I am not normally a fan of using rates to control economic activity but on this occasion it was only partly about the economics narrowly defined and a good deal more about providing a warning to the loose fiscal cannons in charge of managing our economy. The rate increase could not have come soon enough to suit me.

Do I know why the RBA raised rates? No. Am I privy to the discussions of the RBA Board? No again. But I do know this. I do know why I would have raised rates, and would keep on raising them until the Government gets the message. That I do know.

The data below are from the most recent set of National Accounts. The data, which I discussed in my previous posting, show the level of National Net Saving and the Saving Ratio. Both are at extraordinarily low levels.

The figures make it unmistakeable that there has been a collapse in the level of national savings available to all users across the economy. These are investable funds that are potentially available for those who would wish to increase our capital base by borrowing the incomes earned by others for use in projects of their own. The funds available have not only cascaded downwards, falling by half over the past year, but the rate of decline has even been accelerating.

This is an outcome that would worry any central banker worth his salt. Depleting our savings in such a savage way will have left us even less able to regenerate growth than we were twelve months before when the stimulus spending began.

Parenthetically, it might be noted that the only justification for a Keynesian stimulus - at least if there were any consistency between the Keynesian models that are taught and the policies everyone is attempting to pursue - is that there are unused saving that need to be soaked up in higher levels of public spending.

Saving in a Keynesian model creates damage because it reduces the level of spending. Since in a Keynesian model we can't count on investment rising to fill the expenditure void created by our savings, it is the government which must come to the rescue to spend our way to prosperity. It is increased public expenditure and higher deficits that move the economy out of recession.

Well, how much nonsense is that! The government, rather than deploying savings no one else is willing to spend, is spending our savings before anyone else has a chance to get at these savings themselves.

There is then the savings ratio, which the ABS defines as "the ratio of national net saving to national net disposable income." The data show that in the latest quarter, the ratio has not just fallen, it has become negative. Individuals in aggregate are taking money from their savings and using it to pay the bills. Expenditures are rising faster than disposable incomes.

That interest rates must rise in such circumstances is beyond question. They will rise with or without the RBA, and in fact, aside from mortgage rates, already have. Partly the interest rate number has gone up, and partly there has been a restriction on the availability of credit. But up interest rates have gone and for good reason. The RBA is mostly just catching up with the market.

There are then the data from the RBA showing the growth rate in Business Credit between March and August this year. No economy entering a serious growth phase has numbers anything like that.

In the last month for which there are data, in August 2009, there was again a fall in business credit and over the year the level of business credit has fallen by 2.2%.

This is almost the classic case of crowding out. Others are getting to these funds sooner and more cheaply than business. Government spending has replaced business spending. The government stimulus is thus not only wasteful almost down to the last dollar spent, but is preventing the private sector from having access to the funds it needs to invest and employ.

The political side to the rise in interest rates therefore strikes me as a warning shot across the bow of the government. It is a statement from someone worried about the way in which we are ploughing our productive potential into the ground with the certainty that in a year or two we will have an immense debt and nothing to show for it.

Raising rates may begin the process of sobering up those who have been wasting our resources hand over fist and remind them that there is a price to pay and the debt is starting to be called in now.

And let me add one last point. It is said that the rise in interest rates is working in the opposite direction from the increases in public spending. Higher rates will slow the economy while higher public spending will increase it. There is therefore an inconsistency and contradiction in public policy.

This would be true only if there actually were some kind of stimulating effect of higher public spending. Since such spending is a negative, since it only acts to weaken an economy and slow it down, there is nothing whatsoever contradictory about using higher rates of interest as public spending goes up.

I am, in fact, inferring the highest motives to the Governor of the RBA who may himself actually see only negative implications in the stimulus and is trying to get the government firstly to stop spending, and then, if possible, to roll back what planned levels of spending has not yet taken place.

But as for this rise in rates being a contradiction, there is none at all. Savings are being plundered by the government, and if we are going to find our way to a genuine recovery, the government's hands must first be pried off the savings of the nation. A really sharp rap on the knuckles may be the only way.

Dr. Steven Kates
for The Daily Reckoning Australia

• The Dead Weight Cost of the Stimulus
• Dr. Woody Bock’s Essay: The Future Evolution of the Debt-to-GDP Ratio
• Consumer Spending Rises
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar
• Saving Money, Not Spending it, is the Key to Getting Wealthier

But let's start with sovereign wealth fund of China, the China Investment Corporation (CIC). CIC was set up in 2007 with US$200 billion of China's nearly $2 trillion foreign exchange reserves. It's been shopping ever since, with mixed results. Last year, for example, CIC stood pat and only invested US$4.8 billion outside China. It preferred to ride the bubble in Chinese bank stocks, which worked out pretty well for it.

Yesterday, however, Reuters reports that CIC is now cashed up to the tune of $300 billion and ready to buy again. "It will not be too bad this year," says CIC chairman Lou Jinwei. And here's the good part. "Both China and America are addressing bubbles and we're just taking advantage of that. So we can't lose...We have to be in everything because you never know what's going to happen in this world."

Come again?

There's a charitable way of reading these comments and there's a straight forward way. The charitable way is that Lou and the rest of China's economic mangers know that their $2 trillion in forex reserves (which are mostly in U.S. dollars) are in perpetual danger of devaluation. If you had a pocket full of $300 billion in monopoly money, trading it for anything-anything at all-would be the sensible strategy.

You'd want to trade it for a real tangible assets or equity before asset sellers started treating your money with disdain. This is why CIC "can't lose." Better to trade it for something now then watch it turn into nothing later.

The straightforward interpretation is that the Chinese wealth fund managers have lost their marbles. Counting on more bubbles to increase your wealth is a portfolio destruction strategy. Chinese fund managers may end up being every bit as stupid as the hedge fund managers and bankers and CEOs at U.S. banks who ran their respective institutions into the ground making the worst leveraged bet of the century on U.S. housing.

The only real difference, as far as we can see, is that the U.S. bets were made with borrowed money (often borrowed from Chinese creditors, we reckon), whereas China is investing the fruits of its productive labour over the last twenty years. It is a massive gamble. The U.S. managers, who may have been criminal rather than stupid, did tremendous damage to their country's economy. Will China's managers replicate the feat?

This also makes you wonder how much the emergence of China itself is a function of a global bubble in fiat money since August of 1971, when Richard Nixon took the U.S. dollar off the gold standard. Sure, there are tens of millions of Chinese people working in real factories making real products out of real raw materials (many sourced in Australia). These people have real dreams, ambitions, and economic aspirations, not to mention real savings (in gold and paper money).

But is it possible that China's time at the centre of the global economic stage is limited because China's economic model itself always depended on cheap credit and fiat money? Yes, yes. It goes against the whole "next economic empire" way of thinking. But if China's official asset managers are counting on bubbles to make them wealthier, you wonder how sound the model is, and how long the wealth will last. We wonder anyway, which is our main job at the DR.

Empires. They sure don't make them like they used to. Rome lasted a good long while, with a big lead up as Republic. The 1,000 year Reich didn't last ten years. The economic and political clock seems to be speeding up these days.

That would be something. A twenty-year global boom from fiat money that simply accelerated the depletion of natural resources and the misallocation of capital to projects that are uneconomic at lower levels of household and business debt. Hmmn.

Speaking of resources, two notes that prove oil is still out there, but getting harder to find and more expensive to produce. PetroChina will spend $2 billion to buy a 60% stake in the MacKay River and Dover oil sands projects in Canada's Athabasca oil sands. Canadian sources reckon there are 5 billion barrels of bitumen on the properties. But turning bitumen into oil isn't easy or cheap. It takes lots of water and energy, neither of which are money.

