Yet there is a common thread to the current state of economic melancholy. It's money. Most failed marriages, we've heard, end up breaking up over money. Why would Europe or America or Australia be any different?

But before we get into family counselling, let's have a look at markets. Over in America the Dow Jones Industrials Index has closed at its highest level since October of 2008. The Dow sits at 10, 979 and has risen eight days in a row. Woop woop.

The volume figures on the Dow, however, show a disturbing lack of faith, or conviction if you prefer. The chart below shows the Dow since the March 9th low of 2009. It's been a pretty steady rise since then. But you can see that average daily volumes are less than half of what they were when the low was made a year ago. What does it mean?

"It's bearish. That's what it means," said Murray when we ambled over to his desk to show him the chart above. "It means there's a general lack of conviction by buyers. You'd want to look out below."

Where are all the buyers? Is the market just drifting higher based on programmed money flows by institutions? Granted this is an index of just thirty U.S. stocks. But it shows you that once you go below the surface of the index levels, the waters in the market are eerily calm and not frothy at all.

The other point about this is that in market-cap weighted index, a few key constituents can account for big day-to-day moves. For example, the table below from Standard and Poor's shows the top ten weightings in the ASX/200. The financials and the miners dominate, with property, telecom, and consumer staples all making cameos.

Click to zoom in on Top Ten Weightings table

In other words an up or down move in BHP or Commonwealth Bank has a bigger effect on the direction of the index based on the size of their respective market capitalisations. That sounds like gobbeldy gook. But the takeaway is you should beware light volumes and indexes whose higher movements are driven by just a few stocks. It shows a lack of breadth which can turn quickly and result in big sell off.

Now, you probably don't want to talk about this. But we need to talk about Greece. Its on-again, off-again bailout flirtation with the European Union is driving the market nuts. Its reality sovereign debt finance theatre at its most dramatic. But what, really, is at stake?

The European monetary family is in crisis. It meets on March 25th and 26th to discuss whether to kick Greece off the island (survivor style) or to intervene and save the prodigal son. The problem, from a German perspective, is that Europe is full of prodigal children. To save Greece means to save the rest of the economies troubled by rising public debt-to-GDP ratios. Where will it stop? With the trashing of the euro.

But is doing nothing an option? The Greeks have already said they will meet with the IMF on April 2nd if Europe resolves nothing by the end of March. And in the meantime, bond yields on Greek debt are left twisting in the wind. Rising bond yields wipe out the benefits of austerity measures and deficit reduction.

According to Bloomberg, "The yield on Greece's 10-year government bond rose 12 basis points to 6.21 percent. The euro fell for a second day against the dollar, slipping as much as 0.7 percent to $1.3648. Credit-default swaps on Greek sovereign debt rose 7 basis points to 295, the highest in a week, according to CMA DataVision prices."

It's hard to imagine the Northern European powers hanging Greece out to dry. Families are supposed to look out for each other. You do more for your family when the chips are down than you do for most people in the world. But maybe Greece will spare Germany the hand-wringing and default on its own....just throw up its hands and shrug.

The willing default on sovereign debt is what Societe Generale analyst Albert Edwards expects. In a note to clients earlier this week Edwards wrote, "Ultimately, as my colleague Dylan Grice writes, I think we head back to double-digit inflation rates as governments opt to default. I certainly again expect to see CPI inflation above 25% in the UK and indeed in most developed nations in my lifetime."

This is the old "asset-deflation-first-then-hyperinflation-later" two-step. It's the Big Crash dance, with the Bernanke/CNBC orchestra providing mellow tunes as your promenade your way to the lifeboats. Edwards writes that, "In the near term, however, the deflationary quicksand will suck us ever lower until we suffocate. A key driver for underlying inflation remains unit labour costs. While unit labour costs decline at an unprecedented rate, they are sucking us inevitably into a Fisherian, debt-deflation spiral. Only then will we see how far policymakers are willing to go to debauch the currency. Last year saw them cross the Rubicon. Monetisation is now the policy lever of first resort."

Some readers think we're trying to have it both ways on the inflation/deflation debate. But it is one of the issues you have to be flexible about and be willing to go both ways on in order to keep your money safe. Prepare for falling asset prices and a sovereign debt crisis. And then watch out as central banks reach out and take us to strange new monetary places and boldly go where Weimar Germany and Argentina have gone before.

Buckle up buttercup.

Dan Denning
for The Daily Reckoning Australia

• USA Has Fives Times As Much Sovereign Debt As All the PIIGS Put Together
• It’s the Little Economies that Have Trouble
• The Sovereign Debt Disaster
• Historians May Write: In Order to Save Greece, it Was Necessary to Destroy the Euro
• European Governments of the Eurozone are Separately Responsible for Their Euro-debt

Not only did investors and banks lose billions as Australia's financial engineers crashed, but hundreds of other companies, including the once venerable Rio Tinto and Australia's oldest property trust, GPT, desperately raised fresh capital from institutions at prices which would have been unthinkable a year earlier. The pain for retail (or 'mum and dad' shareholders) was compounded - not only did they suffer capital losses on their holdings and their dividends drastically reduced, but they were generally unable to participate in highly discounted capital raisings (the fruits of that were shares by a select few institutions).

Last year I spent several months working on what became Pigs at the Trough: Lessons from Australia's Decade of Corporate Greed. The book covered various examples of corporate governance failings and executive greed, providing 'lessons' to help shareholders avoid being caught in the next, inevitable, downturn (which, as Bill Bonner continues to suggest, could happen sooner rather than later).

The biggest story to come out of the spate of Australian collapses is that there was no real story. The bankruptcies of MFS, Allco and Babcock in particular all bore a striking resemblance. All three companies considered themselves 'asset originators' - that is, their business was essentially buying stuff and selling it to what was usually a captive satellite fund. Aside from the obvious issue that buying and selling assets like toll roads, coal terminals, hotel chains or Irish telecommunication companies adds no net value to society as a whole, but also, their entire business models largely consisted of charging excessive fees to captive vehicles.

