If that's not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we're wading through. So we'll do our best to clear them up for you. But it's probably going to take two days. Today, we'll look at the case against deflation. Tomorrow, we'll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we'll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He's written about it for years. But for a short course on what he's predicting and why, check out this video.

In the video Prechter says, "The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back....The scramble will be for dollars not for things."

The investment outcome of Prechter's scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, "the chances of default are low." Prechter's argument is based on the idea - which we happen to believe - that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter's reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that's trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren't unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that's not in anyone's model might be the sort of thing that precipitates the next crisis. After all, that's the way these things generally begin.

You could make the argument that it shouldn't really matter to the real economy if a bunch of global institutions find out they can't settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can't we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today's funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are "danger" banks. The reason is that these banks own mostly commercial real estate. It's their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren't going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We're going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It's easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it's hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people's preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We'll assume for the moment the regular banks won't do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit...to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it's monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can't have inflation if there's no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won't this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we're going out on a limb. But what we're arguing is that as the private sector is less able or willing to dole out credit into the economy, we're entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It's done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won't do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it's possible to receive 99 weeks of unemployment benefits. This doesn't mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments...well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it's true for the Euro, the Yen, and the Dollar. It's true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed's ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar...mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you'll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and "jobs" programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it's possible - likely even - that you're going to see across the board falls in stocks, real estate, bonds, and commodities....AND inflation. Whether we got the proper sequence right, we're not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Nationalised Banking System Will Come from Global Market Rout
• Bankers Take Money From the Government and Use it to Speculate
• The Single Best Trade for 2010
• World Economy Faces Hyperinflation or Deflation?

Here on the back page, we alert investors. We wag our fingers and shake our heads. Little good it does. We might as well warn surfers about an approaching storm. They don't head for cover; they rush to the beach, hoping it's not too late to catch a big one.

As of this week, investors are still making money. Almost everything has outperformed cash over the last 9 months. Stocks, commodities, gold - you name it. This wouldn't be happening were it not for the government. The feds are making waves from Malibu to Manila. 'Don't worry about the depression,' they tell us; 'we're on the case.' That, of course, is what we're worried about.

Instead of allowing things to settle down, the feds are doing all they can to keep them stirred up. Amid the foam and splash, nobody knows what is really going on. For example, they've driven the yield on cash down to near zero. What's a borrower to think? Why are interest rates so low? Are there so many trillions in idle savings that he can have them for nothing?

Investors don't know whether they are coming or going either. They're buying S&P stocks at more than 80 times earnings, while people who know what they are doing - the insiders - dump 82 shares for every one they purchase.

And in the economy, last Friday, came a puzzling report from America. According to the feds, unemployment dropped by 0.2% last month. That leaves only 15 million without work. Another report tells us that each job created by US government stimulus costs $246,000. What were they hiring, bankers?

While the feds muddy the waters, the de-leveraging of the American consumer continues. Consumer credit fell in the US in October, for the 9th month in a row. As long as consumers are cutting back there is no way a real recovery can begin.

What to make of it all? We turn to a ghost for an explanation. Friedrich Hayek described a similar situation 76 years ago:

"There can...be little doubt that ...a deflation process is going on...Central Banks, particularly in the United States, have been making earlier and are more far-reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion - with the result that the depression has lasted longer and has become more severe than any preceding one.

"...all conceivable means have been used to prevent the readjustment from taking place; and one of those means , which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion... To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about..."

He could have been describing Japan's 20-year depression, too. So far, we have no evidence that the authorities can improve a depression. All we know is that they can stretch it out.

A real recovery is a process of discovery: it begins in misery and ends in prosperity. Investors figure out what their boom-era investments are really worth. Businessmen figure out how to turn a profit in a new environment. Households learn how to match their incomes against their expenses in a world where credit is less forthcoming and jobs are harder to find. Needless to say, the faster these discoveries are made, the better.

