securities, the risk is that inflation (not that published by the government, but the cost of living increase for the median household), which is already higher than these yields, will over time completely eat away the purchasing power of the principal, including the interest.

I hope my readers understand the problem of interest rates, which are artificially low and below the rate of inflation. This forces investors, including individuals, institutional investors, and state and private pension funds, into risky investments, which as we have now seen can also lead to widespread losses. In fact, the losses are now so large that they threaten the entire financial system. I estimate that, when all is said and done, the losses experienced by the financial sector and investors brought about by Mr. Greenspan's and Mr. Bernanke's irresponsible monetary policies will exceed several trillion US dollars if we add up the combined capital losses on homes, nongovernment bonds, and equities.

Expressed in Euros or gold, the total wealth of the US has already shrunk by at least 40-50% since 2000. I don't have a high regard for any government (except, possibly, that of Singapore), but the most destructive course a society can embark upon is to appoint academics to positions of responsibility. A problem of artificially low interest rates that is seldom discussed is that many individuals depend on interest income in order to meet their living expenses. Equally, pension funds depend on a certain annual income to meet their present and future liabilities. Moreover, high interest rates provide investors with a cash flow, which can cushion downturns in asset values. Say, an individual or a pension fund owns a balanced portfolio: 50% in equities and 50% in fixed income securities of various maturities. Let's assume that, in a given year, the stock portfolio declines by 20%. If interest rates average 10% on the fixed income portfolio, the total loss on the portfolio will "only" be around 10%.

Moreover, the cash flow from the fixed income portfolio can be reinvested in equities. But what if the yield on the fixed income portfolio averages only 3%? Obviously, the opportunity to make up for the losses on the stock portfolio by investing the cash flow and averaging down diminishes. And what if the annual cost-of-living increases average 5% or more? In this case, the purchasing power of money will rapidly vanish. Moreover, because of negative real interest rates, consumer price inflation will accelerate, as was the case in the 1970s. At the same time, the "real" spending power of households whose income depends on fixed interest securities will be cut and their standards of living will decline.

My friend David R. Kotok, chairman and chief investment officer of Cumberland Advisors, writes regular insightful comments on the US financial market. Recently he stated: "We still have to deal with dysfunctional credit markets. The Fed must persist in their work of creating liquidity. Only time and transparency will relieve the problem of insolvency. That process is working, too. It takes time and it does and will succeed. Remember, there are no examples of Depression in economic history where stimulus was applied and where the inflation-adjusted interest rate was brought to zero by the central bank. That is the condition in the US today. In sum, stimulus works."

Well, David, on this one I must disagree with you. I know many economies where monetary and fiscal stimulus was applied and yet they still went into depression. In all these economies, the inflation-adjusted interest rates were not only brought down to zero but, in fact, significantly below zero. The failed experiment by John Law with paper money in France at the beginning of the 18th century ended with a depression, and money printing in Germany between 1918 and 1923 brought about total impoverishment of the German working and middle class. Latin America went through extremely poor economic conditions in the 1980s. (In Argentina, car sales declined by more than 50% between 1980 and 1988.)

However, in all these instances, the depression wasn't accompanied by nominal price declines but by hyperinflation and collapsing asset prices, GDP, and standards of living in real terms. In fact, I know of two little empires that, as a result of excessive monetary and fiscal stimulus, went bankrupt and ceased to exist: the Roman and Spanish empires.

Admittedly, these empires' rulers weren't as smart as our present-day leaders of Western democracies... .

Also, I was pleased to hear that Robert Mugabe (another academic with several degrees from Oxford and an honorary degree bestowed on him by China's Hu Jintao "for his brilliant contribution to international diplomacy and peace") has offered Mr. Bernanke a teaching job at the University of Harare. This will provide him with a first-hand opportunity to study the devastating impact of excessive monetary and fiscal stimulus on a society.

So, to a large extent, I agree that "money in cash is also at risk", because there is the risk either of default or that money's purchasing power will decline. Also, I am beginning to wonder for how much longer buyers of ten- and 20-year Treasury bonds will accept their low yields, which are now below the cost-of-living increases and below nominal GDP. The poorly delivered, contradictory, and incoherent statements made by Mr. Paulson and Mr. Bernanke at a recent Senate hearing didn't provide much comfort to holders of US fixed interest securities. Not surprisingly, gold has more than doubled since Bernanke was appointed Fed chairman, while the yield on 30-year US government bonds is higher now than before the January 125 basis points Fed fund rate cuts.