The entire arrangement was made all the more sordid by the fact that the agreements between the mothership and the various satellite companies were intentionally withheld from shareholders. This was all allowed by the ASX. Perhaps coincidentally, various ASX directors also sat on boards like Babcock & Brown (Michael Sharpe) and Brisconnections (Trevor Rowe).

In terms of sheer audacity, the collapse of Babcock & Brown is difficult to top. Led by former tax lawyer Phil Green, Babcock grew from a small leasing business based in San Francisco to a diversified investment bank which at its zenith, had more than $70 billion worth of assets under management. Babcock's share price grew like a rocket in the late 1990s - rising from $5.00 when floated in 2004 to almost $35 in mid-2007 before the credit crunch took hold.

During that time Babcock's leading executives, like their investment banking brethren across the globe, gorged from the trough of fees. In four years as a listed entity, Babcock paid its top dozen executives almost $300 million in cash alone, along with a couple of hundred million of (ultimately worthless) shares. The cash remuneration paid was of course - not refundable. Sadly for shareholders, neither were the billions of dollars of losses racked up by the bank through foolish real estate deals and the grossly over-priced purchase of the already highly-engineered Western Australian power company, Alinta.

But it wasn't only the financial engineers which came crashing down as the market reassessed its tolerance of risk. The high-profile fall of Eddy Groves' ABC Learning Centers was even more remarkable given the business earned around half of its revenue directly from taxpayers. While Eddy Groves never received a large salary, his company paid more than $100 million to his brother-in-law, Frank Zullo, for untendered maintenance works at ABC's centres. ABC also paid Austock (the broking house which was partly owned by Groves) around $50 million in investment bank fees.

ABC surprised shareholders, banks and the Singapore Government when it announced that its fabulous business model wasn't really that fabulous. In fact, the company's $437 million loss in 2008 dwarfed all the alleged profits that the business ever made.

Then there were the somewhat more predictable collapses - the downfalls of the agribusiness twins - Timbercorp and Great Southern Plantations. Both companies were caught holding illiquid assets as they weren't able to refinance debt to support their Ponzi schemes.

The biggest problem from Timbercorp and Great Southern was that while their schemes timber and horticulture schemes provided a tidy tax deduction for city folk, many of the schemes didn't actually make any money. (In 2005 Great Southern admitted in the finest of fine print deep in its Annual Report that the company was funding its schemes after the company realised the woodchips it had harvested were worth less than the costs of planting and maintaining the trees). Great Southern told shareholders the bad news a couple of months after founder and managing director, John Young, sold $30 million worth of shares.

The common link across many of collapses?

Excessive use of debt coupled with almost universally poor governance practices and a remuneration structure geared toward short-term cash bonuses. Have we learned from the mistakes? If the real estate bubble and worldwide government indebtedness is any guide, it doesn't look like it.

Adam Schwab
for The Daily Reckoning Australia

• Trading Airline Stocks in an Energy Bull Market
• Warren Buffett is Buying Four Percent of Goldman Sachs
• 1% Aussie Interest Rate Cut?
• Is the Macquarie Model Dead?
• Coal Delays at Dalrymple Lead to a Longer Boom

Yes, dear reader, we have been a voice howling in the wilderness. First the wilderness around the Café des Dames in Paris's 19th arrondissement...recently the wilderness of Bethesda, Maryland...and lately the wilderness near the Taj Mahal Hotel in old Bombay.

Reading the TIMES of India is a delight. We see that a politician has been given a colorful, over-the-table bribe...a garland made up of 50,000 thousand-rupee notes (about $1 million)...

..a headless body has been found in Kandivli...26 people were killed when their bus fell off a bridge...

..and that more than half the population defecates in public.

In fact, India is Number One in outdoor Number Two, if our dear, delicate readers know what we mean. It has 10 times as many people defecating in public as the runner up, Indonesia. The US didn't even make the top ten.

The poor Indians. They can't handle alcohol. Research shows that Indians suffer higher rates of heart disease if they drink. Even light drinkers face a 40% higher risk of heart trouble, according to the study. Heavy drinkers' risk of heart problems is twice that of non- drinkers...still, well worth it, in our humble opinion...

"110,000 killed on India's roads and railways," says another news item.

"Is that all," we asked a colleague. Every time we cross a road we narrowly escape death. And we're being careful. Other pedestrians seem to ambulate in the middle of highways...beg between lanes of busy rush- hour traffic...and make daredevil dashes across chaotic intersections. It's amazing more aren't killed.

There's also an item that shows how India's civil justice system works. A landlord has finally won an eviction - thirty-three years after he went to court! The unauthorized tenant lived in the apartment for an entire generation before finally being booted out.

But wait...our beat is money. So back to the big money story...

Mainstream economists and mainstream financial media tell us that the worst is over...that the 'recession' has passed...and that things are getting back to normal.

Nope, we reply. Not a chance. The old economy that existed since the end of WWII is dead. No way could it recover; you can't revive a corpse.

It was beginning to look as though we would have to eat our words: the cadaver was sitting up in bed and watching TV.

Everything was beginning to look eerily normal, after all. A year after the stock market hit bottom, it still has not resumed its downward slope. Businesses that should have gone bust are still in business. Politicians who should have been run out of town on a rail are still putting their earmarks on everything. Bankers who should now be parking cars are still making loans.

The government is still misleading... Economists are still mis- interpreting... Investors are still mis-understanding...

..it sure seems like things are back to normal!

But something important has changed. And here comes the proof from the good ol' FT.

The FT, by the way, has the same dim economists as everyone else. While we wouldn't trust a government employee to manage a coffee shop, the FT's leading economist, Martin Wolf, thinks they can manage the whole world's economy. It's just a matter of getting the balance right, he thinks.

But beneath the surface of the flow of silly opinions and distracting noise, there is a powerful tide...an undertow that is sweeping everything out to sea. For the first time since 1946, household debt in the US is actually going down.

