Which shares win and which shares lose the stronger the Aussie dollar gets? Slipstream Trader Murray Dawes has been on the case over the last week, looking for other tradeable trends in the ASX 200. The stronger Aussie affects the costs and export earnings of big domestic companies. That makes it a catalyst for trading ideas. And the size of the moves in these larger capitalisation stocks is kind of surprising. But for it to be profitable, you have to first sort out who wins and who loses.

GoldmanSachs had a crack at it last week. According to today's Australian, "The biggest winners include Qantas and Virgin Blue (lower fuel costs and strengthening outbound travel), Boral (lower offshore debt costs), condom and glove maker Ansell, apparel importer Pacific Brands, diversified industrial Alesco and waste manager and car importer Transpacific."

And the possible losers? The report says they will be, "Defensive stocks with an offshore earnings skew and which also are not exposed to this global growth. These include CSL, Cochlear, Resmed, Ramsay Healthcare and QBE Insurances. GSJBW cites BlueScope, Paperlinx, Caltex, Incitec Pivot and Aristocrat Leisure as other losers, but notes currency is only one of many variables affecting earnings."

We reckon it's all a bit of tempest in a tea cup. Corporate earnings have been inflated by the credit bubble and funny accounting for the last 50 years. A quarter or two of noise about earnings is not the big story, even if the currency move is substantial. There are really only two questions that matter.

The first is whether or not shares as an asset class are a good idea right now. That's a huge debate. But part of the answer lies in your views on inflation. As we argued here in July, stocks are definitely better than bonds when inflation is the big threat. The Reserve Bank seems to think that is the case. So make of it what you will.

What we make of it is that dividends used to account for a much larger percentage of your total return in stocks than they have in the last twenty years. Times change. There's no rule that says the future has to be just like the past. But if stocks beat inflation, should you invest in stocks for income or capital appreciation? That's the second question.

Aussie investors haven't usually had to make that choice. Bank stocks, for example, provide dividends and capital growth. But today, we reckon that cash flows are reverting back to the mean growth rate, which is obviously lower in a world that's deleveraging and relying less on credit to fuel business and consumer spending. Rather than being inflated by consumer demand (supported by credit) we predict slower rates of organic growth, across the board. This rewards investors who pay attention to how a company generates its earnings.

Kris Sayce in his work at the Australian Wealth Gameplan, reckons that now is a good time to add dividends to the mix to beat both inflation and the trend toward smaller growth in corporate cash flows. Practically, this means investing in businesses than can increase earnings in good times and bad and can do so without high capital costs which force them to borrow money. They return the excess cash to shareholders.

In cash flow growth is constrained by less credit in the system, you also want to own businesses with leverage to a rising commodity or an emerging market. This works out pretty well for a lot of Aussie firms.

Take energy. Chevron announced another major gas find off the coast of Western Australia this weekend. Chevron's $21 billion investment in the Gorgon project in WA is already the company's single-largest investment anywhere in the world, according to the Australian Financial Review.

And why? Chevron reckons LNG from WA is going to be the carbon dioxide friendly fuel for Asia's future. True, the fixed capital costs for producing off-shore LNG are high. But the whole industry is certainly leveraged to higher energy prices, which ought to translate into higher earnings for Chevron. Your risk is that oil prices crash and take LNG prices with them, upsetting the whole applecart.

So how does this all fit into an investment strategy for a world where there is no clear winner between inflation and deflation, where there is still massive leverage in the financial system, and where public finance is creating huge long-term deficits to replace (mistakenly) the missing demand from households that are beginning to live beneath their means? Good question!

You can trade the blue-chips in their ranges based on currency exposure or leverage to commodity prices. This is what Murray is up to at Slipstream. Or you can just chuck a few market-tracking ETFs in your portfolio and forget about it, in which case you can read the DR for fun and laughs rather than investment ideas. But you can also afford to be a bit more selective, and should probably consider doing just that. Why?

If the Credit Depression is going to take a bite out of corporate cash flows for years to come, focus on that risk and avoid the stocks most vulnerable to it (leveraged players in property, mortgage lenders, and banks.) But also build yourself, as Nassim Taleb says, a portfolio of risk's that's built for a world of extremes (Extremistan!).

