Fight Fire with Fire!

Fight fire with fire!

"Yes, one right at the back, red tie, just underneath the cabinet rack," said Ben Bernanke.

The Fed chief was giving a speech at the London School of Economics on Tuesday. When time for questions came, our old friend, Terry Easton, wearing a red tie, raised his hand.

Aren't you just making the situation worse? Terry wanted to know. Isn't there a better alternative? The Austrian school, for example?

Here at The Daily Reckoning, we are 'Austrians,' in the sense that we think Hayek was right and Keynes was wrong. We don't believe you can control the business cycle...nor improve on what the free market produces. Given our druthers, we would tell the feds to butt out...and let the 'invisible hand' of the free market sort out the current mess.

Ben Bernanke gave a central banker's reply. He spoke much and said little. In the end, he leaned on a sly metaphor:

"I think it's very important for us to try to put out the fire. I think it's good advice in general, that if there's a fire burning, you try to put it out first, and then you think about the fire code."

What if it's not a fire, but more like a hard rain? It may be disagreeable...but without the monsoon rains, crops won't grow. An economy can't function properly without an occasional downpour; somehow, mistakes have to be washed away.

But Terry didn't get a chance to argue metaphors. The speech was soon over and the feds could get back to work - piling up dry tinder!

Every emergency triggers a response...and every response adds to the burden of regulation and debt. In the United States of America, we are still paying for fire-fighting equipment bought by our grandfathers in WWII. And we are still taking orders from bureaucracies set up by the Roosevelt Administration to solve problems that disappeared 50 years ago.

Eventually the weight of all these saving graces crush the whole society. But for the moment...there's a fire to put out. Everyone agrees. Conservative, liberal, Episcopalian, Holy Roller...blue eyed, brown eyed...almost every silly joker on the planet thinks the feds need to do more to rescue the economy.

Yesterday, the Dow fell another 248 points. Still no sign of the long-awaited Obama Bounce. Maybe it won't happen. (More on that below...)

Oil held steady yesterday and gold dropped $11. Gold looks like it is ready to slip below $800 again.

The real question for an investor is one of faith. How much faith do you have in your top officials? Can they pull it off? Can they stop deflation?

There is now no doubt that the world economy has entered a significant correction. Most likely, it will be long and hard.

Stephen Roach, in the Financial Times, says America may face a 'lost decade,' like Japan in the '90s. Actually, it looks to us that Japan has suffered two lost decades...it's almost the end of the '00s and its economy still hasn't recovered. And with the yen rising - investors are unwinding their yen-based carry trades - Japan's manufacturers are finding it more difficult to sell than ever.

All around the globe, the news is grim. U.S. retail sales - taking out autos - are the worst they've been in more than half a century. Chinese exports are collapsing.

Tiffany's says holiday sales were bad; the rich are cutting back along with everyone else. Overall, U.S. retail sales posted their 6th consecutive month of decline in December.

Meanwhile, the banks are insolvent.

"Banks in need of even more bailout money," says a headline in the New York Times. Analysts say the banks need between $1 and $1.2 trillion more to stay in business.

HSBC says it needs $30 billion in the near-term. Bank of America is asking for more too.

Oh my...oh my...what to do?

Gotta fight this fire! But how? Fight fire with fire! All over the world people suffer from the mistakes they made in the go-go years. They spent too much. They borrowed too much. They paid too much. Now, all those bad debts, bad investments, and bad balance sheets are burning up - scorching fingers all over the planet.

So what do the feds do to try to fix this problem? Fight fire with fire! Throw some more tinder onto the blaze...get people to borrow, spend and speculate even more!

*** We're still waiting for the Obama Bounce. Hardly ever has there been such a major sell-off not followed by a major bounce. But we wouldn't want to bet too heavily on it. What to do? Our old friend Jim Davidson has an idea:

"The great lift to animal spirits that Obama will give the U.S. could well translate into a temporary stock 'boomlet'.

"How should you trade it, knowing that the fundamentals remain weak and deteriorating?

"I believe that the solution is to buy MITTS. Not catcher's mitts but Market Index Target-Term Securities, special purpose trading vehicles on the S&P 500 and the small-cap Russell 2000 Index.

"MITTS allow you to profit if the market rallies while guaranteeing that you can't lose money on the downside. In other words, you can play the 'sucker's rally' of 2009 without being a sucker.

"How is such a miracle possible?

"The concept is simple. MITTS are a combination of long-term options on stock indexes with zero coupon U.S. Treasury bonds that are guaranteed to return to their issue value of $10 a share of each MITT on the maturity date.

"A brainchild of Merrill Lynch, MITTS have been issued on many underlying products with different maturity dates.

"The two that I recommend to play the probable Obama bounce are ML S&P 500 MITTS (NYSE:MCP) (May 2009, recent price $9.72) and ML Russell2000 MITTS (NYSE:RRM) (March 2009, recent price $9.80).

"You are guaranteed a return of 2.9% for holding the ML Russell2000 MITTS until March. This is higher than the return on Treasury notes over five years. You can buy the MITTS through any broker. They are one of the only instruments out there that allow you to make gains on of sucker's rally with virtually no downside risk."

*** It's a question of faith. Those with little faith in their public officials will agree with Stephen Roach; most likely, the world economy led by the United States, is entering a "lost decade" of recession, bear market and deflation.

But here at The Daily Reckoning we give the devil his due; if the feds want to really want to destroy the dollar, we believe they'll be able to pull it off. Just give them time.

To that end, we are still rolling on the floor over the proposal to create a 'bad bank' that will buy up bad investments. We thought the banks already had plenty of bad investments of their own. This proposal is really just another backfire in what has become a worldwide blaze. The feds have already set several other back-fires - mostly 'cash for trash' programs designed to enrich Wall Street and the financial sector at the expense of the rest of the society.

And today's news tells us that the European Central Bank is falling in line with its counterparts in Britain and America by lowering rates. The United States central bank is already down to zero. The BOE and the ECB are on their way.

But the real key to the feds' game is neither bailing out the banks nor offering more credit. Even if their balance sheets were repaired, it will be a long time - probably a generation - before bankers want to lend so recklessly again. And it will probably be at least a generation before people want to speculate on houses again. No, the real key is to undermine the dollar. As long as the dollar is going up against financial assets and consumer goods, people will neither borrow, lend nor spend. Instead, they're going to hold onto every buck as if it were their last.

That's why the bankers are experimenting with "qualitative easing" or "credit easing," as Bernanke called it this week. These are code words for printing money. Rather than recapitalize the bankers, the central banks buy debt directly from the government. This permits the government to finance its stimulus plans without putting pressure on the debt market.

It is as if an investor had entered the market with unlimited resources...determined to buy up as much government paper as possible...

...and to destroy his own credit.

When central banks buy their own government's debt, they create money 'out of thin air' for the purchase. The money supply increases. If they do enough of this money creation, the quantity of money overwhelms the quantity of goods and services which it can buy. Result: inflation.

That is the feds' goal. So far, they are not succeeding. But we have faith; in the end, they'll get the hang of it.

Bill Bonner
for The Daily Reckoning Australia

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