This is what de-leveraging is all about. The credit expansion is over. The tide has turned. Credit flowed for 61 years. Now it ebbs. No more increases in household credit. No more increases in consumer spending, over and above wage gains. No more extra sales. No more 'growth' at the expense of private sector debt.

It's over.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Historically, the Only Reserve a Central Bank Can Trust is Gold
• The Bonner Family Are Taking a Month Off to Paint Window Shutters
• A Life More Simple
• Bear Markets Do Not End With Stocks Still Trading at Nearly 20 Times Earnings
• US Economy is Some 11 Million Jobs Short of Full Employment

For proof of the first claim - that excessive leverage and too much debt cost Australian investors billion of dollars - read today's essay "Pigs at the Trough" by guest essayist Adam Schwab. Adam's got a new book out by the same name. And he makes a great point: Australia may not have learned much from the first round of the GFC.

But is there really going to be a round two? Well, if the first incorrect assumption was that Australia didn't have a bad debt problem, the second assumption is probably even more dangerous. It's more dangerous because it's the single most unexamined assumption behind much of Australia's economic prosperity. The assumption is that we'll always have China.

A growing number of professional investors are betting against China. It's true that all of these investors - short-seller Jim Chanos, our friend Dr. Marc Faber, Harvard Professor Ken Rogoff - are all talking their book to some extent. We all do that all the time. But that doesn't invalidate our arguments.

And the argument is simple: China's economy is the Greatest Bubble on Earth. James Rickards, the former General Counsel for the famously-failed hedge fund Long-Term Capital Management, told Bloomberg that China is in the midst of "the greatest bubble in history." He said the Chinese central bank's balance sheet, "resembles that of a hedge fund buying dollars and short-selling the yuan." "As I see it, it is the greatest bubble in history with the most massive misallocation of wealth," he told the Asset Allocation Summit Asia 2010.

Students of the Austrian School of Economics would identify with the comment. Credit bubbles - and the world has arguably been in one long once since the U.S. dollar could no longer be redeemed for gold internationally in 1971 - know that credit creates excess demand. It gives producers a false impression of the consumer appetite for goods and services. Real resources are poured into providing people with products they buy with debt-based money.

When the bubble bursts, the demand goes too. This is why Australia's government, slavishly obeying Keynesian dogma, has tried to "bring demand forward" or "support aggregate demand"
by giving away the nation's surplus. And once it was finished doing that, it borrowed (stole) from the future in order to support demand.

But this just perpetuates the misallocation of resources (in this case, stealing tomorrow's savings to support today's consumption.) In China's case, however, the misallocation of resources is even more impressive. There is massive over-capacity in commercial real estate with millions of square meters of vacancies. Whole cities lie empty.

These cities and office buildings were made with Australian iron ore and coking coal. If China's miracle economy (regularly achieving politically mandated 8% GDP growth to support employment) is really the world's largest collection of misallocated resources ever, then what do you think will happen to Australia's economy?

On the verge of another big increase in contract iron ore prices, it may seem like a strange time to ask the question. But it's probably the most important question Australian investors could ask themselves this year. "What can I do to protect myself against a crash in China?"

The possibility may seem remote. But remember, no one in the mainstream media or economics profession warned you of the GFC either, did they? Even if you think it's unlikely or absurd, it's probably something you should think about a bit. We've thought about it and we think the best answer is to retire now.

But what does that really mean? It means you should own a lot fewer stocks. But yes, that does contradict the rosy projections for Australia's super annuation system. Australia's super system is projected to have nearly $5 trillion in assets by 2025 according to an article in today's Australian.

Chris Bowen, the Minister of Financial Services, spoke by video to a conference in Brisbane. He didn't say where all the super money would go specifically. But he did say, "This might mean greater investment in infrastructure assets, provided a stable pipeline of opportunities was available."

Now you may want your money to go into infrastructure assets. And if you do, more power to you. After all, they are tangible assets. But you can't put a bridge in your refrigerator. Portable tangibility - wealth you can wear, store, or trade - is the name of the game as you reduce your allocation to deflating financial assets ahead of the hyperinflation. More on that Big Crash two-step in Friday's letter.

Dan Denning
for The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• The ASX Bubble, Fueled by China
• Building a National Economy Around the Housing Industry
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• The Price of Oil is in a Bubble

In the meantime...we await clarification...

When will this bounce end? What will happen when it does?

Yesterday was another inconclusive, information-free day. The Dow rose 17 points. Gold went up $5. Oil fell to $79 a barrel.

But the deep trends continue. The government grows...and heads towards bankruptcy. Most developed nations are running huge deficits in their public accounts. The one that has been most in the news is Greece. The Hellenes promised to cut their spending, rioted in the streets, and now hope for some back-up plan from Europe. The rest of the PIGS (peripheral European states, with good food and wine, but bad finances) watch carefully. What Greece gets now they're likely to get later.

But the problem is hardly limited to the small states of Europe.

Barron's reports that the states face "massive shortfalls" in their pension programs. This is in addition to the other massive shortfalls faced by governments all over the planet.

"US ratings threat," is the headline on today's Financial Times:

"Moody's Investor Service will warn the US today that unless it gets its public finances into better shape than the Obama administration projects there would be 'downward pressure' on its triple A credit rating."

Moody's learned a lesson last year. You take money from the ratee. You give a good rating to junk. Then, people point their fingers at you and sue when the junk goes bad. The raters don't want every Treasury bond holder in the world at their throats.

The US is going broke; no doubt about it. Of course, it may take years...

What the hell? We can wait...

Some Treasury buyers aren't waiting until the last minute. "China continues selling US Debt in January," comes a report from The Wall Street Journal.

Japan too, adds Bloomberg.

Japan, of course, faces a financial crisis of its own. It already has government debt greater than 200% of GDP...and its aging citizens are saving less money each year. Pretty soon, it will be unable to finance its deficits. Then what?

Then, yields will rise and Japan will face a crisis similar to that of Greece.

And what about China? Even countries with sound budgets can take huge financial hits.

"China may face massive bank bailouts," Bloomberg reports.