Surely, the Fed can cut the Fed fund rate to zero. But this doesn't mean that longer-dated bonds will rally. If inflation were to accelerate further, rate cuts would inevitably lead to higher long-term rates and capital losses on long-term bonds - particularly if the dollar weakens further! In other words, the Fed can bring down short-term interest rates, but it has little power over the longterm bond market. I may add that one of the problems of hyperinflating economies is that the long-term fixed rate bond market ceases to exist.

I should like to introduce one more thought. Throughout most of the 1970s interest rates were below the rate of nominal GDP growth and negative in real terms. So, what happened? Inflation accelerated, bond yields soared from 6% in 1970 to above 15% in 1981, and the US dollar tanked. After 1981, we had for most of the following 20 years bond yields that were above both nominal GDP growth and the rate of inflation (positive real interest rates).

What happened? We had a lengthy period of disinflation. Also, because real interest rates were particularly high in the early 1980s, we had a huge US dollar rally between 1980 and 1985. After 2001, we again had interest rates that were below both nominal GDP growth and cost-of-living increases, which led to the unprecedented credit inflation we experienced between 2001 and 2007 and the subsequent historic bust.

Now, let us assume that market participants begin to believe in the nonsense Mr. Bernanke has been coming out with concerning "money printing" and "dropping dollar bills from helicopters" in order to stabilize asset markets and avoid economic downturns. They will begin to realize that he is the messiah of the gold bulls and the arch-enemy of sound money.

What will investors do? They will dump bonds and the US dollar en masse. In this context, it is interesting to note that recently, on very poor economic statistics, bonds didn't rally but sold off. The Institute for Supply Management's non-manufacturing index, which is representative of almost 90% of the US economy, fell in January from 54.4% to 41.9%. (A reading of 50 is the dividing line between growth and contraction, and the index has averaged 57.6% since its inception in 1997.) January retail sales - closely scrutinised - were a disaster and confirmed my view that US economic statistics published by the government misinform the public about the true state of the economy.

How can January auto retail sales increase by 0.6% when volume sales were down 6% month-on-month? According to David Rosenberg, in addition to declining sales at department stores (down in three of the last four months), sporting goods and book stores, furniture and building materials stores, sales at electronic stores were down 1% in January on top of a 2.5% slide in December, which represents the worst back-to-back performance since the 1990 recession. According to Rosenberg, the "bottom line is that the cyclical components of retail sales - autos + clothing + furniture + electronics + sporting goods + building materials + department stores - were down 0.1% in January.

By way of comparison, spending on gasoline, food and health care rose 1.1% collectively for the month."

The poor state of the economy is reflected by the collapse of the ABC News/ Washington Post Consumer Comfort Index and its various components. The personal finance component is now lower than it was in 2002. Also, the University of Michigan index of consumer sentiment collapsed in January to its lowest level since 1992. According to Rosenberg, "consumer sentiment is now at a level that is telling us that we are not on the eve of a recession but are rather already several months into the downturn".

As I have noted in earlier reports, the US economy is already in recession in real terms, but this fact is obscured by the government's grossly understating price increases throughout the economy. Despite, in my opinion, horrible economic statistics (in real terms), the Fed needs to be very careful not to disturb bond holders by "printing too much money" (electronically), which - aside from the collapse in lowerquality bonds that had already occurred - would also lead to a rout in long-term government bond prices. At the same time, the US must be increasingly careful about its budget deficits and about bailing out the entire financial sector, which is loaded with crappy paper.

Otherwise, Treasury securities will reach "junk status" sooner than I had expected. But I can very confidently predict that, in the long term, US debt will become "junk"!

So, whereas under a sound monetary regime high-quality bonds would be - like utilities - a candidate to outperform, under a central bank that lacks any monetary discipline they are a rather dangerous investment. But this isn't to say that, at some point in the current downturn, distressed lower-quality bonds won't provide a great buying opportunity.

Regards,

Dr. Marc Faber
for The Daily Reckoning Australia

• The Problem With a Well-Diversified Portfolio
• Citi Reports $4.69 Billion in Fixed Income Trading
• Fed Willing to Print Money to Buy More Bonds to Keep U.S. Interest Low
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• U.S. Thirty Year Bond Hits Thirty Year Low

The Fed has the Treasury and the government, as well as the Wall Street elite, as allies. The government could implement massive tax cuts in order to stimulate economic activity; the Treasury could bail out financial institutions, which in reality should be punished by bankruptcy; and the monied Wall Street elite will ensure that politicians and the Fed make it possible for them to continue their con-game. The private sector has allies in the form of inflation, a weak dollar, and a dissatisfied public (declining consumer confidence and lack of trust in government, which is reflected by the strong showing of Ron Paul), all of which form a powerful phalanx when battling the Fed's reflation attacks. Inflation is a powerful ally for the private sector because it squeezes corporate profits and curbs personal consumption.