The other note is that BP says it has found as much as three billion barrels of oil in the Gulf of Mexico. It found it by drilling 10,685 metres below the Gulf of Mexico, or 35,000 feet. So BP drilled the equivalent of a Mt. Everest underwater to find the oil. Actually, Mt. Everest plus another six thousand feet.

This is ample evidence of Peak Oil. It shows that oil is getting harder to find and more expensive to produce. Technology has improved, of course, allowing exploration companies to look further afield than ever before. Oil companies can increase reserves this way. They're finding oil. But it is not the cheap, easy, free-flowing stuff once found in the oil fields of East Texas or Saudi Arabia.

By the way, if you're wondering what could cause a second dip in the global recession, we have an answer: government stimulus. Yesterday was full of stories on how the stimulus spending by the Australian federal government made the recession less worse than it might have been and produced positive GDP growth. This has everything backwards, although it's being swallowed whole by the financial press.

A rebound based on monetary inflation and government spending isn't a real rebound at all. It gives the appearance of normalcy and economic health through rising asset values and more transactions in the economy (which GDP itself measures). But unless there's a big pick up in private investment, the economy is not on any sounder long-term footing.

In fact, it's worse. The illusion of prosperity created by stimulus spending induces people into maintaining debt loads they might otherwise reduce. Consumption patterns which ought to change in order to put the household and corporate balance sheets back in working order aren't changed at all. And when the government stimulus is withdrawn later---as it must be before higher fiscal deficits lead to rising interest rates-the economy reverts back to its pre-stimulus levels of growth-only without the underlying issues of over consumption and too much debt having been addressed.

Or the short version: there is no easy way out of this mess. The government can't create wealth by borrowing money or taxing people and spread the lucre around to favoured groups at the expense of others. That's theft and it's immoral. But the real issue is that the whole economy needs to reduce leverage. The housing bubble has to pop. And the nation has to quit living above its means (we remember writing this about America five years ago).

How about some reader mail?

Hi Dan,

Gene A.

Not this first time we've heard this and won't be the last. We write about outliers and Black Swans. Those topics are controversial, which is why the mainstream media is afraid to express a real idea about them. What's more, getting people's attention in this economy is tough. Sorry you don't like the ads. But don't expect them to change.

For one, we have to pay the bills. As much as we like writing the DR, there's an entire publishing operation to support that provides research to paying subscribers. Secondly, we wouldn't describe any of our publications as "loopy get-rich quick schemes." We know how much time and research goes into each monthly report. We stand behind all the ads and have a hand in a fair a few of them to make sure they're telling the stories we think you can profit from. If you really don't like them, you can always just ignore them.

--Hi Dan

Aidan

--DR

John

Dan Denning
for The Daily Reckoning Australia

• The Iron Ore Pricing War Between China & Australia
• China, the Miracle Economy
• Inflation: Enemy Number Two
• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?
• India Beats China to Walk Away With 200 Tonnes of IMF Gold

How did Australia get caught up losing money in commercial U.S. real estate? In yesterday's Age, Bwembya Chikolwa, a lecturer in the School of Urban Development at Queensland University of Technology, says Aussie super funds had money to burn and listed property trusts, with their large portfolios of U.S. assets, were liquid enough to do the trick.

"Unfortunately they were caught up in circumstances to do with the financial crisis," she says. "Moving into the US wasn't a problem because it had more or less the same settings...It was driven by large investment inflows into the super funds...The super funds needed new investment avenues and the trusts were a good avenue. So they invested through the listed property trusts. They had the funds and had no choice but to move offshore and the US market because of its size."

No choice? A portfolio manager always has a choice. It's the retail investor who is forced into compulsory super that has less choice. But this does highlight the obvious fact that fund managers are not paid to put clients into cash. Self managed super investors can do this easily enough, and many did (whether by design or indifference), thus avoiding the share market wipeout. But big fund managers have to buy big stocks. They are too big to buy small stocks, by the way, which creates a niche for Kris Sayce at the Australian Small Cap Investigator.

But now we have yet another seemingly external threat to your cozy domestic retirement: U.S. commercial real estate. Yesterday's Wall Street Journal reports that the $700 billion U.S. commercial mortgage backed securities market saw a delinquency rate of 3.14% in July. That was up six times from the year before.

The Journal reckons that over $153 billion in loans need to be refinanced by 2012. Of that amount, at least $100 billion could be in trouble. Why? The underwriting on the original commercial real estate loans was dodgy (as it always is in a credit bubble). But more importantly, with property values on commercial real estate down by 50% in some areas, refinancing at the same loan to value ratio as before just isn't going to happen.

Cash flows are fine for debt service and principal repayment now, according to the Journal story. It's the write down in property values that will scupper the refinancing. What's more, because the loans were securitised, it's often hard to figure out who you should be renegotiating with. This is reminiscent of the residential mortgage backed securities market where Deutsche Bank couldn't proved it owned the properties it wanted to foreclose on.

Mortgage servicers, banks, and investors would all prefer the problem to go away so no one has to take a write down on their asset values or a loss on their securities. But Aussie firms already know better. The only question now is if a pear-shaped U.S. commercial real estate market will do as much (or more) damage to the global financial system as the residential housing market. Stay tuned....

Dan Denning
for The Daily Reckoning Australia

• Property Sector Has Seen the Value of its Assets Wiped Out
• Commercial Mortgage Backed Securities Are Back
• A Look at Debt and Super
• Paying Attention to the Risk from Deleveraging in Commercial Real Estate
• Your Average Australian Super Fund

"Building and construction activity has weakened for a 16th straight month as firms grappled with delayed projects and difficult credit conditions...The Australian Industry Group-Housing Industry Association performance of construction index (PCI) fell by 4.3 index points in June to 42.6 points. The index has been below the 50 level, which separates expansion from contraction, since March 2008."

But let us not be accused of being pessimists. Take a look at the chart below. It's from a 2002 book called Triumph of the Optimists by Elroy Dimson, Paul Marsh and Mike Stanton of Princeton University. It shows that over the last one hundred years-and importantly, prior to the blow-off phase of the credit bubble in 2000-dividends accounted for half of your total return in U.S. and U.K. common stocks.

Dividends went out of fashion in the tech boom. To be fair, many companies had no earnings at all from which to draw a dividend. But as you can see from a second chart (below), the dividend yield on the S&P 500 is coming off a historic-low in 2000. Even so, the current yield on the S&P is just 2.4%, compared to the 3.5% yield on ten-year Treasury bonds.

The yield on Aussie stocks, for whatever reason, has tended to be higher than U.S. stocks. For example, let's say you read the APRA report on Super we mentioned yesterday and decided your best approach was to passively track the ASX/200, thereby reducing management fees and not trying to beat the market with your own skill. How would you do it?

Well-we're not recommending it-but this is precisely what Exchange Traded Funds are for. The SPDR S&P/ASX 200 Fund (ASX:STW) tracks the ASX. It's also going to sport a yield near 10%, based on 2009 earnings projections. So for investors interested in "one-decision" stocks, this one decision on the whole market that pays a surprising high-yield.

That's not to say there's no risk, or that you couldn't do better picking your own high-yield stocks. And that's only if you thought yield was the way to go. But the idea occurs to us because we believe that with financial assets anyway, the name of the game in the coming years is to find a rate of interest (or yield) that exceeds the inflation rate.

Come to think of it, that's always the name of the game. It's just particularly the case when fears of inflation are more pronounced. And incidentally, this also bears on the housing market. That is, it's possible Aussie house prices will stay the same or even rise nominally, but fall in real terms as the rate of inflation in the rest of the economy far exceeds the rate of price appreciation homes (homes propped up by government aid and reluctant sellers, but not powered higher by new buyers because of rising rates and affordability issues.)