Yes, dear reader...China has a solid budget...and industries that make money. The trouble is, it has too many of them. And now it's made the mistake of stimulating them to increase production - as well as increasing infrastructure - at the worst possible moment, just as their major customer goes into a funk.

So, while China's state finances are in good shape - at least on the surface - its private sector finances are a mess. They are such a huge potential mess that one analyst refers to China as the 'mother of black swans.'

Who's going to bail out China's banking sector? Who's going to bail out Greece? Who's going to bail out Japan? Who's going to bail out the US?

Day by day, the lumbering, clumbering wheels roll on...towards bigger governments with greater debts... One government looks to another one to help it out. The other looks to yet another. One nation depends on its central bank...and its central bank depends on the US Federal Reserve, the capo di tutti capi of all the world's central banks.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• USA Has Fives Times As Much Sovereign Debt As All the PIIGS Put Together
• The Debt Collection Business Booms
• Total Implosion of the Chinese Economy
• More Subprime Thinking
• Greek Banks Playing the Carry Trade and Investing in Government Bonds

The Chinese are paying for their enterprises. They already own footholds in some of the most important companies in the US. Yesterday, they announced another big move. CNOOC, China's state-owned energy company, is buying half of Argentina's second largest oil producer, Bridas. The Chinese have described the deal as giving them a "beachhead" for entry into Latin America.

The world's richest people (two of the top five are Indians)...its biggest markets...it largest financial reserves...its most profitable companies - all are moving away from the US.

And now the Chinese are proposing to help the US upgrade its transportation system. Word from Beijing is that Chinese contractors are pitching high-speed rail lines to California, Florida and Illinois.

What next?

Empires you can trust...

At least there is one area in which the US maintains a clear and decisive lead - the military. Nobody comes close. No navy. No air force. No army. We're number one.

The trouble with being number one in military power is that you need to find a way to pay for it. Which brings to mind a recent book by Thomas F. Madden, Empires of Trust. We spent the weekend sitting in a wicker chair by the pool reading it, drinking lime sodas and red wine.

The book is a delightful history book, recounting Hannibal's war against the Romans and the Romans' many wars against the Greeks. It is a marvelous book of history. It's too bad the author draws conclusions that are comically out of sync with his own tale.

The storyline is that the US, like ancient Rome, is a very different empire from most. It is a good empire...based on strong family and religious values...which wants only the best for the rest of the world and only peace and security for itself. The Roman Empire succeeded, he says, because you could trust it. America will endure, he believes, for the same reason.

If this were true of Rome, it makes the Romans the most hopelessly incompetent race of humans that ever existed. They sought peace? The record shows a thousand years of wars; the history of Rome is a history of war. They fought the...

Sabines & various other tribes
Fidenates
Veientes
Albans
Latins
Samnites
Greeks
Carthaginians
Illyrians
Macedonians
Syracusians
Spartans
Doric Cretans
Argosians
Seleucids
The Aetolian League
The Ebro
Lusones
Various Celt-Iberian Tribes
Lusitani

This leaves out the small fry and only brings us up to 139 BC... They had another 500 years of hard fighting ahead of them. If there was anyone in the ancient world with whom the Romans didn't kick up some dust, we have never heard of them.

And security? Mr. Madden seems to think Roman armies went all the way from the banks of the Tiber to the banks of the Tyne, the Rhine and the Euphrates just so as to make the walls of Rome itself more secure. Having beaten one neighbor, they then faced another, who was naturally nervous about Rome's next move.

As its circle moved outward, Rome found itself with more and more neighbors to defeat. Where once it had only a few potential enemies, it soon found itself ranged, albeit with allies of more-or-less questionable loyalty, against half the world, including against the world's best military powers of time. In the name of security, in other words, it put the ancient world's leading military geniuses to work trying to destroy it.

Mr. Madden really ought to get out more. He seems to know a lot about Roman history. The problem is that he knows not much about other people...their history...their motivations...and their empires. While there are vast differences in the character and the style between various empires, they all are alike in that they are all run by humans who are all after the same heady mix of power, money and status. All use both carrot and stick - insofar as they can. Some were better with the carrot. Others were better with the stick. Using the carrot was often the cheapest way for an empire to get where it wanted to go. But all empires were also capable of making and winning wars, often ruthlessly and cruelly, when the occasion called for it.

Ultimately, an empire is a protection racket. The imperial power provides protection and demands tribute in return. If he gets no tribute...or cannot provide protection...he is out of business. Trust is useful to empires, as it is to the Mafia; it is a tool, not the core business.

This is clear from Mr. Madden's own recounting of the Punic Wars. After the Romans had conquered all of Italy, they looked across the straits of Messina at Sicily. There, the Carthaginians were trying to take control. Naturally, the Sicilians of the time looked for support wherever they might get it, and signaled to Rome that it could use help.

Trouble was, the Romans had an understanding with the Carthaginians. Like Hitler and Stalin before the invasion of Poland, the two had agreed to respect each other's spheres of interest. The Romans, who desired no conquest, according to Madden, had agreed to leave the rest of the world to the Carthaginians; the Romans got free run of Italy in return.

But the empire of trust betrayed Carthage; it went to war in Sicily and won the island for itself. This was the first Punic War. The second came about as had the first; this time the Romans breached their agreement by meddling in Carthaginian affairs in Spain.

The Second Punic War saw Hannibal cross the Alps. Then, we got to see how strong those bonds of trust in Italy really were. Given the choice between weak Rome and the strong Carthaginians, dozens of Italian cities switched alliances - including the second largest city on the peninsula, Capua.

The Romans could be trusted, as long as trust worked for them. When it didn't, they turned to violence - just like everybody else. In the case of the Punic Wars, and all of Rome's wars, it was violence that settled the issue, not trust.

Madden spends considerable ink telling us how nice the Romans were in their wars against the Greeks. But when push came to shove, that is, when trust no longer paid, Roman forces looted the treasures of Corinth, and leveled the city.