According to David Rosenberg, with 90% of companies reporting, third quarter operating EPS fell 8.5% year-on-year; while reported earnings, which include charge-offs, fell 28% year-on-year! Rosenberg also notes that "at $15.29 reported EPS for the S&P 500 in the third quarter of 2007, the P/E multiple on this basis is a lofty 23x - not the 18x 'cheap' multiple (or 14x on forward estimates) that is constantly being bandied about in the media." He adds dryly: "[T]he current $15.29 estimate for reported EPS is the lowest level of earnings since the fourth quarter of 2004. And where was the S&P 500 trading at that time? Answer: It averaged about 1,162 that quarter - just in case you were thinking of buying this dip." (I can't wait to hear the Goldilocks' crowd's positive spin on these dismal earnings.)

The war between the Fed and the private sector will, in my opinion, be very protracted. The Fed will win some battles, which - along with much brouhaha in the media - will see Pyrrhic victories such as the stock market rally of August to early October, which led in dollar terms to new highs but failed to do so in Euro and gold terms, and was followed in Euro terms by renewed severe weakness. (Just for the record, as of this writing, the S&P 500 is down 9% year-to-date in Euro terms, having peaked out in June.)

Other battles will be won by the private sector, which through its contraction (recession) amidst inflation will lead to sharp downward movements in equity prices.

I am well aware that the Bureau of Labor Statistics and the Bureau of Economic Analysis will continue to use bogus figures when reporting inflation, and hence real GDP growth, but they won't be able to hide the squeeze on corporate profits and the consumer from rising prices. I am writing this report at Thanksgiving, an opportune time to point out that the American Farm Bureau Federation has calculated that the cost to feed ten people dinner in 2007 is US$42.26, up 10.9% from last year and the biggest year-on-year increase in over ten years (David Rosenberg has compiled a Thanksgiving cost-of-giving index, which amalgamates the prices of turkey, sweet potatoes, cranberries and gifts, as well as travel expenses: it rose this year by 7.9%.) I don't suppose these indexes took into account the rise in heating and electricity costs for the festivities, or the cost of a nice Bordeaux wine and bottle of Cognac, due to the weakness of the dollar. (I might add that in Switzerland it wouldn't be possible for ten people to be served Christmas dinner for that amount.)

But the point is simply this: cost-of-living increases vastly exceed the reported inflation figures and are squeezing the consumer, which leads to revenue pressure for the corporate sector. (According to the Kaiser Family Foundation, health insurance premiums have risen 78% since 2001, while wages have gained only 19% and "the government's inflation measure during that stretch was 17%".) At the same time, corporations are faced with a squeeze on margins due to rising costs.

Pressure on revenues and cost increases contributed to the dismal performance of earnings in the third quarter of 2007. For example, Starbucks (SBUX) increased prices by an average of 9 cents a cup in July. However, customer visits to US stores fell 1% for the quarter ended September 30. Starbucks' CFO noted that a "similar decline may occur in the fourth quarter although they will be positive for the full year". (This would seem to indicate that the economy slowed down considerably in the second half.) According to him, "unbeknownst to us, we saw economic headwinds that quite frankly came up probably stronger than I thought." Earlier, Starbucks' CEO had remarked: "The consumer is being faced with rising costs in every sector of their lives, and so part of that is reflecting on us." An informed friend of ours suggested that declining traffic at Starbucks stores in the US is of particular concern, since Starbucks serves all income levels.

Therefore, declining traffic is not just a "sub-prime problem"! I should now like to reiterate what I have explained on a number of previous occasions. Rather than paying too much attention to the media and to analysts' positive spins, it will pay to watch the market action of equities as a forecaster of business prospects. Starbucks' stock made a double top between May 2005 and November 2006. After that its shares went downhill, although the stock market continued to rise to its final peak in mid-October 2007. This should have been a warning sign that Starbucks fundamentals were deteriorating.