But the first thing people realize is that they have been idiots. Then, they call for the government to prove it isn't so. In Britain, the government has spent about $8,000 per family to bail out the banking sector. As a result, we don't get to discover what the bankers would do if they were forced to seek honest employment. Nor do we discover what the poor taxpayers would have done with that $8,000 if it hadn't been forcibly transferred to the City.

Likewise, what we want to know about an insurance company is how well it holds up under pressure. But when the feds rushed in to save AIG they corrupted the facts. Then, in the US alone, there were Bear Stearns, Citigroup, Washington Mutual, General Motors, Chrysler, Fannie Mae and Freddie Mac, not to mention the small fry. Our curiosity remains unsatisfied; what kind of world would it be if they had gotten what they deserved?

Alas, the feds have created a world of darkness and depression. No one knows anything. And what they think they see clearly is often a mirage. Employers don't know whether to hire or fire. Consumers are blind too; they don't know whether things are getting better or worse. Finally, government even pokes its own eyes out. Relying on 'funny money' to cover its deficits, it has no idea how far it can go before it falls off a cliff.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• They Say the Stock Market ‘Looks Ahead’
• Feds Can’t Cause a Genuine Recovery Simply by Throwing Money into Economy
• Buffett Not Worried About Depression But How Recovery is Financed
• Feds Think They Have Won This Fight Against the Depression
• Feds Want to Increase the Money Supply and Induce People to Spend Money

If you want to attend the presentations and discussions over the next four days, you can still do so. But you should contact conference organiser Marcus Matthews today. You can reach him via email at feketeaustralia@gmail.com. And if you're there on Sunday, be sure to say hello.

Yesterday we promised to show you how the funding model for the fiscal welfare state is blowing up. But this is going to have to wait at least another day. Don't worry though. It's not going anywhere.

Today, there is a banking story to cover. You recall that yesterday we were worried about the next banking crisis. But the lingering effects of the last one are still with us. National Australia Bank reported a 43% fall in net profit yesterday. Ouch.

Don't feel too bad for NAB. Net profit fell from $4.54 billion to $2.56 billion. But the bad and doubtful debts charge for the year grew by 53% from $2.49 billion to $3.82 billion. With $654 billion in assets and $616 billion in liabilities, the bank is sitting on $37.8 in equity. A few billion in bad debts and loan losses won't wipe out that amount of equity.

But it's worth noting that NAB's total assets are 17.3x times equity. This isn't as high as some leverage ratios in the U.S. just prior to the banking crisis in 2008. But it's not far off where NAB was at the time. And there are two further risks worth mentioning.

First, as the IMF paper on Aussie banks concluded earlier this year, Aussie banks are probably strong enough to withstand a normal shock to the balance sheet. That is, the IMF stress-tested Aussie banks for losses on their two largest loan portfolios - corporate loans and mortgages. The IMF concluded the banks were adequately capitalised to survive the shocks it tested for, but that, "The above shocks do not constitute a rigorous stress test and the results are only indicative of the health of the banking sector."

If we've learned one thing in the last two years, it's that bankers and analysts have consistently underestimated the frequency and magnitude of systemic shocks. That doesn't mean the IMF conclusions aren't to be trusted. But it means in the event of another more severe shock, the banks could face larger asset writedowns and losses than the IMF has modelled.

This brings us to the second risk worth mentioning. A bank facing bigger loan losses takes fewer risks. It reduces lending. This is how the credit crisis was transmitted from America's housing market to Australia's economy. The Aussie banks had to tighten up to prepare for losses on overseas assets.

Next time around, though, we reckon the losses - when they come - will be on domestic real estate assets. And with so much exposure to domestic real estate (mortgage loans), the assets could face a world of hurt. But even if bank asset quality doesn't crash (housing prices don't crash), an external shock affects Aussie bank liabilities.