Mr. Madden misses the point about Rome. He misses the point about the US too. Like Rome, America uses carrot and stick. Carrots are usually cheaper. But, in the end, it's the stick that counts. Americans were able to calm indigenous peoples with treaties and reservations; but if they had not been ready and willing to go to war against them, they would never have been able to colonize the continent. Then, they used big sticks against their own people too. In their war against the Confederacy, Sherman did to Atlanta almost exactly what Mummius had done to Corinth. He destroyed the city...and laid waste to the countryside around it.

Brief dummies guide to empire: A coalition of the willing is all very well; but when they're not willing to go along, get out the stick and whack them hard.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• The Major Difference Between Rome and the U.S. – Electronic Transfers
• I Love Coming to Rome
• No Modern Government Policy is So Stupid that the Romans Didn’t Think of it First
• America Presents Unsettling Parallels With the Disintegration of Rome
• “Did you see Berlusconi?” asked Elizabeth

But first, what in the shillelagh is the Fed actually thinking?

The U.S. private banking cartel left the short-term price of money unchanged overnight. In announcing its decision it concluded that, "Economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

April gold futures were up $17.35.

To be clear, a shillelagh is an Irish cudgel, used to beat things or threaten drunken bar patrons on St. Patrick's Day. Ben Bernanke is not Irish, as far as we know. But the Fed has used its digital printing press to beat 10-year interest rates into submission. That's kept a lid on U.S. 30-year mortgage rates and prevented a further implosion in the American housing market.

Believe it or not, that means something to Australian banks. Without a full-time Aussie bank analyst on board, it's hard for us to say how exposed the Big Four's portfolios are to American commercial and residential real estate. But it's safe to say that the quality of bank collateral - both here and in America - is still a big issue, and probably under-reported in the media.

In the States, the irony is that crappy subprime-backed mortgage collateral has been replaced with U.S. Treasury Notes and Bonds. Ultra safe, right? Not!

On Monday, ratings agency Moody's warned that both the United States and the United Kingdom could lose their AAA rating on sovereign debt if they don't get domestic finances on a more solid footing (cut spending and reduce borrowing). U.S. banks are absolutely stuffed to the gills with government debt. A ratings downgrade would wipe out a huge chunk of bank collateral. Some improvement in the last two years, eh?

As a new capital importer whose chief creditors are banks in the U.S. and the U.K., you'd think Australian banks would be worried about losing their credit lifeline. At the very least, credit would again be hard to come by if the U.S. suffers another banking shock. But in the meantime, Australia has problems of its own.

Today's Age reports that, "National Australia Bank revealed yesterday that its $18.4 billion portfolio of troubled credit instruments had caused losses of $1.3 billion over the past two years. It was NAB's first disclosure of the damage done by the holdings." Better late than never.

NAB says it has an $18.4 billion portfolio of "troubled credit instruments." With total assets of $654 billion, $18.4 billion seems like a drop in the bucket. You wouldn't want to take an $18 billion loss. And by all accounts, NAB says its losses are under control.

But it does make you wonder, doesn't it? Are Australian banks really as insulated from further loan losses as UK and US banks? If property prices never fall in Australia again (commercial and residential real estate) maybe so. But we have our doubts.

One useful nugget from the NAB story is that the bank as set up a new entity for its "troubled CDOs." It's a vehicle for NAB to quarantine its "Specialised Group Assets." Or, the financial equivalent of locking your crazy syphilitic auntie in the attic and chaining her to the wall. She might not be going anywhere. But at least she won't be infecting the rest of the household.

NAB has given us a preview of what we suspect the Federal Reserve is going to do. It's our view that the Fed cannot realistically remove support from the mortgage market. Its announced intention to do so is merely cosmetic. It's placating anxious holders of dollar-denominated assets. After all, when ratings agencies and your main creditor start publicly voicing concerns about your main product, you have to at least pay those concerns lip service.

But do you really think the Fed can afford to withdraw its support of the U.S. mortgage market? The Fed's $1.75 trillion quantitative easing program has kept the U.S. housing market from totally imploding. A spike in mortgage rates would dry up already anemic U.S. housing sales. Prices would fall. Millions more who are hanging on for grim death would see their mortgages go under water. And they would begin to walk away.

Putting aside the implications for bank collateral, we're talking a serious systemic collapse of the U.S. housing market. If you think that unlikely, then you're not paying attention to just how unsuccessful the Federal loan modification programs have been. Housing prices are not recovering in America, and they won't for some time.

So if we're right and the Fed can't risk tipping the housing market into apocalypse, how will it behave? NAB's "Specialised Group Assets" are a clue. This is a distant cousin of Henry Paulson's "Bad Bank" idea at the beginning of the crisis. It was conceived as a government-funded entity that would but all the garbage debt off the banks at some small discount to the theoretical (not market) value of the loan portfolio.

The banks would get rid of the troubled assets and have a clean balance sheet. The loans would be concentrated into a government agency that could modify the loans to its heart content, delaying foreclosure, lowering the interest rate, and lengthening the duration of the mortgage.

Mind you there are heaps of problems with this solution. How will the government agency be funded? Will it create a new class of zombie properties that are carried at above-market valuations and prevent a market-clearing price from emerging in the U.S. market? And won't it keep millions of U.S. borrowers in debt for many years, stuck with an asset that doesn't appreciate and a debt that doesn't amortize?

Who knows?

But we think the Fed will find a way to fund, in some underhanded fashion, a new entity to centralise the risk of the U.S. mortgage market. Risk has been concentrating in fewer and larger institutions over the last few years. But the mortgage debt is still too toxic to be borne by any institution that wants to appear healthy and well capitalised in the market.

The Fed also wants to clear the MBS off its balance sheet so it's free to engage in more QE (which will be necessary when U.S. deficits cannot be funded by creditors and the interest cannot be paid by tax receipts alone). So, the bad housing debt must be off-loaded.

Of course this is all speculation. But it is impossible now for the Fed and the banks to tolerate a further write-down in collateral. It must be marginalised or exempted from being carried on the main balance sheet. A great mortgage default moratorium is coming, and all the assets tied to the mortgages in question are going to be off-loaded on some credit leper island.