But leaving the housing debate aside, we turn the case for dividends over to none other than Ben Graham in The Intelligent Investor. Chapter two of that must-read is called "The Investor and Inflation" and in it Graham writes the following (emphasis added is our own):

Inflation, and the fight against it, have been very much in the public's mind in recent years. The shrinkage in the purchasing power of the dollar in the past, and particularly the fear (or hope by speculators) of a serious further decline in the future, have greatly influenced the thinking of Wall Street.

It is clear that those with a fixed dollar income will suffer when the cost of living advances, and the same applies to a fixed amount of dollar principal. Holders of stocks, on the other hand, have the possibility that a loss of the dollar's purchasing power may be offset by advances in their dividends and the prices of their shares.

It's an intriguing statement, isn't it? We have every reason to believe that deleveraging in the economy is generally bearish for stocks. But Graham is looking past debt-deflation and toward the moment when monetary excess begins driving prices up again (inflation).

In that environment, Graham reckons you hedge against inflation best with common stocks that pay dividends. At least, that's our reading of it. And if it's correct, it means you need a two-stage plan. Stage one is to survive further deleveraging by being more in cash and tangibles than shares. The second-again speaking generally-is to be ready to deploy your cash into assets going up faster than the rate of inflation.

That is enough on the subject today. More tomorrow. And we meant to discuss another 100-year trend, that of global energy production per capita. But it will have to wait. Until then, we've published some more reader mail on property and adolescence.

--Guys,

I am truly disappointed to see you give any credence whatsoever to these clowns.

A fair cop. We're not saying the ratings agencies are going to get it right. But in the aftermath of their complicity in subprime crime, we expect them to err on the side of caution going forward. And correct or not, the downgrades-if they come-will have an impact on what pension funds and other institutions can own debt that is not investment grade. It will have consequences.

--Just read your Monday report. What a load of Crap! Didn't anyone tell you if you have nothing worth saying, then keep your mouth shut.

David P.

We're afraid you misunderstand the purpose of the DR David. It's not to tell you what to do with your money. It's to make you think-or at least share in our own thoughts. If you're not enjoying it, we suggest you get off the pot. And if you want analysis of specific shares, that's for paid subscribers to Diggers and Drillers and Australian Small Cap Investigator.

--Dear Dan,

Ross

Dan Denning
for The Daily Reckoning Australia

• S&P 500 Index Total Return Was Actually Negative
• Stocks Better than Bonds When Inflation is a Big Threat
• Dividend Drop-Off: When Cushions Turn To Rocks
• Consumer Price Inflation has Spooked Investors Everywhere
• After the Bailout of Wall Street, Everybody Wants Cash

In February the government raised its borrowing ceiling from $75 billion to $200 billion. Last week, Finance Minister Lindsay Tanner said the bleak IMF report highlighted the big revenue gap in Australia's budget. He said Australia might have to raise its debt ceiling to $300 billion.

This is the nice thing about being a sovereign government. A household cannot arbitrarily vote itself the power to go deeper into debt. Households are at the mercy of their creditors. This either forces households to live within their means, or forces lenders to be more discrete with their loans.

A sovereign government generally doesn't face the same kind of restrictions on its ability to borrow. The only real restriction is that it doesn't much up its public finances so badly that creditors begin to demand higher interest rates. Or even worse, turn their back altogether.

Granted, Australia's funding needs look pretty modest in the global scheme of things. But the question we ponder to start the week off is whether the Rudd government can trash the country's credit rating even more quickly than anyone expected.

Australia's triple A credit rating could indeed be at risk, according to an article in the Sunday Age. S&P sovereign risk analyst Kyran Curry says his agency is watching Australia's current account deficit to determine if the government is borrowing more than it should. He says the current account deficit shows both Australia's need to import capital and the effects of declining export revenues (an even larger deficit).

He wasn't ringing any alarm bells just yet. But it was pretty clear what he meant. "We believe this Government will develop a credit exit strategy to stabilise its fiscal (budget) position in the medium term...But if the balance sheet weakened (the current account deficit), combined with a further weakening in the fiscal position (the budget deficit), that could bring some pressure on the rating."

"Pressure on the rating," means higher borrowing costs for the government in the future. That makes all sorts of financing more expensive, and exposes Australia's big vulnerability, its reliance on foreign capital to grow the domestic economy.

So how big would an annual deficit have to get before the ratings agencies downgraded sovereign Aussie debt? "It is believed a deficit of $60 billion or more could prove a trigger point for ratings agencies to re-think the outlook, which would lead to higher interest rates and a bigger taxpayer-funded public interest bill," the Age concludes.

David Uren in the Australian writes that it could come sooner than you think. "The crunch point for government borrowings will be reached in 2010-11, when government bond issues totaling $17 billion fall due, compared with just $6billion in 2009-10. This would potentially lift the financing requirement in that year to well above $70 billion, requiring the Treasury to issue bonds at a rate of more than $1.3billion a week."

The job of borrowing $1.3 billion a week from the rest of the world falls on the shoulders of Andrew Johnson, the Chief Executive Officer of the Australian Office of Financial Management (AOFM). Good luck to him on that.

Mr. Johnson gave a speech in Sydney last week called, "Australian Government Debt in a Changed Financial World." In that speech he said, "If we were to continue our current pattern of bond issuance at the rate of $1 - 1.4 billion per week, this would provide $48 -$ 67 billion over the course of 2009." He then showed a chart to prove it.

Source: www.aofm.gov.au

Let's be clear, we're not saying the AOFM is going to have trouble selling this much Aussie debt. Some of it will be bought domestically by super funds. Some will be bought by European and North American financial institutions. And some will be bought by the Chinese we reckon. One clear result is that non-residents will end owning a larger piece of Australian government bonds than ever before.

Source: www.aofm.gov.au

Maybe it's good that foreigners want a piece of Aussie debt. Maybe that means the place remains attractive to foreign capital. And maybe it means the government can run even larger deficits in the coming years without paying substantially higher interest rates. But maybe it also means the Aussie dollar is headed down soon.

Over to Alan Kohler at Business Spectator who writes that, "International investors will not buy Australian government debt at a yield of 4.7 per cent and an exchange rate of 70c/70¥, when debt levels are at the point where a negative rating watch is likely, if not an actual downgrading." Alan predicts/suggest that the Reserve Bank ease the government's borrowing pain by lowering the cash-rate to two percent by June 30th.

It's just over two weeks until Wayne Swan has to present his budget. But we'd expect currency and share markets to start putting the pieces together before then. The weaker Aussie dollar ought to be a bonus for the Aussie gold price (and investors in gold shares). Meanwhile, another big question is whether the share market can keep up its recent run.

You know our take on it by now. Deleveraging and liquidation have a long way to go. There are many more housing-related losses to take for U.S. and European banks (not to mention emerging market debt). Governments are trying to spend their way out of it, and in the process they're jacking up tax rates to soak the rich.

Bottom line? The plan to borrow and spend our way out of the recession isn't going to work. The results of the stress tests for U.S. banks are due the first week in May. But the bigger stress test is going on in the bond markets right now. It's a stress test for sovereign governments in the U.S., the U.K. and here in Australia. Who's going to pass and who's going to fail? More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Australia’s Capital Crisis and its Chinese Future
• For the GSEs the Rest Has Been History
• How to Boost Your Retirement Income
• Commercial Mortgage Backed Securities Are Back
• Government Debt Bubble is What Directly Precedes Inflation

First up is Christopher Wood, regular analyst at CLSA Asia-Pacific and writer of handy newsletter called GREED and Fear. "The ban on shorting Australian financial stocks is due to expire on 27 January," he writes. "If it is not extended, this presents a clear opportunity for absolute-return investors. GREED and Fear continues to take the view that Australian financials will be the last area of Anglo-Saxon consumer financing excess to bottom with, as in Britain and America, the seemingly inevitable involvement of taxpayer money before the end of the cycle."