Similarly, the fact that retail stocks failed to better the July high in the recent August 16 to October 11 rally, which led to a new all-time high for the S&P 500 in dollar terms (but not, as we have shown, in Euro terms), isn't a good omen for retail sales, consumption, and the economy. I am not the only person who questions the economic statistics published by the US government: writing recently for Kate Welling (welling.weedenco.com), Lee Quaintance and Paul Brodsky of QB Partners observed:

"...the credit markets finally clogged towards the end of Q2 2007, closing the major private sector artery policymakers had been using to synthesize domestic output (expressed in nominal dollar terms through nominal GDP growth). True to form, they began creating U.S. dollars out of thin air at an accelerated rate in Q3 2007 (14.7% annualized). The Bureau of Economic Analysis (BEA) published nominal U.S. GDP growth at an annualized rate of 4.7% in Q3 2007. Taking the BEA's figure at face value and subtracting the annualized rate of monetary inflation, we believe inflation-adjusted U.S. GDP contracted at about a 10% annual rate in Q3 2007. This rate of economic contraction would seem to be consistent with the analysis of the corporate profit slump discussed above, and with the observations made in earlier reports that the US economy is already in recession.

Regards,

Marc Faber
for The Daily Reckoning Australia

Editor's Note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow's Gold , one of the best investment books on the market. Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

• None Found

The stock market peaked out in July 1998, after having been in an uptrend since the 1991 lows. It then sold off on the Russian default and on the LTCM crisis by 22% to its intraday low on October 9, 1998. When it became obvious that the Fed would bail out LTCM, and it flooded the system with liquidity, the stock market took off. Between the October 9 intraday low and the year end, it rallied by 33%, to achieve a new all-time high, and then continued to rise — interrupted by a correction in 1999 — into the final March 2000 top.

Pundits who are likening today’s market rout to that of 1998, and who expect the market to rally strongly towards the end of this year and to close at a new all-time high, are failing to consider the very different economic and financial circumstances of today, compared to those of 1998. In the years leading up to the 1998 crisis the US dollar was in a bull market, and interest rates - which had peaked in September 1981 - were in the middle of a secular decline. At the same time, gold and other commodities were still deflating. Also, in the 1990s, the US stock market had significantly outperformed the emerging markets, most of which had peaked out between 1990 and 1994 and had crashed during the Asian crisis of 1997-98.

Therefore, in 1998, the emerging markets and commodity prices were very depressed (unlike today). Moreover, in 1998, house prices weren’t elevated, the subprime lending industry was in its infancy, Japan and Europe were largely stagnant, and Asia and Russia were in depression (i.e. there was no synchronised global growth). The process of securitisation existed, but was very modest when compared to the present.

Today, the key difference is that the dollar looks extremely wobbly. In 1998, the US current account deficit was 2% of GDP; today, it’s hovering around 8%. This massive deficit puts continuous pressure on the dollar. Moreover, gold and other commodities are in an uptrend. There is another reason why conditions today are very different from those in 1998: in 1998, total credit market debt to GDP was 250%; today, it’s 330%. In addition, whereas debt growth averaged 4% per anum in the 1990s, it has averaged almost 10% per annum since 2002. In particular, household debt has surged from 65% of GDP in 1998 to almost 100% in 2007. Since debt growth has been so strong in the last few years, and because the system is now far more leveraged than in 1998 (not to mention the derivatives market), a tidal wave of liquidity would be needed to bail out the system, which would have to lead to even stronger debt growth; but, obviously, it would
only lead to even larger dislocations and problems later.

Another difference: in 1998, the Fed had to deal with the bailout of just one institution — LTCM; today, who should it bail out: the subprime lending institutions (it’s too late), leveraged home owners, the US$2 trillion-plus collateralised debt obligation (CDO) market, or the financial institutions, which are now stuck with over US$200 billion of leveraged buyout (LBO) loan commitments which they cannot sell to investors? So, whereas it was relatively easy to bail out just one institution in 1998, today the task would be extremely complex and daunting. Of course, the Fed could try to bail out everybody by cutting the interest rate aggressively and taking “extraordinary measures”, such as buying up the entire CDO market. [Editor’s note: Faber wrote the words above in late August, well before the Fed’s aggressive rate cut yesterday.]

Aggressive Fed fund rate cuts may not help much for the following reason: from June 2004 to August 2006, the Fed increased its fund rate in 17 baby steps from 1% to 5-1/4%. During this period of “tightening”, no actual tightening took place because credit growth accelerated as lending standards were eased and leverage increased. Moreover, as Bridgewater Associates recently pointed out, “globally, central banks have kept interest rate levels out of line with economic growth rates”. So, even if the Fed were to cut rates massively now, it is unlikely that it would stimulate credit growth, which, as I have explained repeatedly in the past, must continuously expand at an accelerating rate in a credit- and asset-driven economy in order to keep the economic plane from losing altitude. Accelerating credit growth is most unlikely now, because I cannot see how financial intermediaries will ease lending standards any time soon after the losses they have recently endured and following their dismal stock performance.