Taleb says you want a maximum amount of zero-risk securities. Whether that is cash, bonds, dividend-paying stocks, property, or gold bullion (not really a security) is where the debate lies. He also recommends, though, that you have a small amount of risk capital in maximum risk securities. Which ones?

You want securities where you'll find low-probability but high-value events that can move the share price. This is not banking. In banking, all the low-probability (or frequency) events tend to have catastrophic consequences when they do occur. Russia defaults. The subprime market blows up. You have maximum risk. The probability is remote, but the magnitude of an occurrence is a portfolio destroyer.

But in other areas - small cap stocks, oil and precious metals exploration and production companies, for example - the low probability events are almost always high magnitude events in a positive way. You cure baldness or impotence. You find gold or oil. You invent the iPod or Google.

In these businesses, cash flows and earnings are above trend for a three to four year period in which the share price trades at a steep premium, factoring in future growth. This is the sweetest of sweet spots for growth investors. But to taste it, you have to also have a taste for risk.

That's why it's worth being in the market in a small amount of low-probability but high-magnitude type companies. You want a portfolio of risks like that. And it doesn't have to be a big one to be worth it, or jeopardise an otherwise risk-averse strategy. In fact, we reckon that this strategy is going to generate far better returns over the next ten years that the conventional buy-and-hold blue chips through your super strategy.

Dan Denning
for The Daily Reckoning Australia

• Note to Australia: Buy Resources, Not Banks
• The Problem With a Well-Diversified Portfolio
• Gone Fishin’ Investment Strategy
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Inflation is a Reality in China

But let's not forget about oil. It too is priced in dollars. In fact, the big gold move started because Robert Fisk claimed the Gulf States and China et al. are tired of paying for oil in an unstable currency. You could say that gold moved closer to being money again because of how important oil already is to the real economy.

We'll get back to oil in a moment. But there was a story in today's Age that gave us the willies. "The Aussie dollar is poised to storm past parity with the US dollar, propelled by local interest rate rises and Australia's close ties to the booming Chinese economy, according to currency analysts," reports Chris Zappone.

It doesn't sound too creepy. But there IS a creeping hint of euphoria to the Aussie story at the moment. The dollar...the economy...the fact that summer is just over the horizon...you can feel the animal spirits getting friskier. It was like this in the summer of 2008 as well, right before the bottom fell out.

But enough of the weird sense of déjà vu. How does the big picture affect your investments? That is always the tricky part. It's one reason why we are stuffing our new offices with all kinds of traders and analysts and writers whose ideas would probably get them thrown out of a respectable job. These are just the people we want thinking about the investment future.

Dan Denning
for The Daily Reckoning Australia

• Gold, the Aussie Dollar, the Greenback and You
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar
• Dollar’s Demise Has Started a Chain Reaction in Currency and Commodity Markets
• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• The Aussie Dollar as a Measure of Global Risk Appetite

First, Goldman's buy on the banks seemed to buoy the market. The Dow finished up 112 points and is just under 9,600. Meanwhile, Aussie stocks shrugged off that sense of impending doom and rallied 43 points yesterday. The ASX 200 is at 4,622 and thoughts of 5,000 by the end of the year must surely be dancing like sugarplums in the heads of some investors.

Ho! Ho! Ho!

But seriously. The banks? Really? Aren't you the least bit suspicious that Goldman is talking up the banks? Doesn't this mean Goldman is probably already short on the banks?

We have been hanging out at what we now call the "Trading Nebula" in our new offices. Our research department is growing, so we like to drop by and see what the traders think is happening. Often, it seems nebulous to us, given the peculiar vocabulary of indicators and charts the guys are using. Hence the "Trading Nebula."

But Murray Dawes was especially clear this morning when he told us that his screens are producing all sorts of warning signals on the banks. He is obviously running a different trading algorithm than Goldman. But then, he's producing trading leads for our new Slipstream Trader, which is designed to produce long and short ideas on ASX 200 stocks. In our chat this morning he told me that two banks showed up, although neither were part of the big four.

If Murray is suspicious that the banks can lead the market to higher highs, at least he's in good company. Bear heroine and noted financial analyst Meredith Whitney wrote in the Wall Street Journal over the weekend that, "Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting."

You don't say?