"GREED and Fear also continues to recommend, as has been recommended since March 2008, that Asia-Pacific relative-return investors maintain a zero weighting in Australian financials. Australian banks, including their New Zealand subsidiaries, are characterised by high loan-deposit ratios and low loan loss provisions."

"Meanwhile, the household sector is extremely leveraged while the former high flying residential property market is weakening fast. Household debt to disposable income is still running at 156%, compared with 130% in America. While Australian residential building approvals fell by 32% year-over-year in November, with new home sales down 15% year-over-year."

"GREED and Fear hears from recent visitors to the 'Lucky Country' that there is still a state of denial, which is certainly not the case in Australia or Britain. If so, this mentality will not last. But the good news is that reluctant Australian taxpayers will be able to afford to pick up the tab. Public sector debt is only 15% of GDP."

So there you have it. From the outside looking in, Aussie banks and investors are in denial about the housing market and the impact of the asset deflation and the credit crunch on bank bottom lines. Does that sound about right to you? Or is Australia's residential property market truly immune from the Credit Depression? Discuss. Or write to us at dr@dailyreckoning.com.au.

Meanwhile, allow us to turn the podium over to Australia's Prime Minister, the Honourable Kevin Rudd. Rudd was in Adelaide, trying to bask in some of Lance Armstrong's cancer-fighting limelight. But he was preoccupied with the emerging fact that foreign lenders are turning off the supply of credit to Australia as the world banking crisis accelerates.

"When markets fail, governments must act," the Prime Minister said, apparently with a straight face. What he was referring to, according to today's Age, is the $75 billion in foreign loans owed by Aussie firms that must be rolled over in the next two years. Trouble is, foreign lenders-and really lenders everywhere-appear to be in nearly full-scale retreat from lending.

This is the trouble with having only four big banks and being a net importer of capital. You can finance your lending out of domestic savings, of course. But Aussie banks-mostly to finance the housing boom of the last ten years-borrowed overseas to lend at home. And if you can't borrow overseas? Hmm. Maybe government lending, or a government guarantee on borrowing, will work instead. We'll see. Meanwhile, back over to Rudd...

"It would be difficult for Australia's four major banks to fill the gap [between borrowing needs and foreign willingness to fund] on their own," Mr. Rudd he said. "When businesses cannot get loans and are not confident about the future, they can't or won't invest, meaning they can't create jobs and they can't grow. The Government stands ready to take whatever further action is necessary to stabilise financial markets."

Mr. Rudd could be getting a lot of action pretty soon. Between the $10 billion stimulus, bond guarantees, the expanded first home buyers grant, and various infrastructure plans, Bloomberg reckons the Rudd government has committed or spent $45 billion so far. It's probably going to take a lot more than that, especially if the government has to guarantee (or the RBA provide outright) credit to local borrowers who can't borrow internationally.

Not that the Aussie banks are being singled out. Heck, Australia's four big banks may outnumber solvent banks in the U.K. and America combined by the end of the week, if things keep going they way they're going. Bank stocks in America were absolutely hammered in Tuesday trading. Citigroup (NYSE:C) was down 20%. Bank of America (NYSE:BAC) was off 29%. And Wells Fargo (NYSE:WFC) was off 24%.

What gives? It's the sinking feeling that the world's banks still don't have enough capital and will need much, much more to offset coming losses and begin lending again in normal way. But the equity capital just keeps melting away. For example, the Royal Bank of Scotland had a market cap of £75 billion two years ago. As of yesterday, it was only 4£.5 billion pounds. And that's AFTER a taxpayer injection £32 billion!

More on what this means for Australia in just a second. And later this week, we'll get into the real heart of the problem in the banking sector, dwindling capital and mismatched liabilities and assets.

But for now, let's be clear: the banking crisis has entered a new stage in the equity markets. It has real world consequences for commodity demand and resource shares. We'll get to that in a second. But what about Australian financial shares?

Well, we won't get into any analysis of loan books or balance sheets. It is true that Australian banks did not get into the subprime mortgage game. But it is also true they did make a lot of loans to margin lending firms in the stock market and still have significant exposure to residential real estate. We asked SWARM Trader Gabriel Andre to put that all aside and tell us what was the worst looking Aussie bank stock on a technical basis.

Here's what he told his readers yesterday in a SWARM alert. His analysis included a forecast for the ASX/200. "Among the losers," Gabriel wrote, "there may have one famous banking institution. Besides the balance sheet and the macro news, we had a look today at the Aussie banks. Just on the chartist side. Only with technical indicators. And there is one chart that does not look really good. It's ANZ. Take a look at the chart below.

"The key level is at $15.5. It has been the main support of the price action during several months (points A, B, C and D) but has been cleared in November (point E) when the price went further down to a low of $12.30. The key level of $15.5 mechanically became the new resistance. Hit a few times since the beginning of the year (points F and G), the resistance has been holding firmly. The long-term resistance (red line) is also just above. The price action is therefore well capped."

"Two different momentum indicators have already turned bearish: the MACD and the Klinger oscillator, which is sensitive enough to signal short-term tops and bottoms, yet accurate enough to reflect the long-term flow of money into and out of a security. This afternoon ANZ is quoting $13.7. It should go clearly further below, especially if the ASX ban on shorting the financials will expire next week."

Maybe ASIC and the ASX will reconsider the ban on shorting financials. And maybe it will not matter anyway. Either way, stay tuned.

We wrote above that the renewed banking crisis is bad news for commodity demand and resource shares. But how so? The problem is asset deflation.

Yesterday we speculated that there could be trillion dollars more in credit-market losses related to commercial real estate, residential real estate, and corporate bonds. If that is the case, it means much lower share prices. It also means finance is going to be extremely tough to come by for mining companies, who are facing falling real demand to begin with.

Today Nouriel Roubini checked in on the issue of how much more asset deflation we face. At a conference in Dubai he said, "I've found that credit losses could peak at a level of US$3.6 trillion for U.S. institutions, half of them by banks and broker dealers...If that's true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion. This is a systemic banking crisis."

Now you can see why it was such a bad day for the banks. The scary fact is that Roubini's estimate could still be conservative. You still have the corporate bond market, securitised consumer loans (credit cards and loans), and GSE and Agency-backed bonds (both of which are tied to U.S. residential real estate.)

But quibbling over trillions is not the point. The point is that if there is more asset deflation to come, it is extremely hard to find any positive argument for continuing to own, much less buying, all but very specific types of commodity-related investments. And just what would those investments be?

We turn to the late Harry Browne for the answer. In the early 1970s, Harry wrote a book called "How to Prepare for the Coming Devaluation." Harry's book was an investment primer on how to live in a world with massive, deliberate debasement of national currencies. Naturally, the strategy favoured "stuff" over "paper." But not just any stuff.

It was-and still is-a radically simple asset allocation model. Harry said that roughly 25% of your assets should be in gold (combination of bullion, coins, and equities), 25% in foreign bonds, 25% in U.S. Treasury bonds, and 25% in growth stocks.

Investing: once complicated, now simple!

Would that model hold up well today? Well, we'd be wary of having money in the bond market. That's one thing that's changed since Harry wrote his book in the 1970s. And we'd probably add more energy investments, given our subscription to the Peak Oil theory of declining global oil production. But his observation that simpler is better when preparing for inflation is spot on.

An actively managed portfolio with a weighting of 60% to 70% of your assets in stocks does not look like a financial survival strategy for the next five or ten years. You want a more permanent portfolio that takes into account the macroeconomic and monetary events that influence share prices.