In addition, being fairly familiar with the cowardly attitude of investors, it is most unlikely that investors will now wish to buy anything other than top-quality paper and solid companies’ shares. Therefore, I can see only one solution if the Fed really wanted to attempt to bail out the system, and that would be for it to drastically cut interest rates. Unfortunately, massive interest rate cuts at present may not help much and could potentially have very negative side-effects (an even weaker dollar, inflation, rising long-term interest rates, further widening of income and wealth inequity etc.)

The crises that build up in international financial structures always ricochet from country to country…. Boom, distress and panic are transmitted through a variety of connections between national economies: psychological infection, rising and falling prices of commodities and securities, short-term capital movements, interest rates, the rise and fall of world commodity inventories.

These connections, moreover, can take various forms, and may be interrelated in various ways…. Boom and panic in one country seem to induce boom and panic in others, often through purely psychological channels…. Just as one huge bubble breeds others in a country, so a host of bubbles in a financial market seems to inspire the production of others in other countries.

For the last several years, investors have enjoyed a massive global boom. But they should not rule out a massive global panic.

Dr Mark Faber
The Daily Reckoning Australia

• None Found

As in the case of the US, but in a more extreme way, while stocks are soaring in Zimbabwe, the currency is collapsing. (In fact, it is an exact replica of what happened during the Weimar hyperinflation of 1919-1923, in local currency terms, the stock market index soared into the trillions but collapsed in gold terms.) John Paul Koning, an analyst at Pollitt & Co in Toronto and writing for the Mises Institute, has made the following pertinent observation about the Zimbabwe Stock Exchange:

"The ZSE is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they've already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicide.

"Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability. As for capital improvements, there is little incentive on the part of companies to invest in their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe's policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.

"Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions, and not changes in GDP. New money gets spent or invested. In Zimbabwe's case, because there are no alternatives, it is stocks that are benefiting. This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock markets over the preceding twenty-five years has been created by a vastly increasing money supply, and how much is due to actual wealth creation.

"Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency."

Now, I don't anticipate that a Zimbabwe-like scenario will unfold in the United States soon, but the phenomenon of investors realizing that cash deposits don't give them adequate protection from the loss of their paper money's purchasing power and therefore rushing into any kind of asset is the same everywhere in the world. Also similar is the increase in asset prices in local currency in Zimbabwe and the United States, and the collapse of the Zimbabwe dollar and, to a far lesser extent, the decline in value of the US dollar.

Still, for now, there is some hope for the US dollar. As explained in last month's report, it is not the Fed that has tightened monetary conditions, but the marketplace through the collapse of the sub prime lending industry. Since the housing market is more likely to deteriorate further than to recover, credit problems could get much worse. In any event, Robert Toll, CEO of Toll Brothers (NYSE: TOL), just sold another US$8.3 million worth of shares. Since his company's shares are down from almost US$60 in 2005 to US$27, his selling would indicate that he doesn't see any immediate turnaround in the housing industry.

Moreover, there are several reasons why the Fed is unlikely to cut interest rates in the near future. Food and energy prices as well as import prices are rising, which could further increase inflationary pressures. The dollar is also in a very precarious position, and bond yields have so far failed to decline despite evidence of an economic slowdown.

Finally, I suppose Mr. Bernanke understands very well the difficult position he finds himself in as the chairman of the Fed. Should inflation under his chairmanship at the Fed become a problem, he knows that he will be blamed for it. Conversely, he is also well aware that if some sort of recession occurred due to a currently somewhat more hawkish monetary stance, financial observers will be quick to blame Mr. Greenspan for it, since the former Fed chairman addressed any financial crisis or any potential problem (Y2K, for example) by printing money and can thus be considered directly responsible for the housing bubble.