The IMF report says that, "On the liabilities side, however, banks had sizable short-term external debt obligations, and access to offshore wholesale markets was disrupted by the Lehman Brothers collapse in September 2008." Of course the government's wholesale funding guarantee eased the pain of this shock, which is one reason why that guarantee may become permanent in all but name.

But the IMF wrote that, "A key remaining vulnerability is the roll-over risk associated with sizable short-term external debt. Banks' wholesale funding (domestic and offshore) accounts for about 50 percent of total funding, of which about 60 percent is offshore. Financial institutions short-term external debt (on a residual maturity basis) is estimated by staff at about $A 400 billion (35 percent of GDP) in March 2009."

Maybe the short-term external debt levels have improved in the last six months. We haven't checked yet. But in simple terms, it means a lot of domestic lending is funding from external funding, borrowing abroad to loan at home. If American banks again blow up on the destruction of their remaining collateral (mortgage loans and U.S. Treasury bonds) we'd predict another ice age in global credit markets.

Needless to say, as a capital importer, this would put Australia in an awfully uncomfortable spot. But hey! No one is worried about that at the moment. The Aussie dollar is being inflated by the U.S. dollar carry trade. It's a shame that the strong Aussie is going to devastate local industry and manufacturing with higher costs, but at least it obscures for now the risk that Aussie banks are reliant on foreign borrowing.

In the bigger picture, this means the investment needs of the economy can't be met by household savings alone. But that's an even bigger problem than we can address today. So we won't!

More cow bell!

And what about our theory that a U.S. dollar rally will trigger a correction in gold, oil, and stock markets and lead to a mini-rally in U.S. Treasury bonds? Bond fund king Bill Gross agrees. Writing on Pimco's website, Gross concedes, "Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets -- while still continuously supported by Fed and Treasury policy makers -- is likely at its pinnacle."

Dr. Doom himself, analyst Nouriel Roubini, called the present market "The mother of all carry trades." "This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals," Roubini said via satellite to a conference in Cape Town, South Africa. "The risk is that we are planting the seeds of the next financial crisis."

With the S&P up nearly 65% since touching 666 in March (seriously), we'd say the seeds are already bearing fruit. But maybe it's poisoned fruit. After all, the rally has been worldwide and extremely impressive by historical standards. But it's fully consistent with previous bear market rallies. If anything, it's happened faster.

What nobody yet knows is if it IS a bear market rally...or a garden variety stock market rally that precedes a recovery in the economy. You know what we think.

There IS one notable difference between 2008 and today, though. Yesterday we mentioned that U.S. banks have loaded up on a whole other kind of super-dodgy collateral; U.S. Treasury notes and bonds. Demand for those securities may go up with a U.S. dollar rally and a reversal of the dollar carry trade. But in the longer-term, we think the banks have invited another toxic house guest on to the balance sheet.

But where did the previous smelly houseguest go? You know, all those mortgage backed securities and subprime loans? Where does that risk now reside? And what happens if it comes home to roost?

According to this report by the San Francisco Federal Reserve, over 95% of all new residential mortgage lending in the U.S. is now being backed directly by the U.S. government. With the banks unable or unwilling to lend, Uncle Sam has become the sugar daddy of the U.S. mortgage market. See the chart below.

The Fed supports this market by purchasing the securitised mortgages issued by Fannie and Freddie. The Congress funds the agencies which make the loans available. But no matter how you slice it, the U.S. government is supporting the housing market. It will continue to do so as a political imperative.

But by taking on this massive liability - not that it doesn't already have its hands full - the Fed is further consigning the dollar to the scrapheap of history. Do you think foreign creditors will not realise that the U.S. is borrowing money to keep house prices elevated? Will they not notice that the U.S. is printing money to do this? And what will happen to the dollar then? And gold?

The truth is that creditors already do know this. Today's Australian Financial Review reports that overseas Chinese investment is "surging." Chinese policy makers are trying to trade dollars for tangible assets or equity in resource shares as quickly as possible. "China reported a 190% jump in overseas investment by its companies for the third quarter."