Harry's big call was to buy gold and silver. And as you know, that worked pretty well. Buying gold has also been Bill Bonner's trade of the decade since 2000. It's working out pretty well too.

But did you know that there's a fund that's traded since 1996 which essentially imitates Harry Browne's investment strategy? It's called the Permanent Portfolio and trades under the symbol PRPFX. Note that we are not recommending you buy the fund.

What we are recommending is that you pay close attention to its strategy. "Designed to provide growth at low risk," the home page says, "the primary goal of Permanent Portfolio is to preserve and increase the real long-term purchasing power of each shareholder's investment, regardless of economic climate. "

It does this with a portfolio consisting of gold, silver, Swiss Francs, real estate, U.S. Treasury bonds, and aggressive growth stocks. Take a look at how the fund has done since its inception versus the S&P.

As you can see, the Permanent Portfolio got clobbered during the tech boom. It's relatively low allocation to growth stocks had it underperforming. Then, starting with the great Greenspan reflation of 2003, it roughly tracked the S&P 500, while still slightly underperforming. However, since late last year, it's held up much better than the S&P 500 as the financial crisis decimated stocks.

By the way, here's how the fund's assets were allocated at the end of last year:

Gold: 20%

Silver" 5%

Swiss Franc Assets: 10%

U.S. and Foreign Real Estate and Natural Resource Stocks: 15%

Aggressive Growth Stocks: 15%

U.S. Treasury Bills, Bonds and Other Dollar Assets: 35%

We might have fewer U.S. dollar bonds and more growth stocks in there too, but what's killed the Permanent Portfolio in the last six months is its exposure to commercial real estate through its REITs. We mentioned last week that we thought arable farm land would be an increasingly valuable asset in the coming years. So if we were going to make this union of asset classes even more perfect, we would strip out the REITs and backfill some agriculture and land investments.

But the rest? It looks pretty sound for a world where you face more asset deflation prior to rampant, government-backed inflation. The 80% up figure translates to about six percent a year since its inception, which is just about the historic return for common stocks (if you include reinvested dividends).

One other item to note about this. The Austrian School's analysis of the credit cycle is what informed Harry's strategy. Like today, he understood that changes in the money supply would affect the real economy and the stock market. The credit cycle and the business cycle are inextricably bound together.

But that didn't mean there isn't a prime place in Austrian theory for the role of the entrepreneur. In fact, the great Austrian economist Joseph Schumpeter pointed this out in his early work, The Theory of Economic Development. Schumpeter pointed out that the aim of all economic production is to satisfy human wants.

In Schumpeter's world, the entrepreneur is more important than the capitalist because it's the entrepreneur who has the vision to challenge conventional ways of doing business and take risks (albeit with someone else's money.) In Schumpeter's vision of capitalism, "the gales of creative destruction" are unleashed by single-minded entrepreneurs who bring change. And not just change you can believe in, but profitable change!

Or as Schumpeter writes in The Theory of Economic Development, "Entrepreneurial profit ... is the expression of the value of what the entrepreneur contributes to production." This is why Schumpeter's kind of capitalism is inherently moral and ethical. It is based on production which consumers find valuable and exchange which they enter into voluntarily.

There is no compulsion or arbitrary setting of prices or government-mandated production or lending. If the idea of the entrepreneur contributes to the production of some good or service people want more of than what's already available (or if it's entirely new) he profits. And sometimes enormously so.

That is one good thing we can say about the world we live in and one big reason why growth stocks should remain part of your asset allocation strategy. In medicine and energy, the world faces huge challenges and enormous entrepreneurial opportunities. It's going to present investors with great chances to share profits from innovative firms.

With great volatility you also get a lot of innovation. As much as we focus on value destruction here in the Daily Reckoning, there are a lot of wealth creation stores to be pursued too!

But we'll have to save the story of creative destruction for tomorrow! In tomorrow's edition, we tackle the issue of fair value versus market value in the U.S. mortgage market. And we'll have more on AGMOIL, the next trade of the decade involving a portfolio of agriculture, precious metals, and oil. Until then!

Dan Denning

for The Daily Reckoning Australia

• The Problem With a Well-Diversified Portfolio
• Australia Presents Investors With Great Portfolio of Energy Choices
• Banks or BHP?
• Note to Australia: Buy Resources, Not Banks
• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?

It's not normal to see these kinds of one-day moves. But these aren't normal times. Traders love volatility. But if you're going to trade this market, your timing had better be exquisite.

We're back on the edge of a credit abyss. Just when investors were convinced that the Gordon Brownification of the world's banking sector had put the credit crisis behind us, we have more bad news.

Brown's plan to recapitalise British banks by directly inject money into them has been widely adopted. But the money (which isn't the same as capital at all) is not going to be enough to replace the "wealth" being destroyed by debt deflation. It's sort of the opposite of bailing a flooded ship out. In order to keep asset prices from sinking, the bankers need to pump more money into the global sea of liquidity.

But even that does not keep bad debts from sinking to their intrinsic value. Reuters reports that Standard&Poor's may cut its credit rating on over US$351.7 billion worth of residential mortgage backed securities that are secured by Alt-A loans. These aren't subprime loans. They are supposedly loans made to more credit worthy borrowers. But S&P notes that losses on Alt-A loans of five-years or more with fixed interest rates will rise from 35% to 40%.

You can't make this stuff up. As we pointed out, the core of the capital in the banking system is directly tied to securities whose value is tied to the price of U.S. houses. With U.S. house prices falling, more mortgage owners are underwater. More are in default. More will be foreclosed on. The securities tied to those mortgages will need to be marked down.

Until the connection between U.S. housing values and the banking sector is severed, the credit crisis isn't going away. Merely flushing more paper money into bank coffers doesn't improve the bank's solvency. You can't fix a solvency problem with more liquidity any more than you can keep a leaky bathtub full by pouring more water into it.

Stocks now face the dual challenge of an extended global recession (bad for corporate earnings) AND the possibility that it may not be so easy to simply 'recapitalise' the banking system with funny money.

Don't forget. The Keynesian economists running the global financial system are engaged in a giant game of poker with the rest of us. They want us to believe in money backed by nothing but confidence. And they want you to believe that the government can simply increase spending (of money borrowed into existence) to stimulate business activity. If banks and consumers show their doubt by hoarding cash, then the Central Bankers will have to go "all in."

"All in" is another rate cut or two. But more than that, "All in" is direct government support of stock prices (and house prices, and corporate debt, and frankly anything which needs buying to prop up its value). How soon will Paulson, Bernanke, Trichet, Brown and the rest of this gang go "All in?" It won't be long now, at this rate.

"Perhaps what we need is to go back to the first Bretton Woods, to go back to discipline," says ECB head Jean-Claude Trichet. Sound money you say? Hmm. "It's absolutely clear that financial markets need discipline: macroeconomic discipline, monetary discipline, market discipline."

"If we don't discipline ourselves, the world will do it for us," wrote Wiliam Feather. When you don't have access to credit, you are forced to live within your means. Expenses must be lower than income. Or else. But it hasn't been that way for years. Credit has enabled us all to live well above our means. Is that era ending?

Are you witnessing the last stand of the Keynesians? Our friend Gary North wrote earlier this week, "The heart of original Keynesianism was its commitment to government deficits as a way to stimulate consumer demand. Keynes also recommended central bank monetary expansion, but the heart of his economic theory was fiscal imbalance [deficit spending]."

Governments, being inherently political animals, want to promote growth at any cost via inflation. Meanwhile, it is vogue to blame poor regulation and greed. But politicians have to paint the bankers as greedy in order to justify the huge sums of money being transferred from the taxpayer to the banking industry. As Gary writes, "In justifying this immense transfer of taxpayer wealth to the commercial banks, politicians have promised a new era of regulation. They have all blamed American regulators for not regulating the securities market.