"Access to credit is being denied at an accelerating pace," Whitney adds. "Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan...In the U.S., small businesses employ 50 percent of the country's workforce and contribute 38 percent of GDP...Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business."

What then, has the regulatory and policy reaction actually produced? It's propped up large institutions that still have heaps of bad assets and have used the last six months to increase their leverage. But at the regional and local level, real businesses with real customers and real capital needs can't get credit.

To summarise: We have saved the zombie companies with zombie assets at the expense of the living, breathing engine of the free market; the small business. This leads Whitney to conclude, that "We are only in the early stages of the second half of this credit cycle...I expect another $1.5 trillion of credit-card lines to be removed from the system by the end of 2010."

What will happen to the economy then? And what will happen to Australia then? Will it matter? The ability to extend credit to small businesses and households is concentrated in the hands of the Big Four. Does that make us safer? Or does it concentrate the risk in a few major players, jeopardising the whole system of credit?

What's clear is that the supply of commercial credit is more concentrated now than ever before. Will the Big Four shun risk and build a capital cushion by cutting off small business credit? Will they double down on their housing lending in order to support house prices; a scheme which supports the value of the assets the banks carry on their balance sheets?

If we're making it sound like the market and the economy are at a critical inflection point, it's because they are. The complacency of the last six months is giving way to some real questions about what to do with troubled assets that are still troubled and bad debts that are still bad. Can a global economy really grow when the financial system is weighed down by so much debt?

Professor Michael Hudson is coming to Australia and he says "No!" If you're interested in hearing what he has to say in person, check out his schedule here. You can RSVP for the event near you, provided seats are still available. If you can't make it, there's a good You Tube video of his ideas here.

We're not familiar with everything Dr. Hudson has to say. We're planning on catching up for lunch and will report back to you how it goes. In the meantime, he gave an interview with the folks over at Business Spectator and put his views lucidly: "There's a basic mathematical principle; a debt that can't be paid won't be paid."

Talking about the explosion in consumer debt world-wide, including here in Australia, Hudson says, "These debts are beyond people's ability to pay and so we're going to see breaks in the chain of payment and this means that a lot of debts are going to go bad. It means that people are going to hesitate to realise that they can't pay, a kind of cognitive diffidence [sic] that people have about the fact that they really can't pay their debts."

"They're willing to run down their savings, they're willing to sell off their assets and do everything, but in the end they default and this is what breaks the back of an economy. The houses are defaulted on, they're put up for sale, that crashes real estate prices all the more and, again, the commercial real estate is even in more serious condition than residential real estate right now."

Coming back to Barofsky and Goldman then, and if Hudson is right, is this the time to buy the banks? Barofsky's report concluded that not all nine of the banks that received $125 billion in capital infusions from the U.S. government here as "healthy" as Ben Bernanke and Hank Paulson made them out to be.

The nine institutions combined had over $11 trillion in assets. But Paulson made it sound as if the capital infusion would not only stabilise the banking sector, it would prompt the resumption of credit flows in the economy. That turned out to be...not true.

So what is the truth? Well, as we suggested at the time, the TARP was just a massive delaying tactic. The capital infusions (putting aside that it wasn't really capital but money the Federal government borrowed that must be repaid) were designed to prevent the banks from going insolvent on further asset write downs. But the whole logic of the deal was that asset values would stabilise and even improve, meaning the banks wouldn't have to take losses or raise more capital.

Give it time baby. Time heals all asset values, right?

No. It all goes back to what you mean by "troubled." And this is the real heart of the issue behind our mistrust of the stock market rally. There has been no real improvement in the quality of troubled assets in the last year. In fact, they are more troubled than ever. The financial system remains troubled, and not much in it has really changed.

This leaves the highly-leveraged banks in the same precarious position as they were before, albeit with slightly more confidence from a gullible public. But at the balance sheet level, have things really improved? And more importantly, have the trillions in assets in the financial system related to residential and commercial real estate really become more valuable in the last six months? Or is just a Ponzi Finance pyramid of junk waiting to go up in flames?

In our view, the last year has been a policy and regulatory sham to cover the retreat by bankers. The people heavily invested in the old system of debt-based asset appreciation are stalling for time. They hope that the passage of time will improve earnings for a quarter for two.