At least that's how we'd do it if were trying to save a doomed system without freaking out the public and sparking a run on the dollar. Thankfully, saving a bankrupt system is not our job. Surviving it, however, is.

Dan Denning
for The Daily Reckoning Australia

• The Collapse of the U.S. Housing Market and Mortgage Bubble
• Bernanke Calls U.S. Economic Recovery “Nascent”
• Commercial Mortgage Backed Securities Are Back
• Property Sector Has Seen the Value of its Assets Wiped Out
• Federal Reserve to Buy $300 Billion In U.S. Treasury Bonds

As Dan discussed last week, we too think inflation is a likely long term outcome but you should also be wary about the very real possibility of a nasty deflationary episode beforehand.

In a deflation, cash is king and your investment strategy should be one of focussing on valuation and margin of safety. In an inflationary environment, valuation is still important but opportunities for the disciplined value investor will be much harder to come by, as speculation becomes the dominant theme.

So where are we? Ahhh...if only it were that easy.

Before we try to answer the question, we need to establish the framework for our thinking. To keep things simple, we'll keep our focus on the US, which as manager of the world's reserve currency is THE economy to focus on.

Now, a definition - inflation or deflation refers to an expansion or contraction of money and credit. Some analysts have focused exclusively on the money supply or the monetary reserves injected into the banking system by the Fed and made the claim that this is inflationary.

This is because in a fractional reserve banking system, the monetary reserves created by the central bank are lent out many times over by the banking system. This is how banks 'create credit'.

But an increase in money does not always lead to an increase in credit, which is what is happening now. So when attempting to answer the question of inflation or deflation you need to take into account money supply AND credit.

The other point to note in this debate is that we'll focus on the two areas that concern us as investors - inflation or deflation in asset prices and in consumer prices. Movements in money supply and credit impact on both, but to varying degrees.

Firstly, let's talk about asset prices.

An historic credit expansion from 2001-2007, which was predominantly an expansion of private sector credit driven by the banks, resulted in sharply rising asset prices. Greenspan's ultra low interest rate policy was the driving force here. Capital-intensive assets, namely property and also commodities, benefitted most from the credit expansion.

But it was more than just that. As the credit expansion made its way through the economy it resulted in higher household incomes, company profits (and therefore share prices) and government tax receipts, giving the illusion of widespread prosperity.

Then the credit expansion stopped, causing a collapse in the asset prices that most benefitted from the boom and a general fall in nearly all other asset prices.

Because the underlying banking system that provided the credit was capitalised largely by residential and commercial property, the collapse morphed into a credit crisis. Banks were widely viewed as insolvent and under these conditions no one was willing to extend credit to anyone.

Because the credit expansion was allowed to run unchecked for so long (and keep in mind the 2001-07 run-up was part of a much larger secular expansion of credit which had been running for decades) the bust was particularly nasty.

Money supply and credit were contracting simultaneously as banks wrote off their assets and the household sector decided it did not need to take on any more debt. So from roughly late 2007 until early 2009 we experienced an acute deflationary asset price shock.

But then the government and Fed stepped in to halt the deflation and credit contraction. The Fed expanded its balance sheet massively and the government ran an equally massive fiscal deficit. This stabilised the credit contraction.

It is important to realise that the unprecedented intervention has not caused credit to begin expanding again. The monetary base has soared but an excess of debt and a dysfunctional banking system is not turning this into credit growth – and nor will it. Government and central bank actions have merely stabilised the massive deflationary force of a burst credit bubble.

The recently released Fed Flow of Funds Report shows Total Credit Market Debt Outstanding at $52.4 trillion. It has declined marginally for the past three quarters and is pretty much flat year-on-year. Federal Government credit expansion has offset the small decline in Household Sector credit and large decline in Financial Sector credit.

Yet this total credit market stabilisation has resulted in widespread asset price inflation.

How can this be?

Our best guess is that much of it has to do with sentiment, or 'animal spirits', as well suspension of the rules regarding marking bank assets to market. The second point is related to the first. (Co-ordinated global stimulus and unprecedented credit expansion in China are also no doubt playing a major role).

As we mentioned banks' asset bases are underpinned by property. Marking these assets to market would render the whole banking system insolvent, which is hugely deflationary. Obviously the authorities do not want this to happen so mark-to-market accounting has been suspended and the Fed has purchased $1 trillion worth of dud mortgage debt.

The plan is for banks to trade their way back to solvency. But because the private sector doesn't want to borrow, banks instead try to make their money from speculating in asset markets (proprietary trading) and lending to the government, thus earning easy money on the interest rate 'spread'.

This has given money managers and private investors the green light to head back into the market. As a result equity and corporate debt markets in particular have rebounded spectacularly over the past 12 months.

But in order for asset inflation to persist from here, total credit outstanding must grow again. Federal stimulus is set to fall later this year and the Fed is due to end its quantitative easing program this month. The expectation is that the private sector will pick up the slack again but we doubt that will happen. As Japan proved following the bursting of its credit bubble in the late 1980s, deleveraging is a long term trend.

So if the artificial support of the government and the Fed begins to diminish, we expect deflationary forces to re-assert themselves. The risk to this outlook is that the authorities actually have no intention of removing stimulus. We will soon find out.

Should some form of exit strategy unfold, does this mean markets fall to new lows? While any decline could be significant, we do not think this is a likely scenario. Governments have proved they are always ready to 'do something' and any significant equity market fall would be met with more government credit creation.

So by our reckoning, the next phase for asset markets will be deflationary. Your current investment strategy should therefore be focussed on fundamental value and in the absence of these opportunities – cash.

But the automatic government response to such an environment will be to print and spend. As Ludwig Von Mises wrote in Human Action many years ago:

All governments are firmly committed to the policy of low interest rates, credit expansion, and inflation. When the unavoidable aftermath of these short-term policies appears, they know only of one remedy – to go on inflationary ventures.