"No one is pointing to the main culprit: expansionist Federal Reserve monetary policy under Greenspan, which was matched by central bank policy around the world. Central bankers inflated their national currencies to support the domestic export markets. They did not want the [U.S.] dollar to fall, thereby reducing imports from foreign nations."

"It was the mercantilism of central bank policy that produced the asset bubbles, especially the largest one: residential real estate. This is the ultimate carry trade: borrowed short (months or weeks) and lent long (30 years). When it popped, it removed consumer demand around the world."

The borrowed money went to consumers to buy houses. Now those are falling in price. The whole global supply chain is locking up: from finished goods consumed in America, to capital goods manufactured in China, to raw materials inputs in Australia.

Is the Keynesian answer really the way out? No. The Keynesians always confuse money with capital. What we have on our hands is a historic misallocation of capital on residential real estate. Whole economies grew up around the housing industry in many countries. Tremendous leverage was employed to buy securities related to real estate. It's all crumbling in a great destruction/deflation of value.

You don't simply prevent that by printing more money. Real capital is land, labour, an asset, or entrepreneurship that's capable of generating new wealth. The Fed's low interest rate policy-followed by global central banks everywhere-led investors and consumers and businesses to speculating on higher house prices rather than investing in real economic activity.

You don't restructure a global capital structure easily. As Roger Garrison writes, reviewing the work of the great Anti-Keynesian Friederich Hayek, "The costs of restructuring capital are easily absorbed during a policy-induced boom when credit is cheap and profit expectations are high. But after the bust, the costs of undoing the misallocations caused by unduly cheap credit take the forms of business losses, bankruptcies, and unemployment."

Gee. That sounds familiar. We are now finding out that artificially low interest rates badly skew prices and the information they normally communicate. Not only that, but the low rates have led to a disastrous global misallocation of capital in bogus assets. Houses are tulips full of copper.

"If the interest rate is held below its market, or 'natural,' rate by credit expansion," Garrison writes, "the decisions of producers will be inconsistent with the preference of consumers. The economic expansion will be unsustainable. The boom will end in a bust. Only with a market-determined rate of interest can cyclical variations be avoided."

Markets are telling us the price of money should be much higher, given the huge risks in the global economy. Global regulators are telling us that money is free, and that more of it is all we need to solve the problem. They will keep loaning and printing until the whole world is drowned in a sea of fiat money.

Who do you think is right?

Dan Denning
The Daily Reckoning Australia

• Willem Buiter Attacks Fed Policy
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• One in Four US banks Announce Unprofitable Quarter
• Rate Cut of 100 Basis Points Couldn’t Cheer Up the All Ords
• Do the Facts Support Impending Inflation?

The government wants people to understand their money is safe in the banks. That's why that last bit is in there. It's designed to keep foreign holders of Aussie dollars from engaging in a run on the dollar and bringing their money home, wherever home might be (Japan, for example).

The Australian dollar is up in early trading. But its huge slide in just a few months is remarkable. It's good for exporters (especially farmers). Aussie agricultural goods now become relatively cheaper on foreign markets. It's not as good for consumers, who could see higher prices on imports (and there are a lot of imports in the consumer goods sector of the economy).

The big question, of course, is how shares will react to the weekend's events? So far so good. They're up 6% in early trading.

Polling the crowd this weekend and the Melbourne Investment Expo, we got the impression that there was a bit of capitulation on Friday. Investors who could not afford to lose anymore capital may have exited the market during the big 8.3% slide. Fear gave way to abject terror.

There may also be another reason-aside from the panic in the banking market-for Friday's frenzied selling. When Lehman Brothers was allowed to fail, it defaulted on some US$130 billion in senior debt. Against that debt, hedge funds and other Wall Street investment banks had sold some US$400 billion in credit default insurance.

Remember, anyone can sell credit default swap (CDS) insurance. It's a little like writing options. You collect the premium and hope you never have to pay out on the policy. So firms like Goldman Sachs (NYSE: GS), JP Morgan Chase (NYSE: JPM), and Morgan Stanley (NYSE: MS) sold huge amounts of credit insurance against default in Lehman bonds.

One theory making the rounds last week was that those investment banks and hedge funds were selling assets and hoarding cash in preparation for judgement day on how much of that insurance they would actually have pay out. An auction was held last week to determine the value of the outstanding Lehman CDS.

Based on the results of the auction, it looks like anyone who sold default insurance on Lehman bonds will have to pay out around 90.25 cents on the dollar to the holders of the CDS. Obviously, that could be a huge number, based on the gross value of the CDS outstanding ($360 billion). But if the banks and hedge funds have already hedged against their risk in writing these credit default swaps, it won't be any big deal.

If, on the other hand, you were a hedge fund selling CDS on Lehman's debt without making any provision that you'd actually have to pay up, well you, my friend, are in a sorry state. And you were probably selling assets like cheap underwear to raise cash last week. What does any of this have to do with the Aussie share market?

Blue chip Aussie mining shares like BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) and OZ Minerals Limited (ASX: OZL) have been the darlings of hedge funds wanting to own commodity stocks. The Aussie dollar has also been a popular commodity currency and yield play. If hedge funds and investment banks were liquidating commodity positions to raise cash for the Lehman CDS auction, it would most likely hammer Australian stocks.

That's one reason Aussie stocks fell much harder on Friday than stocks on Wall Street. Australia has a high percentage of stocks that were attractive to leveraged speculators when commodity prices were high. Now, those assets have seen a large amount of selling. With the Lehman CDS auction behind us, will the selling end?

We'll see. Beyond Lehman, there are the larger issues in the global financial system. On that score, politicians in Europe raced against the opening of global markets this morning. They announced a package of reforms that would: guarantee interbank lending, guarantee debt issued by banks until 2009, give government's permission to buy preferred shares in banks, make provisions to directly recapitalise any banks that were deemed "systemically critical."

While the Euro nations try to unfreeze the banking sector by effectively guaranteeing all lending, regulators in the U.S. and the U.K. are taking similar steps. The British government will take controlling stakes in the Royal Bank of Scotland and HBOS Plc. The Brits have also decided to inject about A$125 billion in capital directly into the banking system.

We covered the big-picture implications of this policy response in yesterday's special Sunday edition of the Daily Reckoning. If you missed it, you can find it here (Australian Resource Shares, What's Next). But it's not hard to see what's going: government guarantees to all bank lending, and direct, unsecured government lending to anyone who asks for it.

Will putting more money (credit) into the hands of those who created the problem in the first place actually help? Probably not. As Jim Rogers told CNBC, it's setting the stage for an 'Inflationary Holocaust.' It's hard to believe at first that the current deflation in financial assets will give way to astonishing inflation. But that's just what we expect to happen.

Specifically, governments will boost lending to the private sector via central banks. You can also expect direct stimulus for households via rebate packages and tax breaks. In the long-run, big government spending programs on public works, infrastructure, and energy are a certain political winner.

And where will the money come from? Good question. It will be printed or borrowed into existence. Money supply will rise. And with the banking sector effectively nationalised, private investors will look for a real hedge against the inflation being unleashed.

We would take a strong look at over-sold Aussie oil stocks right now. Not only are they over-sold from a technical perspective, but the oil price has nearly halved from its highs earlier in the year. You may not get a better chance to buy them at this price.

Of course, if the market gets any worse than it got last week, it will no longer be the worst financial crisis since the Depression. It will be the worst financial crisis of modern times, full stop. If that is the case, it marks the end of one era and the beginning of another.

In the meantime, however, you could do worse than build a "Robinson Crusoe" portfolio. That is, when his ship ran aground and all his colleagues were lost at sea, Crusoe spent three days salvaging anything from his ship that would be of use in living on his deserted island. His misfortune was severe. But he had enough sense to realise the ship contained items that would be essential for his survival after the shock of his shipwreck.