And if they are the religious sort, they pray that some other scheme will be established to take the troubled assets of their hands. But time cannot heal troubled asset values. Faith healing doesn't work in financial markets. We'd humbly suggest that the day of reckoning is still out there, hiding somewhere on the calendar, waiting to rise again. Until then...

Dan Denning
for The Daily Reckoning Australia

• Normally Small Businesses Lead the Economy Out of Recession
• Meredith Whitney and the Buy Recommendation on Goldman Sachs
• Rising in Defense of Goldman Sachs
• Warren Buffett is Buying Four Percent of Goldman Sachs
• Is the Macquarie Model Dead?

And on to today...Shouldn't this be an interesting week? "Markets have gone up too much, too soon, too fast," says Nouriel Roubini. The ASX 200 fell nearly 100 points on Friday, or 2.11%. This echoed the previous day's trading in New York.

Friday wasn't so bad on the Dow. But the jobs report released by the U.S. Department of Labor showed 263,000 lost jobs in America and an official unemployment rate of 9.8%.

That rate is undoubtedly much higher, once you figure in people who've given up looking for work but are no longer included in the survey. In fact, the "U-6" figure kept by the Department measures labour "underutilisation" in the economy. And according to that figure, U.S. unemployment is at 17%, nearly twice the figure quoted on Friday.

There have been jobless recoveries from recession before. But you still have to wonder how there can be such a big difference between the stark news in the job market and the behaviour of the stock market. True, economists will tell you that jobs are the last thing to recover from a recession. Businesses don't hire until they are sure everything is in the clear.

And we are often told that stocks lead the economy. The market has priced in a recovery which the labor market will confirm...eventually. At least that's the conventional wisdom. It's reassuring.

But the unconventional wisdom is probably more correct. The unconventional wisdom is that low interest rates (near zero in the U.S.) have driven people out of cash and forced them into higher-yielding and often speculative assets. The biggest obvious beneficiaries of low rates and credit facilities has been financial sector stocks themselves (and presumably their options-laden directors).

The question this week is whether there is any momentum left in that trade. Can easy central bank policies keep stocks going higher? Or has the trade exhausted itself? And if it has, what happens next?

Well, one answer is that you may again see a mini-rally in the U.S. dollar and a fall in common stocks and commodities (oil and gold especially). We'd expect this to a cyclical dollar rally. In the bigger picture (a secular trend) the dollar is toast. But markets do not move in linear fashion. They give and they take. And the dollar may be due.

If we do get a greenback rally, this may pave the way for a higher Aussie gold price. The strength of the Aussie dollar has capped the gold price here in Australia. But we reckon you may get a nice move in the Aussie gold price if the greenback rallies. The question is whether U.S. dollar strength takes gold down too, neutralising the benefit of the weaker Aussie.

How do you sort out the relationship between two currencies, one commodity, and many stocks? It all sounds complicated. That's why we've added another mind to the trading desk here at Daily Reckoning Australia headquarters on Fitzroy Street. Murray Dawes is at the helm of the trading desk today. We'll keep you posted on what he has to say.

One question we'll have for him: what the heck should investors do with Woodside Petroleum (ASX:WPL)? Dow Jones newswires is reporting that over the weekend, Federal Resources and Energy Minister Martin Ferguson awarded permits to explore ten new off-shore oil and gas blocks in the Carnarvon Basin off the Northwest coast of Australia.

Woodside is one of the firms that won a permit. Ferguson said that, "The additional investment in Australia's offshore petroleum exploration sector not only offers exciting potential for petroleum discovery but will ultimately help to further develop our petroleum resource and underpin our security of energy supply,"

The security of Australia's energy supply is exactly the issue our special situations analyst Mike Graham took up in his research about Australia's oil industry. You can find that complete report here. The findings may surprise you.

With respect to Woodside, there are not too many better blue-chip energy stocks in Australia. Unlike the smaller explorers though, the blue chips are valued differently. Adding to their reserves is crucial, so that the company is not inexorably depleting its assets. But the energy blue chips like Woodside are well known by analysts and they are well-traded by institutions.