You can guarantee the people who did not see it coming will blame the renewed deflationary forces on that fact that the prior stimulus was not big enough. They will advocate even larger spending programs. The next round of stimulus will be larger fiscal deficits and more money printing. Such a policy is inflationary, first in asset prices (as we have seen in the past 12 months) but ultimately it will manifest in consumer price inflation.

How quickly this inflation comes about depends on a few things. If the wider public maintains faith in the purchasing power of the dollar, the increase in dollars will probably be matched by an increase in demand for dollars and dollar denominated assets. In this case inflation will take quite a few years to manifest because of the considerable unemployment and spare capacity in the economy.

We reckon the global economy is in this position now. It explains why bond markets are rallying or at least holding up in the face of massive government bond issuance.

But, if the public begin to question to value of the dollar then demand will decline (as the same time as its supply rises) and the demand for real assets or goods or whatever will take off. This is the 'crack-up boom' that Mises talked about, the exchange of paper money for goods at any price. The end result is the destruction of the monetary system.

We think we are some years away from Mises' end game. And if governments make some hard decisions in the years ahead, it can be avoided. But is there another Volcker out there to replace Bernanke? Let's hope so.

Bringing all this together, our best guess is we get deflation then inflation of asset prices, followed by a general rise in consumer price inflation, the severity of which depends on how quickly the populace loses faith in government fiat currency. We'll be watching the bond market closely for clues here.

So what should you do about it? The first thing to recognise is that macro events play out over a number of years. But you still need to be prepared. Because we are cautious about a renewed deflationary downturn we think you should focus strictly on quality companies with cheap fundamental valuations. In the absence of such opportunities (and there are not many) we like cash...and gold.

If we are right in our thinking, the silver lining for investors holding decent cash balances is that there will be some very, very good opportunities down the track. We just have no idea when those opportunities will arise.

And how do you take advantage of these opportunities? We advocate and practice good old-fashioned valuing investing. Forget trading, forget charting and forget other short-term schemes...these are simply methods designed to separate you – slowly - from your money.

Over the decades, all great investors have proven that simply buying good quality companies well below intrinsic value (no matter what the macro environment) leads to healthy outperformance and increasing wealth. But it takes discipline, and that's were we can help.

Keep in mind the above analysis is simplistic in that it focuses on the US and ignores the major emerging economy of China, which is obviously hugely influential for the Australian economy. We'll tackle that issue in a future report.

But the US is still at the centre of the global economy. Like it or not, the manager of the world's reserve currency has a huge influence on the economic fate of the rest of the world.

Greg Canavan
for The Daily Reckoning Australia

• World Economy Faces Hyperinflation or Deflation?
• Inflation or Deflation?
• The Battle Between the Forces of Inflation and Deflation Wages On
• Inflation and Deflation Battle is a Long Way from Won
• From the Gold Pan… Inflation, Deflation and Precious Metals

This is the day Caesar was assassinated. What's it to us?

Well, it just reminds us that things go wrong. Even when you're on top of the world. There are always countercurrents...undercurrents, beneath the surface, where you don't see them...plots...conspiracies...and just bad luck.

On the surface, the US economy is recovering. Well, not even. It is stabilizing.

The Dow has been creeping up. It rose 12 points on Friday. Gold fell $6. Oil held at $81.

The most recent figures show the consumer becoming a little freer with his money. But look beneath the surface and you find government statisticians juking and jiving with the numbers. They seasonally adjusted downward the figures for January...which boosted the figures for February. Had they not done so, the figures for February would have been negative!

Still, consumers are not as lifeless as they have been...and on the surface, this is good news.

And who can blame consumers for being a little more ready to spend money? The newspapers tell us that the Great Recession is over...and that we're in a recovery. The lumpen consumer probably thinks he's going to find a job soon...and that his house is going up in price.

But beneath the surface, there are powerful downtrends still underway. These trends began in 2007. They were misinterpreted, naturally, by leading economists and policymakers as a "liquidity crisis." In fact, they were signs of a debt crisis. The private sector had far too much debt.

Economists who never expected trouble, reacted to it in a predictably moronic way - they rushed to the rescue with more debt. Now, they think they've triumphed... They've prevented another Great Depression. They've saved the world!

We're written so much about that; you surely don't want to read any more on that subject.

But here's the interesting point: by failing to address the real causes of the crisis, the feds only allowed those undercurrents to grow more powerful and more dangerous.

Instead of reducing the world economy's reliance on debt, they increased it!

On the surface, the rescue efforts look vaguely like a success. The private sector stopped spending. Government increased its spending to make up for it. Okay so far.

Alas...net, the world's debt is still increasing - by a huge margin. Over the next 3 years, the biggest 20 economies in the world - the G20 - are expected to slip over the 100% mark, with more debt than GDP.

Now, let's do a little math. The US has total tax receipts equal to about 15% of GDP. If the interest on the debt is only, say, 3%...that means you're spending 20% of tax receipts on debt service. But suppose inflation rises...and interest rates go back up to where they were in the late '70s. Back then, the feds had to pay 15% interest to borrow
money for 10 years. At that rate, financing the whole federal debt would take 100% of tax revenues - just for the interest.

Obviously, that's not gone to happen. Something else is going to happen. What? Hard to say. Some combination of default and inflation, most likely...

Of course, this doesn't bother the feds. That story is still beneath the surface... It's a crisis that hasn't happened yet. They couldn't see the crisis in the public sector coming in '07. They can't see the next one coming either.

Economists can't tell a government job from a private sector job...and can't tell $1 of government spending from a dollar spent by the private sector...and can't tell a dollar's worth of GDP from a dollar's worth of real prosperity...which means, they can't tell the difference between what's happening on the surface to what's happening underneath.

In a sense, this is just another manifestation of the same "battle" we wrote about years ago. On one side are the feds. On the other is Mr. Market.

The feds want to inflate. Mr. Market wants to deflate. The feds want a boom. Mr. Market wants a bust. The feds want to inflate another credit bubble. Mr. Market has a knife in his hand.

On the surface, the feds are winning. At least, that's the way it looks if you get your information from reading the newspapers or listening to CNBC. And in a sense, these reports are correct. Superficially, the battle is going the feds' way.