The stock market offers you a similar opportunity, once the selling abates. You will get an excellent chance to buy Australia's best shares at very low prices.

Dan Denning
The Daily Reckoning Australia

• The Asian Banks Have Finally Been Heard From
• Short Selling Ban May Kick Off Market Liquidation
• $4.1 Billion in Investor Funds Have Been Frozen Overnight
• Big Australian Resource Stocks Up 24% in 2008
• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?

It doesn't get much more direct than that. The truth is, governments are trying to do the impossible. They are trying to make bad loans turn good by propping them up with extra money, money that comes from out the blue. And instead of encouraging household saving that would form the base for future productive investment, governments are encouraging more consumption and nursing along trillions in mal-investment (housing-related securities).

Debt-based consumption and the securitisation of those debts are what brought us to the point of systemic crisis in the first place. Had markets been allowed to work, the over-leveraged financial firms would have failed, a deep recession would have ensued, and consumers-cut-off from credit-would be forced to save rather than consume.

So far, though, efforts to save the system by propping up bad debts are only weakening confidence in the system itself. It's happened with surprising speed. My friend John Robb writes that it's a cascading collapse of ever larger bubbles. It starts small and grows to encompass the entire global financial system.

• Small. A belief in the US consumer. US subprime mortgages collapse. US prime mortgages and US commercial real-estate and consumer credit follow.
• Big. A belief in the Shadow Banking system. The investment banking system implodes. Hedge funds liquidate. Money markets/commercial paper seize up. Financial insurance evaporates.
• Bigger. A belief in the global banking and market system. Systemic bank failures. Global markets crunch.
• Huge. A belief in the US as a global economic power. US treasuries and the dollar crash. Numerous national bankruptcies

A critical point to realise for investor is that creating more debt and credit is not going to solve the problem. The bad debts need to be liquidated and the people who made them need to be replaced by better capitalists who can put available savings to a productive use. Yet propping up the people who got us into this mess with more money is precisely the response we are headed for. In an interview with CNBC last week, Jim Rogers predicted an 'Inflation Holocaust.'

In an effort to save their own skins and prevent consumers around the world from a very healthy and natural return to living within their means, global politicians are again making a bogus promise that everything will be fine if we just borrow more money. By doing so, they've upped the ante in the crisis and put the entire financial system-in its current form-at risk.

Will the 2003 lows on the ASX and Dow be taken out?

Before we get to the larger question of what will happen to the global financial system, let's return to the more immediate question of what stock markets are going to do when they open Monday (assuming they do, in fact, open for business as usual). Without a clear plan emerging (as of yet) from the G20 meeting in Washington (it followed the G7 meeting), the futures in Asia are down, although the ASX/200 futures are up 27 points as of this writing.

Where stocks go from here depends on what they are pricing in. Remember, stock markets are forward looking. The market tries to determine the current value of future earnings. There are two factors that cloud that picture right now: the credit crunch and a global recession.

The crisis in the financial sector was not successfully quarantined. Banks are not only unwilling to lend to one another, but to anyone at all. Hence the freeze in the short-term commercial paper market. Companies that relied on the money market and commercial paper market to fund payrolls and inventory now have to go straight to the local central bank. Wire service reports from the U.S. suggest General Motors may soon borrow directly from the Fed.

The earnings picture is nearly impossible to paint if the credit markets remain locked up like this. We simply don't know who can get credit from the Central Banks and who can't. Who will fail and who will survive? Who will have to cut prices or slash payrolls?

The other factor weighing on shares is the emerging fact that we are facing a synchronised global recession. If consumers are also denied access to credit, consumption must decline as savings rates rise. Unless retailers slash prices (and profit margins) we don't see how they will sustain revenues for the last quarter of 2008 and the first quarter of 2009, much less increase them.

That means stocks would have to begin factoring in a dramatic decline in consumer spending and 2009 earnings. The analysts would prefer to do this in piecemeal fashion. The market will likely do it in a few lump sums.

3,500 or Taking out the 2003 Low?

Last week we published analysis by our chartist and Swarm Trader Gabriel Andre. Gabriel said the first line of resistance for the ASX/200 would be at 4,300. That support was taken out on Friday. If the index is unable to regain it, Gabriel highlighted the next line of resistance at 3,500. That decline would be just 460 points from current levels-or 11.6% in percentage terms (one very bad day of trading or two awful days, at this rate).

Click to Enlarge

An 11.6% decline from the current levels would put Aussie stocks back at 2004 levels. You'd have to think that the big blue chip miners would start to look extremely attractive at those prices-once (and if) the banking crisis is quarantined (via nationalisation and equity stakes). Cashed-up private investors might be willing to come in from the sidelines at that point, lured by the valuations.

But we have drawn a third line on the index where the 2003 lows are. We should consider the possibility that the current crisis is going to wipe out all of the equity gains that began with the low-interest rate cycle in 2003. The March, 2003 low on the ASX was 2,715. A fall to that level form 3,960 would represent a decline of 31%.

Obviously a decline of that magnitude on top of the 40% drop from the October 2007 high is astonishing. Remember, the closing high for the ASX/200 was 6,853 on November f1st of 2008. A decline to 2,715 or below would represent a 60% fall on the index (which curiously coincides with one of Gabriel's key Fibonacci retracement levels.)

2003-2007: A Bear Market Rally

Could the market really give up 60% from its all time highs? The argument to support this retracement starts with the claim that this bear market began in 2000, not in 2007. Stocks declined for three years as the market purged the easy money created in the tech boom.

Then a host of a factors-cheap exports from China and Asia to keep down consumer price inflation in the West, low interest rates to fuel simultaneous booms in housing, shares, bonds and commodities-conspired to prevent the bear market from doing its work. Globalisation and interest rates banded together to give us a mighty, but unsustainable boom.

In essence, this view suggests that the entire rally from 2003 to 2007 was simply a rate-fuelled rally in the midst of a secular bear market. It you accept that view, then it becomes quite easy to see how the 2003 lows could be challenged. And if the view is correct, they won't just be challenged, they'll be taken out and a new low established.

For this scenario to unfold, you'd have nothing less than a global financial system reboot. It would represent the complete collapse of the global system in which American consumption, fuelled by credit, is the engine of global growth. It would also mark an emphatic end to the system whereby global exporters keep their currencies artificially cheap against the U.S. dollar in order to remain attractive to the U.S. market.

You could also expect to see a sudden and violent end to the habit of recycling trade surpluses in the U.S. stock and bond market (a form of vendor financing that no longer makes sense when your customers are broke and can't get credit.) The Treasury market would see much higher interest rates and the U.S. dollar would crash (especially against gold, oil, and commodities, giving us the 'Inflationary Holocaust' predicted by Jim Rogers).

Global Rebalancing

This series of system shocks would eventually bring about the long-anticipated "global rebalancing," where Americans save more out of necessity and the developing world eventually consumes more of its own production. On the American side, it means lower levels of consumption, more saving, paying down debt, and investment in real wealth production (infrastructure and energy rather than residential housing and shopping malls).

For the developing world, it means more investment in domestic infrastructure and the domestic economy. Savings will have to be unleased locally to finance this investment, rather than loaned to rich Western countries to finance deficit spending. And with rising per capita incomes and the beginning (yikes) of consumer credit, you'd expect to see higher rates of consumption on consumer and durable goods, all of which is resource intensive and in the long-run, very good for Australia.

But all of that is an enormous shift, a huge wealth transfer from the consumption and debt based economies of the industrialised world to commodity producers and high-savings nations in Asia. It is the Money Migration at light-speed. It creates real wealth for investors while destroying bogus balance sheet value for bankers.