This, in our mind, makes Woodside a perfect candidate for a Slipstream trade. That is, if we were a full time trader, we'd be looking for a pattern in the stock chart to see where key levels of support and resistance were. But since we don't run the trading desk, we'll ask Murray and see what he says.

Today's thought of the day from John Robb at Global Guerrillas, "The American 'kleptocracy' has run out of steam due to too much debt and is already in the midst of a perpetual depression. Why? The US middle class -- faithful to the cult religion of free markets even while being taken for all they are worth via a 35 year process of substituting debt accumulation for income gains -- is financially broken. If this is even remotely true: is the US headed for Privatopia and the viral spread of Global Guerrillas?"

Substitute "Australia" for "America" and it makes just as much sense, doesn't it?

Dan Denning
for The Daily Reckoning Australia

• Looking at WPL and Oil Side by Side
• Apparently More Debt is Now Acceptable in Australia
• Commodities Tell Us the World Won’t Stop Turning in a Financial Crisis
• Oil Prices Under $70
• The Future of the Australian Resource Market, Two Ways the Boom Could End

So how much more bounce is there left in this market? That's the question we grapple with today. If you're into rhetorical fallacies, you might say we're begging the question. You only assume it's a bounce if you reckon the rally is not based on an improved long-term earnings out-look.

There are plenty of analysts and investors - many of whom are now filling up our inbox with snarky notes - that contend the worst of everything is over. It's a recovery. And even if America is stuffed, Australia has its cosy China relationship to power commodities and the currency higher.

Maybe so, put probably not. We reckon it is a bounce in the image of the post 1929 stock market crash. You don't liquidate a decade's worth of speculation and leverage in 18 months. It takes years. They started the process in Japan in 1989...and it's still going on.

But the stock market is not a television show or a graphic novel. It does not have a tidy beginning, an enthralling middle, and a miraculous end. Attention spans are short these days. People expect instant resolution. But the unwinding of a credit boom doesn't work that way, especially when you have central banks and governments fighting it every step of the way with measures to prevent the needed liquidation.

Consider this our warning then: this rally is on borrowed time. We don't know when. We don't know why. But we do know what. And the what is that stocks are going to price in much lower earnings and investors are going to pay less for those earnings. Expect a lot of spring volatility.

Unlike late 2008, though, this is a great opportunity for traders, mainly because you can short financial stocks. The S&P ASX 200 Financial index is actually up 63.5% since the March six lows. We've been working with Swarm Trader Gabriel Andre to add short recommendations to his service. It's ready to roll now, and Gabriel says the financials make inviting targets.

Energy investors ought to take heed as well. Lately there's been a nice correlation between the oil price and stocks. The better the economy, the better it is for oil and earnings. Both have gone up.

We're still bullish on energy for a lot of reasons. But if the party ends sometime in September/October/November, you can expect lower oil and energy prices. That means if you have gains in energy stocks, you'd want to think about trailing stops and profit taking. In fact look for profit taking on the share market as a precursor to a new move lower.

It certainly does make for a tricky investment strategy. Energy stocks are some of the few stock we'd really want to own for the next ten years. But stocks are stocks. And in a bear market, most stocks go down. So what do you do?

A more active management strategy is probably what's called for. But this violates one of those old axioms of institutional investors: do not try and time the markets. The buy-and-hold strategy works when you're in secular bull market. It also works to the extent that most investors take control of their investments in moments of extreme uncertainty. People end up selling at the bottom and buying at the top as a result.

So why become active when being passive is so much easier? Because your money - and perhaps your retirement - is what's at stake. You can go along with the media and pretend the last two years haven't happened, or that they did but everything is better. But remember, these are the people who didn't see the whole thing coming in the first place. Does trusting them sound like a good game plan?

Of course most of the time, trusting the conventional wisdom/do nothing approach works. Most of the time the world's financial system doesn't totter on the brink of a cliff. Most of the time you wouldn't have to bother reading about outliers, black swans, and worst-case scenarios - the subjects it is our full-time job to explore here in the Daily Reckoning.