"Policymakers might be encouraging Chinese firms to invest abroad, in part to help counter pressure for the nation's currency," the article continued. "Investors are betting on the yuan to appreciate as China's growth accelerates from its weakest pace in a year."

Most currencies that are not the U.S. dollar could appreciate in the coming years. Australia's currency has already done so. Brazil is considering a tax on capital flows into the country in order to prevent investors from speculating on a further rise in its currency by buying Brazilian assets. And of course speculators have tried for years to find a way to position themselves for an appreciation in China's currency. China's capital markets are not friendly in this regard, although Hong Kong stocks remain a popular option.

The fact that countries like Australia, China, and Brazil are trying to limit currency appreciation versus the greenback shows you how unbalanced the world economy still is, how unprepared it is for the reality that America's deleveraging will take place for years. Households and businesses must save and repair balance sheets. Some other country is going to have to consume what the world produces.

In the interim, the U.S. government will increase deficit spending to make up the difference. It is the stupidity of Keynesianism to support aggregate demand when what everyone needs is a correction and a recovery. But all the Feds will succeed in doing is blowing up the balance sheet of the U.S. government in spectacular fashion. Go gold.

Mind you we still think the short-term move is a dollar rally and some profit-taking on the dollar carry trade. We asked Slipstream Trader Murray Dawes what he sees when looking at the U.S. dollar index. Murray spends most of his time finding trading opportunities in Aussie stocks. But he also knows that Aussie markets (and capital flows) are still massively affected by what's going on in America.

Murray wrote that, "If we look at this chart of the US Dollar index going back to 1985, you can see quite clearly that the 10 week moving average crossing over the 35 week moving average has been a very good indicator of the trend. There are only a few instances over that whole time period where this indicator gave a false signal."

Click to enlarge

"Therefore," Murray continues, "we should be keeping an eye on this indicator going forward to tell us whether the US Dollar index has turned back up and is ready for a counter trend rally. The short US Dollar trade is getting pretty full, as I have mentioned in the past. And there is a high correlation between the direction of the dollar and the direction of gold, oil and stocks.

"The US Dollar has taken over the Yens role of funding the carry trade and this will be the situation for as long as the Fed remains too scared to raise rates, which seems to be for the foreseeable future. So we can probably expect the dollar to weaken further over the long term, but a counter trend rally (short squeeze) may be closer than people think and this would lead to weakness in commodities and stocks.

"When should we trade this move? Well have a look at the chart again. Notice the false breaks that keep occurring when the all time lows get breached (denoted by the numbers 1,2,3). With the trend still strongly down we can expect to see either a false break of the lows around 71 reached last year or if that doesn't occur then a crossover of the 10 week/35 week moving average to confirm that the trend has changed. Trading the move before either of these are confirmed would be jumping the gun."

Murray is tracking which Aussie stocks will move if and when we see the dollar index break out. We'll keep you posted.

Dan Denning
for The Daily Reckoning Australia

• The US Dollar Showing Signs of Life
• IMF Report Concludes Aussie Banks are “Very Sound”…
• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• A National Mortgage Bubble
• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable

All thirty components of the Dow Jones Industrials fell in New York trading on Thursday. In total, the index fell over 200 points and 2.09%. The slap in the face came from a survey of manufacturing activity that indicated a slow-down in the rate of expansion.

If you're an optimist, the good news is that manufacturing activity - as measured by the survey - is still expanding. But investors looked at the report and must have begun thinking that the euphoria of the last six months is premature. "Maybe," they are thinking, "the rally in the stock market is completely divorced from the reality in the real economy where real things are made."

Today we promised to talk about world class speculations as the antidote to Ponzi finance. Mind you these are still speculations. And we'll get to that in just one second. It's none too soon, given the slow-motion meltdown of America's regional banks and the bankruptcy of the agency charged with insuring them (the FDIC).