In the meantime, you can expect global policy makers to try and engineer some replacement for the broken system of global finance. Italian Prime Minister Silvio Berlusconi called for a new "Bretton Woods." It will involve ever greater monetary cooperation and centralisation.

It is worth noting that the G7 nations think they will be the architects of the new financial system. It has not occurred to them that perhaps the global balance of economic power is now tilting away from Europe and America toward something else entirely. More on where this leads in tomorrow's regularly scheduled Daily Reckoning.

The Best Value in the Resource Share Market

For now, suffice it to say that there IS real economic growth in Asia. And once the global economy emerges from the recession induced by the collapse of the leveraged credit bubble, demand for the resources to build the developing world will resume. Valuations in the resource sector will not be driven by speculative money hitching a ride on soaring commodities prices (the first phase of the commodity boom).

Instead, valuations will be driven by solid balance sheets, excellent projects, and good management (the second phase of the commodity boom). For Aussie resource share investors, it means it will be your best chance since 1987 to buy best-of-breed resource companies leveraged to the urbanisation, industrialisation, and infrastructure trends that are making Asia the new engine of global growth.

But how do you know where to begin your search? In light of the crisis and the appetite for helpful analysis, we've elected to publish a small section of the latest issue of Diggers and Drillers, normally available only to paid subscribers. In it, you'll find what editor Al Robinson is doing now to turn this crisis into an opportunity.

Al has selected his four favourite cash-rich Aussie companies to emerge from the crisis stronger. To protect the investment made by paid-up subscribers, you won't read about those four in this free sample. But we have given you a table of ten firms Al researched and what he found.

How to Find the Safest, Cheapest Resource Stocks During the Crisis
By Al Robinson, Diggers and Drillers

How do you know which undervalued stocks will survive the mauling in finance? You search for the ones with quality assets and cash. Cheap mining and energy companies can use cash to shield their currently-oversold mining, oil, and gold assets.The businesses survive. The cheap assets live on and rise to their real value.

That means steady, satisfying, long-term investment gains for you if you play your cards right in the next few months. I've scanned the entire resource market and laid out the ten of the most cash-greedy stocks. They have some of the most profitable assets; oil wells, coal mines, gold reserves and iron deposits. All are going on a massive sale this month.

But these ten companies are sitting on a $2.1 billion mountain of cash. That's your ticket to safety.

Ten Oversold Resource Firms, Each with a Shield of Cash

This selection includes both producers and juniors. It includes energy and mining stocks. It includes small-caps and mid-caps. It's a table with variety. But they all have big cash accounts in common. Of the resource shares in the top 300 listed Australian companies, these companies have the most liquid backing. They ooze safety compared to the rest of the market. They're getting cheaper just as fast though.

They have minimal short-term debt maturing in the next year. That's just as crucial as the cash balance itself. These companies have liquid assets unsoiled by heavy borrowing. They aren't leveraged to the credit crunch through debt exposure. They are leveraged to the resource boom through asset exposure.

All up, these 10 stocks have over $2.1 billion in cash on hand right now. Their market cap is $6.2 billion. Over 35% of the equity here is un-invested and un-spent.

Credit stretches and contracts like a length of elastic. That gives credit-based companies a wild ride up and a wild ride down. But cash doesn't stretch. It's solid. It sits there. It does nothing until you need it. That time has come.

Overall the companies above have less than $1 million in short term debt. It's insignificant. And above all, every single firm owns a quality project that the market is chronically devaluing this month.

Six are energy stocks. That's not surprising, considering the massive boom in energy company cash-flows over the last year and a bit. Oil, gas and coal assets have leapt in price. Liquidity has flowed to the companies that own them. These ones held onto it.

But the juniors have cash too - if you're brave enough. Some aren't producing yet. They've filled their wallets with clever financing methods instead. And the juniors on that list are still getting a lot of attention from important investors.

Al Robinson
The Daily Reckoning Australia

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• Lehman CDS Auction Hammers Australian Resource Stocks
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• Big Australian Resource Stocks Up 24% in 2008
• The Dark Underbelly of Australia’s Resource Boom: Chinese Resource Demand

In the share market, we had a look back on the 2003 low on the ASX. On March 12, 2003 the index closed at 2,673. If the rally that began the next day and ended in October of last year was really just a multi-year rally in the midst of a secular bear market, you have to ask whether the 2003 low will be tested and/or taken out.

This would be the equivalent of "Ctrl+Alt+Delete" for global share markets: a system reboot that wipes out all of the gains from 2003 and before. Could it really get that bed?

Well, today alone in the U.S., some US$872 billion was wiped of the Wilshire 5,000, the broadest measure of U.S. stocks. It's lost $2.3 trillion in the last seven days, and $8.3 trillion in the last year.

You have to keep in mind that the global boom of the last five years was almost entirely a product of excessive credit. Credit to households for residential real estate. Credit to Wall Street and the Masters of the Universe for speculation. And credit to governments in the Western world blowing out public spending.

The fictitious gains in global wealth were the product of leverage, plain and simple. That leverage is collapsing, and it's doing so much more swiftly and comprehensively than nearly anyone imagined. Even deep value blue chips and stocks with strong intrinsic value and cash are not immune. Nothing is.

Every piece meal 'solution' designed to get credit flowing again has failed. Every attempt to recapitalise failing banks with slim capital bases supporting a tower of tottering assets has failed too. So now, governments are taking the next logical step in the progression of events. And what's that?

The global banking system is quickly become another government agency. Governments in Europe have already bought equity in the banks. Now the Treasury Department in the States will do the same. For now the fiction exists that the banks can survive as private enterprises. But surely it is just a matter of time before that fiction gives way to a nationalised banking system.

This weekend's G7 summit is the next best chance for global regulators and politicians to try and "save" the banking system. But what will they announce? We don't know. It's hard enough to get Europeans to agree on anything. Now you're talking about coordinated global financial policy. Perhaps a new global currency will be one result of this crisis. As we've said before, a stock market holiday and a bank holiday, and/or a cap on withdrawals by mutual fund share holders and bank depositors in the logical end-game of the crisis.

But that is getting ahead of the game. The banks will effectively become arms of the government and finance will now be another government function. We wonder how well government will do allocating, considering its track record in delivering basic services like law and order and fiscal prudency. Perhaps we should look at other economies where capital allocation is done by the State, like China. Do you think it's a coincidence that civil liberties decline as the State's influence on the economy grows?

In any event, our contention from years back is that the modern nation state is singularly ill-equipped to deal with globalisation. It does not respond well to fast-moving crises. It is too cumbersome and complacent, more interested in self-preservation as an institution than anything else. Before States (like Iceland) begin to fail though, the private financial sector is going to be subsumed.

We wish we had better news to report today. But the truth behind fractional reserve banking, as my friend Dan Ferris says, is that it's inherently leveraged and thus, inherently insolvent. To keep one dollar of deposits on hand for every ten you lend, and to be able to create ten dollars from thin air for every one that comes in via deposits...that is the nature of fractional reserve banking.

It is money that is not tied to metal. The money isn't tied to anything at all except confidence. And when the confidence goes, the purchasing power of the money disappears. Governments try to restore this confidence, along with central banks, by printing more money.

They're going to have to print a lot more. But sooner or later, we reckon they'll just hand out pre-paid debit cards to everyone. It will be sort of like a credit ration card for the war on deflation. You can enlist if you'd like. You'll probably be drafted eventually.

The only good news in all of this is that some good businesses have become absolute bargains. If and when the central bankers and bring credit spreads down (nationalising the banking system and commanding the banks to lend is one way to do it), then look for private investors to look for inflation hedges again.

That should favour energy and resource shares. But the question is when? When will the bottom be in?

Dan Denning
The Daily Reckoning Australia

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