But we reckon now IS one of those times. In fact, it's been that way since the Fed took interest rates to zero in 2003 and kicked off a global liquidity boom in all asset markets. You live and invest in an era of global fiat money. How that era ends is a dead certainty. But when is another question altogether. More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• The Australian Resource Boom Isn’t Dead Yet
• Bear Markets Do Not End With Stocks Still Trading at Nearly 20 Times Earnings
• Stocks Better than Bonds When Inflation is a Big Threat
• Should You Buy Stocks Now to Take Advantage of Bull Market?
• June Producer Price Index Indicates Slower Inflation in Australia

Actually that's not fair. Rallies don't last forever. If you go back to March 6th, the ASX 200 closed at 3,145. It's up over 1,000 points since then-or 32.5% if you're trading at home. You'd expect a correction or consolidation at some point. We may be at that point.

But let's not leave Mr. Stevens out altogether. The Governor of the Reserve Bank of Australia gave a fascinating speech yesterday in Sydney. The market reacted to the speech by pushing up the Aussie dollar. It did so because Mr. Stevens said that Australia's economy and financial system have, "been travelling rather better" than other industrial economies.

This leads some people to believe the next move for Aussie interest rates is up, which is bullish for the currency (given that interest rate differentials to the U.S dollar and the Japanese yen are currently the big driver for the Aussie). Another way of looking at it is that interest rates are rising because the economy is healthier than we all thought.

We'll see about that. Stocks are certainly pricing in a profit recovery (about which we have our doubts). But Mr. Stevens also had a bit to say about credit markets and balance sheets, in comments that were not as widely reported as his comments on Australian housing. More on housing in a second.

But what about our claim this week that corporate cash flows are headed back to early 20th century level growth rates because of the burst credit bubble? Does the Governor of Australia's central bank agree? Judge for yourself.

Stevens writes that, "The pace of global growth, and the easy availability of credit, seen in the period up to 2007 was not the norm. It is unlikely to be seen again any time soon." So far so good?

"The path to economic health for the major countries of the world will still be a difficult one, because the legacy of the crisis will cast a shadow for some time." Could he mean that the destruction of bank collateral (commercial and residential real estate loan books) is still a problem restricting the availability of credit, or will restrict future lending?

"Major international banks will remain diminished in stature and balance sheet capability, and will be required to devote more capital to their strategies in the future. If global regulators have their way, the world will be characterised by less leverage and more expensive credit, than in the earlier period. We here in Australia have to accept that fact and accommodate it in our thinking."

Bravo! We reckon that means that Aussie bank profitability-indeed the profitability of the whole real estate, finance, and insurance sectors-will never again reach the 2007 highs, or not at least for a very, very long time. And if that's the case, it means that income investors used to counting on dividends from safe bank stocks may need a new game plan.

One other non-housing note from the Governor, this one on debt and the changing nature of global capital markets (due to the massive destruction of global capital). "Government and government-guaranteed debt of one form or another is rapidly increasing globally...Certainly people will worry, longer term, about increases in long-term interest rates potentially 'crowding out' private borrowers. To date, though, long-term rates remain historically low for public borrowers, despite the prospect of very large debt issuance."

The important words in that sentence are "to date." If historically low interest rates do not stay historically low, the cost of government-guaranteed debt is going to rise along with interest rates. And if the government itself maintains and increases its role as middle-man lender in the capital markets, we can't see how government borrowing wouldn't crowd-out borrowing by smaller businesses and even households.

We all know how efficient the government is at spending money and allocating capital to productive enterprise, don't we? This puts Aussie banks in a tough spot. They can use the government-guarantee to borrow. But who are they going to lend to? Households?

"The prominence of household demand driving the expansion from the mid 1990s to the mid 2000s should not be expected to recur in the next upswing," Stevens said. "The rise in household leverage, the much lower rate of saving out of current income, and the rise in asset values we saw since the mid 1990s, are far more likely to have been features of a one-time adjustment, albeit a fairly drawn-out one, than of a permanent trend."

Now that's a bit of a bomb shell. Stevens describes the whole model of getting rich in the Western world for the last twenty years and says it was a one-off, not to be repeated. But if you can't borrow, leverage, and spend your way to wealth as your stocks and houses go up in price, how are you going to get rich and retire?

Stevens says that, "The households of the Western world are currently feeling that they can no longer consume as they did, in part because the earlier spending is now seen to have been based on an unrealistic set of assumptions about long-run income and wealth. To that extent, there is no real way around a period of adjustment involving lower consumption for awhile." What about lower standards of living too? Hmm.