But first, just a reminder about the gold conference in Canberra November 2nd through 5th in Canberra. You can read about it here. Space is limited, so if you're keen to go, you'd better move fast. Your editor will be there too, for the first time, and is looking forward to a world-class line up of speakers on gold as money and gold investments.

And that brings us to another point. On Tuesday we had the pleasure of sitting down for coffee at The Pelican here in St. Kilda with Dr. Steve Kates and his wife. Among other things, we discussed that monetary parable that is now 70-years old, the Wizard of Oz. Not many people know that the story was about whether the U.S. would have a gold standard or a gold and silver standard (bi-metal). Or neither!

Dr. Kates is a senior lecturer on economics and finance at RMIT here in Melbourne. We were introduced to each other by a mutual friend, and are glad to have met him. So glad, in fact, that today's guest essay is from Dr. Kates. He recently gave testimony to a Senate panel about why the stimulus is such a bad idea. Have a look below. You'll be hearing more from him in this space, hopefully.

"Part of the problem with the current thinking," he said on Tuesday, "is that when you're born into it, all the assumptions and premises of the system are not things you'd actually question. It's only when the system starts breaking down that people are forced to stop and ask what's wrong. All of today's policy makers and economists are born and raised in Keynesianism, and that's why there are so few people who can step outside of it to see its failures."

For once in his life your editor managed to shut up and let someone else continue talking. It was a great conversation, and as we said, we hope to bring you more like it in the future. One subject sure to come up is the financialisation of the economy and what economist Hyman Minsky called the era of Ponzi Finance.

A brief explanation. Minsky showed that the longer credit-financed expansions went on, the more all economic activity became "financialised." That is, debt growth leads to excessive leverage in household, corporate, and public balance sheets. This makes the entire economy (as we're now seeing) much more sensitive to changes in interest rates (the cost of capital) and changes in asset prices (which exist at large multiples to tangible equity on the balance sheet).

In the early stages of debt growth, the economy endures Hedge Finance, where cash flows are sufficient to make both principal and interest payments on debt. In the next stage, Speculative Finance, cash flows cover interest expense but not the principal. These leads to more borrowing for the purchases of financial assets to grow the balance sheet.

When you reach the Ponzi Finance stage, business cash flows are not sufficient to pay either interest or principal payments. New debt must be taken on or assets sold to keep the enterprise as a going concern. But by now, the real purpose of the business - providing goods and services that consumers want at a competitive price - has been entirely supplanted by the need to service and roll over debt.

That's where we are now, globally speaking. And it's not a good place to be. In the States, for example, the FDIC is trying to prevent the collapse of the Ponzi Finance economy by a drip-feed of regional bank failures. These banks are generally not as leveraged as the money-centre banks in New York. But they are apparently small enough to fail, as long as they don't fail all at once. And they are not well connected politically, lacking the cover give to Wall Street by Washington.

What's killing the banks is the inability to roll over new debt, even as assets on the balance sheet shed value. This is the ongoing deterioration in bank collateral we've written about before, and it's largely driven by a 10-year binge of speculation in residential real estate (sound familiar). That binge is still purging.

The FDIC - the American regulator charged with insuring depositors - is going bankrupt (if, in fact, it is not broke already). It will be funded by new money printed by the Fed. The Fed is allowing the drip-feed of failures (managing it, even) because it prevents a landslide of bank failures, which might touch off another crisis of confidence e in the banking sector (and more bank runs).

What's more, the Fed fears that an en masse collapse of U.S. banks will lead to a repeat of the Depression era contraction in money supply. When banks failed in the 1930s, the money supply contracted and deflation set in. Ben Bernanke, ever the historian of the Depression, must reckon that a slow-motion banking collapse allows the Fed to keep the money supply from collapsing by extending huge credit to the money centre banks, which are largely nationalising the distribution of mortgage and personal credit.

But what is the fallout from this? If the Fed triages the banking system by pumping more bogus cash into the FDIC, surely that would be a death-by-a-thousand-cuts for the U.S. dollar, wouldn't it? But then this strategy is nothing new. The Fed has been destroying the purchasing power of the dollar in that way since 1913. An inflation rate of 3-4% a year disguises the systematic theft of purchasing power that's inherent to fiat money.