But deeper down...the debt is still there...and it is growing bigger. And Mr. Market sharpens his dagger.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Economists Agreed the Stimulus Was Working and the Recession Was Coming to an End
• How Does an Economy Expand When the Banks are Lending Less Money?
• Government Pretending Debt-fueled Spending is the Same as Growth
• Why Do Men and Women Want Money and Power?
• Government Debt

What's more, if banks could borrow from the Fed at 1% and loan to the Treasury at 3%, that' a nice little interest rate spread. That money could be dumped right back into the stock market too. It's not exactly risk-free. But with the Fed on your side, a bank would be in the position of rebuilding its balance sheet slowly.

In any event, we reckon the end of the QE program will lead to falling stock prices. In today's essay, our colleague Greg Canavan takes up the issue. He reckons the end of QE calls for a two-part strategy: get out of the way of falling asset prices and build a cash position is the first part. That's where we are now.

The second part is picking through the rubble of an asset price crash for the really good stuff. In order to do this, you have to know how to value stocks. Of course if you get your timing right, you just buy a broad basket of stocks at the exact bottom and ride the elevator up. This is more of a trading strategy, and it's what Slipstream Trader Murray Dawes is engaged in on a full-time basis

But for our part, we think the days where everyone can passively surf the index to higher and higher share prices are over. You're better off finding companies that make good use of your capital and deliver higher returns on equity. Greg's got his take in his article.

China's Wen Jiabao has told the Americans to stuff it, although not in so many words. At a two-hour news conference in which he warned that removing stimulus too early would lead to second dip in the global recssion, Wen also defended China's currency manipulation. Defying the global consensus, Wen said, "I don't think the yuan is undervalued. We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency."

In a floating-exchange rate world, no one forces a currency to appreciate. If people don't want to own it for yield or sound monetary and fiscal policies, it's hard to "force" a currency to rise. You can, however, forcibly depreciate your currency by selling it and buying others. And that's exactly what China's been doing for years.

To be fair, China's currency manipulation is a form of economic stimulus. It's just less direct than Kevin Rudd's method of giving people money. By pegging it's currency to the U.S. dollar, China engages in a kind of perpetual devaluation. It preserves the price competitiveness of Chinese exporters. And more importantly for China's economy, a humming export engine keeps employment high, achieving the primary goal of political stability.

But there's no doubt that China's policy is costing jobs in the Western world. To be fair, the U.S. is also a world-class currency manipulator. The central bank sets the price of money and, from time to time, considers how to keep the gold price from appreciating and exposing its fiat fraud.

And the U.S. is the only country in the world that enjoys the luxury of paying off its debts in the same currency that it alone can print. That is a privilege without peer in the global economy. The U.S. has enjoyed that privilege since 1971 because of its military and economic dominance and, to a lesser degree, because the rest of the world needed to do business in a stable currency and the U.S. dollar (for the most) part, fit the bill.

It doesn't fit today. And that's why everything is coming unstuck. As Bill shows below, U.S. tax receipts currently cover the cost of servicing the outstanding debt. But if, as we mentioned yesterday, market-based 10-year yields spike anywhere near where they did in the late 1970s, the cost of servicing the debt would eat up nearly all the current tax receipts.

After that, there's only so much a government can realistically do. Printing money - radically devaluing the currency - is the only way out (if you're not going to adopt Greek-like austerity measures on spending, which we don't expect anyone in America at the government level to willingly do.)

Of course in the meantime, the deleveraging of the household and private sectors (see the 2009 in total credit market debt) is driving current demand for the dollar. That and the weakness of the euro. While these trends can see-saw a bit - don't be surprised to see a euro rally on some kind of short-term Green band aid - it's important to see the currency movements for what they are. And what are they?

Chimeras. The super cycle in paper money is blowing up. Currencies are moving relative to one another. But our guess is that relative to gold and tangible things, all of them will lose value. The dollar is bad. But it is less bad than the euro at the moment. And vodka and gold are less bad than the dollar.

But have we unintentionally made the argument for deflation? One reader thinks so.

Dear Dan,

"Your argument is incredibly difficult to follow because most of it seems to be a damn good argument for deflation. You finally get to the point that because deflation actually is happening, due to the failure of the private sector (the banks) to dole out the credit into the economy, then the government will do it itself. You then expect us to believe that the government will be more successful than the private sector at doing this. This is an extraordinary argument from The Daily Reckoning. Both you and Bill Bonner have been at pains for years to point out that government simply cannot do things as well as the private sector. Now you expect us to believe that they can revive credit markets. Have you gone over to the dark side? Are you now the new marketing arm of government?"

Nick M.

Nick. We don't work for the Feds. Neither do we think the government will revive the credit markets. We think the government will replace the credit markets. What else are the nationalisations of the auto sector and mortgage markets about if not the elimination of the lender as the middle man.

It's true that if lenders don't want to lend and borrowers don't want to borrow, achieving credit growth would be impossible and asset deflation and deleveraging would rule the land. But we're advancing the argument that the response of the Feds will be to simply print money and give to people. This destroys the currency, rather than increasing the value of cash and Treasuries, as the deflationists argue.

Yes, we admit this is speculation about future government policy. But Australia previewed this strategy. The difference is that Kevin Rudd gave away money Australia had. Barack Obama is spending money out of an empty pocket. The argument against this is that the bond market would not permit such a policy and would immediately send yields sky high.

We don't dispute this. But we think the big winner here is gold more than cash. A direct monetisation of the U.S. job market can hardly be the sort of thing that's bullish for the U.S. dollar. And if the confidence game in the dollar is up, then the moment when people are willing to trade paper money for tangible goods at any price (the Misean "crack up" Greg cites below) can't be far away.

Dan Denning
for The Daily Reckoning Australia

• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• Everyone is Busily Debasing Their Currency
• US Dollar Declining as China’s Currency Rises
• Gold Flourishes but Silver is the Real Precious Metal Story of Late
• China’s Economy is the Greatest Bubble on Earth