So, from a career and reputation risk point of view, Mr. Bernanke will likely move very slowly in cutting rates and rather take the risk of some mild form of recession occurring. He could then blame a recession, which would have come from the housing sector, on Mr. Greenspan. After that, he could take some "extraordinary monetary measures" in order to engineer an economic recovery for which he would take credit. And should at that time inflationary pressures have failed to abate or have even increased - as I would expect them to do - he could always argue that the Fed's policy priorities have temporary shifted to emphasize "economic growth" over "targeting inflation", and that the Fed will deal with inflation once the economy has fully recovered. The stance of emphasizing "economic growth" over "inflation targeting" would by then also be perfectly acceptable politically and thus would be welcomed by the "establishment", which would have taken advantage of a bear market in housing and hardship among sub-prime borrowers to acquire some assets at bargain prices…

I am mentioning this because as my friend Bill King, author of The King Report reported, Ben Bernanke recently gave a speech at Stanford in which he said that "increased trade with China has reduced U.S. inflation, now running at about 2%, by only about 0.1 percentage point". He also noted that while emerging economies have added to the global supply of manufactured goods, they are also adding to the demand for oil and other commodities. And according to Mr. Bernanke, "There seems to be little basis for concluding that globalization overall has significantly reduced inflation in the U.S. in recent years; indeed, the opposite may be true."

And this is where I think the Goldilocks prophets with tunnel vision, who argue for continuous economic growth amid low inflation, will be as wrong as they have been for the past few years. The super-bulls on the US have simply overlooked the fact that if economic growth in China, India, Vietnam, and other emerging regions of the world remains strong and the US economy continues to expand, this synchronised global boom will be supportive of commodity prices whose price gains have significantly outstripped the performance of US financial asset prices since 2001. So, in the event, as the entire Goldilocks sect argues, that the global economy remains strong, inflationary pressures should increase. Commodity prices, especially for agricultural products, are in real terms still extremely depressed and, contrary to expectations, could rise far more than many would think possible.

However, illiquidity among the US household sector, along with the reluctance of the Fed to cut rates right away, combined with the requirements for enormous capital investments for infrastructure in emerging and developed economies, could lead to some tightening of liquidity around the world.

Therefore, I expect a more meaningful setback in asset prices and would certainly defer the purchase of financial assets. In particular, I am concerned by the inability of financial stocks to rally convincingly from their March 2007 lows, since financials are usually leading the market up and down. In my opinion, there is an ongoing deterioration in the US stock market. In the summer of 2005, the homebuilders peaked out. Last year, it was the turn of the sub-prime lenders to top out. And early this year, financial shares, including brokers, made their highs. The economy is likely to follow this slow stock market erosion and gradually deteriorate, with disappointing corporate profits to follow.

Investors who must own US shares may find some relative outperformance among pharmaceutical companies, and oil and coal stocks.  For the reasons outlined above (a relative tightening of liquidity in the world), I don't expect the US dollar to collapse immediately. However, it should be clear that in the long run the purchasing power of the US dollar will continue to decline against sound currencies such as precious metals. Therefore, I continue recommending the accumulation of gold and silver.

But it is increasingly likely that something will give soon: either asset prices will decline in a tighter liquidity environment, or the US dollar will fall sharply if the Fed continues to pursue expansionary monetary policies. For the US financial market, this means either weak equities and a strong dollar or strong equities and a weak dollar.

Not a particularly appealing scenario!

Regards,

Marc Faber
for The Daily Reckoning Australia

• None Found

In the 1990s, we had rolling bubbles in the emerging markets, but Japanese and Taiwanese equities were in bear markets while commodities continued to perform poorly. Finally, the last phase of the global high-tech mania (1995-2000) was accompanied by a collapse of the Asian stock markets and Russia, as well as a continuation of the Japanese and commodities bear markets. By the late 1990s, most emerging markets (certainly in Asia) were far lower than they had been between 1990 and 1994. In the 1990s, emerging markets grossly underperformed the US stock market

Currently, looking at the five most important asset classes - real estate, equities, bonds, commodities, and art (including collectibles) - I am not aware of any asset class that has declined in value since 2002! Admittedly, some assets have performed better than others, but in general every sort of asset has risen in price, and this is true everywhere in the world.

In the early phases of all previous investment booms, investors failed to recognize that the "rules of the game" had changed and continued to play the asset class that had been the leader in the previous investment mania. In the 1980s, every increase in gold and silver prices was perceived to be the beginning of a new bull market in precious metals (after silver prices collapsed in January 1980, prices doubled three times between 1980 and 1990 - all within a downtrend), while investors maintained a very skeptical view of bonds. In the early 1990s, investors failed to recognize the emergence of a high-tech sector uptrend, although, as explained above, high-tech stocks were already performing extremely well between 1990 and 1995. Global investors continued to believe in the merits of Asian stocks right to the end and actually stepped up their buying in early 1997!

Similarly, in the current asset inflation, investors have continued to focus on the high-tech bull market and have largely missed out on the huge increase in price of commodities, and of Indian, Latin American, and Russian equities. At the end of each investment mania, investors believed in some sort of "excess liquidity" that would drive the object of the speculation forever higher.