Today, the Fed hopes to prevent a large collapse in the money supply (bank's create more money than the Fed through fractional reserve banking) by incrementally distributing bank failures across the calendar. So far, it's working...or...the bit-by-bit failure strategy is not alarming people about the systemic failure of the Ponzi Finance economy.

But it is failing. So what can you do? Well, as often as we've written about gold, today we will make a distinction between bullion and stocks. Bullion, physical gold you own and store, provides you with a tangible hedge to cash. It should be part of your Ponzi mitigation strategy.

Gold stocks have a role too, though. They give you leverage to the gold price. And the gold price should continue going up as the dollar accelerates its terminal decline. But there are a couple of things you should know about gold stocks and gold mining.

First, gold mining is a terrible business. Your capital costs are large and upfront. The asset is an inherently depleting asset (the mine has a life and production of the resource depletes the resource). This is arguably better than holding billions of housing-backed securities, which don't so much deplete as they disintegrate.

But valuing gold stocks - especially the explorers - is not something Graham and Dodd would have much luck with. Most of the companies don't have regular earnings. And you have to deal with fluctuating underlying commodity prices. Plus, the companies have to get lucky and find gold in economically mineable deposits for which they've received the proper permits and government and environmental approvals.

Altogether it's a terrible investment, but an excellent speculation. As long as you're aware of the difference, the benefits become obvious. The tiny gold stocks can go up ten and twenty times on moves in the gold price and upon successful exploration. That's as good as you're going to get when it comes to big profits from the decline of the dollar.

But as a speculative position, don't go overboard. Diversify with a handful of gold speculations and make sure it's with speculative money. Diggers and Drillers analyst Dr. Alex Cowie is currently looking into the gold junior universe and will report back shortly on his findings. Until then...

Dan Denning
for The Daily Reckoning Australia

• The FDIC Is in Trouble
• Gold Coins for $870-$890 An Ounce
• Chartwell Enterprises – Pyramid or Ponzi?
• One in Four US banks Announce Unprofitable Quarter
• Fannie and Freddie are Finito

One our new partners wrote a very shrewd comment. We'll pass along a little of what he had to say, but first, some context. The feds are desperate to restart the economy. The only way they can imagine is by increasing the money supply...and inducing people to spend money. They want inflation, no doubt about it. And they'll get it - no doubt about that, either.

The question is when. Our view is that they'll get more than they expect, but later than they want it. We're looking for another crack in stocks...followed by more fear and loathing in the economy. This will have two major effects. First, investors will turn to the familiar dollar for safety. Second, everyone will hoard money...speculation will cease...and prices will fall - including the price of gold. Our first writer disagrees:

"One mistake [your editor] might be making is his belief that we are already in another Great Depression. We probably will be in a depression or some other form of economic calamity, but not yet. Every Depression (or monetary contraction) in history has followed a similar pattern - expansionary monetary policy followed by a contraction of the money supply... While we have experienced a huge monetary expansion/easy money in the '90s, we have not yet experienced a real monetary contraction (which is a scary thought). Instead, the central planners did the opposite and doubled the monetary base (keep the addict happy with more heroine). These extra paper dollars have to go somewhere, and we are seeing the results in higher prices for stocks, oil, copper, sugar, gold, so far..."

Well, yes...as long as the economy seems to be on the mend, investors' "appetite for risk" improves. They want to speculate on the recovery. But then, when the recovery proves an illusion...they're going to run for cover.

Then, another new partner came to help us roll our stone.

"Bill is correct, not from money supply & credit data, but from 'black swan' type events such as: how deflationary forces will play out for lenders and holders of mortgaged backed bonds both commercial & residential, in a disruptive resetting of interest rates for Option ARMs, ALT-As and various other prime borrowers in the next 6-12 months... Will we witness another series of major bank failures from this next round of resetting? And if so, how disruptive, in a deflationary sense, will this be?"