This is remarkably frank talk from a central banker. Stevens paints a picture in which business confidence has recovered. But he also shows that systemic leverage will have to be reduced and that the economy will enter a period where households lower their consumption "for awhile"-even as the government is forced to withdraw its support for "aggregate demand" through cash giveaways s mis-directed stimulus splurges.

All of that leaves us with a question about the Australian economy: who is going to be borrowing and who is going to be spending? What is going to drive the growth? If banks have to repair balance sheets by being more guarded with capital, and if consumers tighten their belts because their real net worth is falling (along with their real wages), why would a business borrow for demand that isn't there, assuming it could even get a loan from a bank reluctant to lend?

Our guess is that Aussie banks don't want to lend to businesses because there's too much risk in that. Besides, Aussie corporations have successfully tapped the equity and bond markets for new capital in last year, leaving the banks out of the loop. But one asset class Aussie banks are keen to lend to is residential housing. Why?

The destruction of bank collateral is what's behind the shrinking of bank profits and balance sheets. The largest part of Aussie bank collateral is in property, especially residential property. If banks don't keep lending to the property market to support demand and prices, prices will fall, damaging bank collateral and forcing the banks to tighten credit (housing finance) which leads to even further house price declines. Vicious circle. Feedback loop. Take your pick.

We were discussing just this subject earlier in the week over lunch with Phillip J. Anderson. Phil is the author of a new book called "The Secret Life of Real Estate." He's also one of our panellists for this Friday night's Debt Summit and the State Library of Victoria. He had some forecasts about the Aussie housing and stock markets that some investor might find...surprising.

Incidentally, if you can't make the Debt Summit, Phil is signing copies of his book tomorrow between noon and 1:30 pm at the Educated Investor Bookshop at 500 Collins Street. We recommend dropping in if you're in the area. It's a great book shop. And Phil's written a book about the real estate cycle that Aussie investors can't afford to miss.

Glenn Stevens says now is the perfect time to build more houses in Australia and hopes that the "ready availability and low cost of housing finance is translated into more dwellings, not just higher prices." He seems to be arguing that the Aussie property market could be in strife if someone doesn't start building more homes ASAP.

"If all we end up with is higher prices and not many more dwellings-then it will be very disappointing, indeed quite disturbing. Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track."

Dan Denning
for The Daily Reckoning Australia

• IMF Report Concludes Aussie Banks are “Very Sound”…
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• RBA Rate Cut Does Little to Unlock Credit Market
• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit

The RBA rate cut WAS a full percentage point as we speculated yesterday. And it certainly did make a splash. Economists loved it. The critics praised it. And investors "huzzahed" the ASX 200 up nearly two percent on a day when the rest of the globe quaked in fear.

What has changed? The bank has shifted from being worried about inflation to being worried about recession. A credit crunch? Slowing global demand? Falling commodity prices? All those DO seem to add up to much slower growth.

"The recent deterioration in prospects for global growth," the RBA released in a statement, "together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast."

But is the biggest RBA rate cut in 16 years more symbolic than anything? What will change in the real economy and the credit markets because of what the RBA has done? The big four banks did pass on a rate cut of 80 basis points to consumers. That's a win for the battlers.

Will the RBA rate cut unlock the interbank lending market, though? The RBA board said it took careful note of movements in funding costs in wholesale markets," and that, "an unusually large movement in the cash rate was appropriate in order to bring about a significant reduction in costs to borrowers." So credit is now cheaper. But is anyone selling? Banks might begin lending if they were sure it was safe to lend. But is it?

To the extent that Aussie banks fund domestic lending by borrowing from foreign banks, the lower rates don't help either. The cut DOES help reduce the cost of all that debt Aussie consumer are carrying (160% of disposable income according to Dr. Steve Keen). But it doesn't make the debt go away.

We made an error earlier this week when we said Australia had moved to guarantee bank deposits. That move has been made in the U.S. and Europe, but not yet in Australia. And according to Wayne Swan on Lateline last night, there's probably no need to do so, since Australian banks are well regulated and well capitalised. Hmmmm.

Dan Denning
The Daily Reckoning Australia

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• Aussie Banks Addicted to Foreign Borrowing