At the end of the 1970s, the "excess liquidity" related to the OPEC surpluses; at the end of the Japanese stock and real estate bull markets, "excess liquidity" centered around the enormous Japanese current account surpluses; during the 1990s emerging markets mania, "excess liquidity" was perceived to come from foreign buying and the Yen carry trade; and at the end of the high-tech boom the investment community believed that "excess liquidity" would come from record mergers and acquisitions, a reallocation of funds from bonds to equities, and easy monetary policies by the Fed (a belief that was fostered by the Mexican and LTCM bailouts and money printing ahead of Y2K).

But as Albert Edwards so eloquently explained in a recent scathing report entitled "Lies, rhubarb, poppycock, bilge, utter nonsense, caravans and liquidity" (see Dresdner Kleinwort Global Strategy Report, January 16, 2007), "liquidity is the hocus pocus of the investment world. It means totally different things to different people but is often cited as being a major driver for buoyant markets".

Most presciently, Edwards explains that with respect to investment manias, "when markets are rallying but seem expensive, when new issues fly out of the door and when fundamental analysis often appears to fail to explain events, the safe haven for the market commentator is often to rely on the explanation that there is lots of liquidity". I urge our readers never to forget these words!

What is peculiar to the current investment environment is that liquidity is supposed to come from not just one or two sources, but from everywhere! From OPEC surpluses, from the US Fed and other central banks, from the Asian current account surpluses (excess savings), from the Yen and Swiss Franc carry trade, from the large size of money market funds and bank deposits, from rising asset prices, leverage, and a tidal wave of private equity funds, and from artificially low interest rates. It's no wonder that, given such beliefs, asset markets are all flying to the moon!

In all the previous investment booms we discussed, the bull market was interrupted by severe corrections. Gold corrected by more than 40% between December 1974 and August 1976, equity markets corrected violently in 1987 (Taiwan and Hong Kong dropped by 50%), and bonds corrected sharply in 1983-1984, in 1986-1987, and in 1994. In the high-tech mania, technology stocks corrected sharply in 1995-1996 and in 1998. Between its 1997 high and its 1998 low, the Russian stock market gave back almost all its previous gains

In the current asset bull markets, we have, with very few exceptions (copper, zinc, oil, and sugar), not had a concerted and strenuous correction phase à la 1987 and 1998 (and certainly not in US equities). As the advance in previous investment manias matured, its leadership tended to narrow considerably. At the end of the 1970s' commodities bull market, only oil, copper, precious metals, and energy and mining shares were still rising. In Japan, most of the listed equities peaked out in 1987-1988, but financial stocks, including insurance companies, banks, and brokers, drove the index up until the end of 1989. In the rolling emerging market bubbles of the 1990s, most markets peaked out between 1990 and 1994 but some markets such as Hong Kong still managed to make a final high in 1997. In the TMT boom, the advance became extremely concentrated after 1999, with many tech issues only making marginal new highs in March 2000 or failing to better their 1999 peak prices.

In the current asset boom, we haven't yet seen any significant narrowing of the asset markets' advance (although Middle Eastern markets tumbled last year). Aside from a few commodities and US home prices and housing-related stocks, most asset prices are still rising, although admittedly with varying intensity.

A feature common to all great investment booms is that they were born from either an extremely low valuation in real terms, an extended base-building period, or from a lengthy and pronounced underperformance compared to other asset markets. In 1970, the gold price was no higher than in 1933, and down in real terms by 70% from its 1897 high. The Japanese asset boom, which had in fact begun back in the 1960s, led to the entire Japanese stock market having a stock market capitalization in 1970 lower than that of IBM. In other words, in 1970, Japanese equities were very inexpensive compared to the US stock market. In 1982, US stocks had declined by more than 70% in real terms from their 1966 highs. And although, at the time, US equities were, adjusted for inflation, no higher than they had been in 1899, to be fair their total real return (including dividends) was far higher.

Still, by 1982, including reinvested dividends, US equities were no higher than in 1961. Also extremely depressed were US bond prices, with bond yields at their highest level in the 200-year history of the US capital market. Taiwanese and Korean equities in 1984 were at about the same level they had been in the early 1970s and, adjusted for inflation, dirt-cheap. In the late 1980s, Latin American stock markets were, in US dollar terms, no higher than they had been in the late 1970s and far lower than in the early 1970s and early 1980s.