Either way, the result is the same. Market events - such as another big break in the banking sector - could bring a deflationary collapse. If not, the Fed itself may have to step in to protect the dollar. In either case, gold is not likely to reach its final, bubble phase until this contraction is over.

In the meantime, our advice remains unchanged: buy gold on dips.

We continue to laugh at recovery sightings. Yesterday, for example, the Fed reported to the nation that a recovery was underway. But even the Fed couldn't ignore the fact that consumers aren't spending money the way they used to. The New York Times comments:

"The prolonged slump in consumer spending has been one of the most serious points of worry for economists, and the Fed's warning about it deflated some of the market's optimism. About 70 percent of the economy depends on spending by consumers."

The other sticky wicket in this game is unemployment. Jobless ranks are swelling like a floating corpse. But the jobless numbers don't tell the whole story. There are 34 million Americans who live on food stamps. One out of every nine people depends on the government for his daily bread. The Financial Times fills in the details:

"Less attention has been paid to those still in the workforce, whose incomes are also being squeezed. The average working week is now about 33 hours, the lowest on record, while the number forced to work part- time because they cannot find full-time work has risen more than 50 per cent in the past year to a record 8.8m. Wages and benefits have decelerated.

"The food stamp data suggest that 'the labour market problems are more significant than you would expect, given just the unemployment rate', said John Silvia, chief economist at Wells Fargo. 'For me it suggests the consumer is not going to rebound or contribute to economic growth for the next year, as the consumer would in a traditional economic recovery.'

"Consumer spending has traditionally been the engine of the US economy, making up about two thirds of GDP. Economists fear that people may be unwilling to resume that role.

"Food stamps are distributed once a month on electronic cards that can be spent at many grocery stores. The $787bn stimulus bill added about $80 (€55, £50) to a family's monthly allowance, which now stands at an average $290.

Nothing very original about keeping the masses fed with government food. The Romans figured it out 2,000 years ago. You have to distract the mob with pane et circenses (bread and circuses). Otherwise, they vote you out of office...or burn down the capitol.

"Everything, now restrains itself and anxiously hopes for just two things: bread and circuses," wrote Juvenal.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Bankers Take Money From the Government and Use it to Speculate
• A Paralyzing Rise in Money Supply
• Feds Can’t Cause a Genuine Recovery Simply by Throwing Money into Economy
• Baby Boomers Face Early Retirement With No Money Saved
• Feds Have Used the Correction to Increase Their Power and Add to Their Wealth

So where's the surprise for us? What'll it be? Japan or Zimbabwe? We've already said we're expecting both Japan and Zimbabwe. What else could it be? And we're ready for them both.

Well, needless to say, we'll be surprised like everyone else. And needless to say, we don't know what will surprise us. But we have an idea. Almost everyone we know is expecting a fairly quick up-move in inflation. Our guess is that that up-move might be a long way off.

"It's a very funny and troublesome situation," said a fund manager in Boston last night. "The world's central bankers are committed to a policy of monetary inflation...which they call 'Quantitative Easing.' And they believe that inflation targeting is the way they can tell if their policy is working. That is, they believe they will know when to stop inflating the currency by looking at consumer prices. When consumer prices begin to rise, they'll be ready to stop adding to the money supply. In fact, they say they'll then turn the machine to reverse to take out the extra cash they've added.

"So, they'll keep at it until the CPI goes up. But by the time they see consumer prices rise, it will be too late. By then, people will be eager to spend...to get rid of dollars. And once they begin to spend again, the velocity of money will go up. And with it, inflation rates will go up higher...and then dollar holders will want to get out of bonds quickly...because they'll see the next move too - a drop in bond prices.

