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

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

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
for The Daily Reckoning Australia

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

Hao, our guide to our first visit to China in 2004, put it to us this way while we ate Peking Duck in Beijing: If it has got four legs and is not a chair, if it has two wings and it flies but is not an aeroplane, and if it swims and is not a submarine, the Cantonese will eat it.

"China may be chasing Twiggy," reports Matthew Stevens in today's Australian. "There is talk in New York that the Rudd Government has approved an application from China's Baosteel to acquire 16 per cent of the iron ore maverick, Fortescue Metals Group (ASX: FMG). Fortescue says it does not know whether its biggest Chinese customer has even made an application to the Foreign Investment Review Board, let alone received a green light."

Fortescue is the low-hanging fruit in the Australian iron ore sector. It's easy pickings. It aims to be the third major iron ore producer in the Pilbara, behind BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO). It's not surprising that Baosteel-China's largest steel maker-would go over the biggest plum in the pie.

What IS surprising is just how far into the Australian iron ore sector Chinese companies are drilling for ownership of undefined resource bases that are years away from production. It speaks to the strength of demand for iron ore... and the itch in Chinese pockets to trade U.S. dollars for real assets before the dollar falls even more... or before the Chinese revalue their own currency.

First up on the menu yesterday was Aussie iron ore producer FerrAus (ASX: FRS), a member of the North West Iron ore Alliance we mentioned last Thursday. China's Shanghai-listed Western Mining Company announced its intention to take a 10% stake in FerrAus at $1.15 a share through a share placement arrangement. Regulators have to approve the deal.

Here's the interesting thing about this deal; Western Mining is a base metals miner. It doesn't even produce iron ore. It just likes the cut of FerrAus's jib. And for its part, Adelaide-based FerrAus hasn't even proven up its indicated resource of 43 million tonnes. But hey, when the market value of the assets is going up, these kinds of deals get done.

And there are more of them. Gindalbie Metals (ASX:GBG) shot down rumours that Angang and Iron and Steel was seeking to increase the 13% stake it already has in the mid-West iron ore junior (a member of the Geraldton Iron Ore Alliance). Investors may or may not have been convinced. But they seemed to like Gindablie's announcement that it would spend $10 million this year on 12 drilling targets that it hopes will yield 80-100 million tonnes of hematite ore in the Pilbara. The shares closed up 16%.

And the beat goes on. Prosperity Resources (ASX:PSP) announced that Shougang Holding Limited would buy up to 19.9% of the company through a share placement. To be honest, we had never even heard of Propserity Resources until this morning. Perhaps we are not digging and drilling thoroughly enough.

We do like at least one thing about the company, though-its ticker symbol. PSP is the acronym we've taken to using for a new research service we hope to launch soon, the Penny Stock Prospector.

We want to offer your our research into the junior mining and energy shares...and hopefully suss out the shares that are moving. It will be as close as you can get to pure speculation. But there's so much going on in the resource sector now that it's more than we can cover in Diggers and Drillers.

Low-hanging fruit is easy to pick. But there's plenty of fruit on the Australian iron ore tree if you're willing to shake the tree a little.

By the way, the Koreans are getting busy too. Posco, the world's fourth-largest steel maker, announced its intention to buy 19.9% of Sandfire Resources (ASX:SFR). The mineral grab goes on.

Dan Denning
The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• The Iron Ore Pricing War Between China & Australia
• Saudi Arabia Pours Oil Investment into Australia
• The Fourth Biggest Iron Player in Australia
• Posco’s Production Cuts May Be Bad for Australian Iron Ore