In 1990, US high-tech stocks were selling for about the same prices they had reached at their 1973 peak and for around ten times earnings. Compared to the valuation of the Japanese stock market in 1990, US high-tech stocks were then extremely depressed.

The 2002 asset price increase in all asset classes also included some asset classes that started to rally from extremely low inflation-adjusted prices or low valuations compared to some other asset prices. Particularly low inflation-adjusted prices were evident for commodities (which bottomed out between 1999 and 2001). And whereas the Nikkei had massively underperformed US and European equities in the 1990s, and was therefore relatively inexpensive compared to these markets, emerging markets had both underperformed US assets since 1990 and were, adjusted for inflation, very depressed.

However, not depressed (adjusted for inflation) or compared to other asset prices, were US equities. Moreover, following their 20-year bull market, US bonds - and especially Japanese bonds - were by no means depressed! Every epic investment boom lifted prices far higher than anyone could have imagined (although I concede that in the mid-1990s, Richard Strong told me that if Japanese stocks could sell for 70 times earnings in 1989, US equities could also sell in future for 50 times earnings). In 1970, no one dreamt that precious metals would increase by more than 20-fold. In the early 1980s, it would have been considered heresy to forecast that the Dow Jones would double and bond yields would decline to less than 4%! And investors certainly didn't expect the

Japanese stock market, which had already quadrupled in the 1970s, to rise by almost another six-fold between its low in 1982 and its high of 1989. In the late 1980s, few people expected the Latin American markets would ever recover; and in the early 1990s, no one (including myself) expected US high-tech stocks to become the best performing asset class in the 1990s.

Since the current asset price increases got under way in 2002 - and contrary to the expectations of some of the perma-bulls on US equities - commodities, and emerging stock markets and economies, in which, fortunately, platform companies are largely absent, have performed substantially better than US asset prices. Since 2000, the Dow Jones has lost more than 50% of its value against gold and much more against industrial commodity prices. Moreover, since 2002, the Argentine and Russian stock markets, whose economies are perceived as "knowledge absent" when compared to the great "knowledge-based" American economy, are up ten-fold or more!

Now, I will concede that the current "asset inflation" (a pompous and potentially dangerous notion, to quote my friends at GaveKal Research) may be far from over and that the end game in the current asset price increases is far from predictable, but, based on the experience of the previous four investment booms, it is likely that the significant diverging trends in the relative performance of asset classes (underperformance of US assets) will persist for far longer than is now expected.

Another common feature of the last stage of every asset boom was high trading volume, widespread public participation, high leverage, and money inflows into all kinds of money pools (Zaitech and Tokin funds, investment clubs, mutual funds, LBO funds, venture capital, private equity, emerging market, art and collectibles, and equity, commodity and index funds). In this respect, the current asset boom is no different than previous investment manias, except that it includes all asset classes and is taking place practically everywhere in the world.

In the four great investment booms we have described, and also in previous investment manias, once the boom came to an end, most, if not all, of the price gains that occurred during the mania were given back. In 1992, silver prices were lower than they had been in 1974. In 2003, the Nikkei was lower than at its high in 1981. In 2002, in dollar terms, most Latin American markets were no higher than in 1990 and most Asian markets had declined to their mid- or late 1980s level. By 1998, the Russian stock market had given back its entire advance since 1994; and in 2002, most high-tech and telecommunication stocks were no higher than they had been in 1996 or 1997.

And in those manias where prices didn't retreat in nominal terms to the level - or, as frequently happened, to below the level - from where the investment boom had begun (as was the case in 1932), prices retreated in inflation adjusted terms to those levels.

Adjusted for inflation, in 2001 the CRB Index was far lower than it had been in 1971, while precious metals, oil, and grains were all either no higher, or lower, than they had been in the early 1970s. Following all great investment booms, the leadership changed. The 1970s' precious metal boom was followed by the boom in financial assets in the 1980s. The Japanese stock and real estate mania of the late 1980s and the emerging market boom of the early 1990s were followed by the parabolic rise of high-tech stocks in the late 1990s.

Therefore, while it is possible that in a prolonged environment of "excess liquidity" all asset markets could continue to increase in nominal value, it is most unlikely that the leaders of the previous boom - the US stock market and, specifically, the TMT sector - will be the leaders of the current asset inflation. And whereas it may be premature to make a final judgment about this point, as the current asset inflation could last for much longer, so far the gross underperformance of US equities and especially of the Nasdaq (still down by 50% from its 2000 high) compared to the emerging markets and commodities seems to confirm that the leadership has indeed changed.

Regards,

Marc Faber
for The Daily Reckoning Australia

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