"Well, how could the Fed combat this rising inflation? And prices could be rising very, very fast. It would have to go back into the market and sell those bonds that it bought from the Treasury. Selling the bonds would have the opposite effect as buying them. Instead of creating money with which to buy bonds, it would re-absorb money when it sold them. People would pay money for the bonds...and the cash would be sequestered by the Fed.

"So, you'd have the Fed trying to sell bonds just when everyone else was selling them. At that point, with the biggest bond buyer in the world turning into a seller, the Treasury market would collapse. This would paralyze the Fed. It might want to sell Treasuries. But, under the circumstances...with yields soaring and prices crashing...it wouldn't be able. So all the inflation that it put in the system would have to stay there...and inflation would have to run its course.

"It's very hard to know what to do as an investor. I guess in theory you should stay long treasuries...buy them as long as the Fed is buying. And then you should go short...sell them, just before the inflation numbers turn positive...and just before the Fed tries to sell. But that is going to be very, very difficult timing.

"I began buying gold for the first time ever last week."

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Central Banks’ New Money is Piling Up
• Things That Matter in the Economy are Going in the Wrong Direction
• Irish Govt Pledges Bailout, Who’s Next?
• Zero Percent Interest Rate Didn’t Work for the Japanese
• In Gono We Trust

"Dad, don't pick on Obama," said Maria, calling from California. "I watched the inauguration yesterday. It was moving. Really moving. They seem like such nice people...and they really want to do what's right. At least, that's the way it seems to me..."

We watched the TV news. The British press focused on the race issue. Blacks interviewed by the BBC spoke of the 'historic moment'...of the dreams of Martin Luther King finally realized...of a new era of race relations. There were hoorahs and tears...

We were never fond of racism, so we weren't especially tearful upon reading the obituaries for it. Besides, we're a little suspicious of the coroner's report. We'd like to see the toe tag, just to be sure.

Still, everyone wants Obama to succeed. His mother and grandmother, looking down from heaven. His relatives in Kenya. His party. His country. The entire world. Even we hardened cynics here at The Daily Reckoning wish him well.

But we weren't born yesterday.

And neither was the stock market. The man who got the warmest welcome ever from the press and the public got the rudest brush off from Wall Street. It was the worst sell-off for an Inauguration Day in history. The Dow fell 332 points. Oil traded around $40. The dollar strengthened...to $1.28 per euro.

O! Bama! Where is thy bounce? Perhaps it is already over. From their low in November, to their high a couple weeks ago, stocks worldwide recovered about a quarter of what they had lost. Now, they seem to be going down again.

We don't know what the stock market sees, but we see a lot more trouble coming.

Houses in Southern California are down 35% from their peak.

Japan says its economy is "worsening rapidly."

"Air France warns loss is likely" is one headline in Europe this morning; "German retailer to cut as many as 15,000 jobs," is another.

But the big news is in the banking sector.

U.S. banks are "effectively insolvent," says Nouriel Roubini. He figures losses in the United States might rise to $3.6 trillion - most of it in banks and broker-dealers. Which leaves the sector a little short. The banking system in the United States only has $1.4 trillion in capital.

Last week, Bank of America posted a quarterly loss of $1.79 billion...the first loss it's taken in 18 years. Citigroup out-did it, with a loss of $8.29 billion for the last quarter of '08.

As in Japan in the '90s, the economic boat cannot right itself until this bilge is dumped overboard. But the feds are against it - fighting the correction with every tool they've got.

Obama says his team with be "bold and swift" in its efforts to deal with the problem. But the action they take will be timid and slow. That is, they will try to hold on...to protect what we have...to prevent change at all costs. "Yes we can!" they will say. But they can't make the mistakes of an entire generation disappear - especially if they try to prevent a correction.

The truly bold and swift solution, on the other hand, would probably get him impeached. It would be to simply announce that the Obama government was letting nature take her course. No more bailouts. No more stimulus packages. No more federal guarantees or 'refund checks.'

"Keynes is dead," Obama should say; "the bankers will get what they deserve."

In a matter of days, the whole banking sector would go bust...along with GM (more about that, below)...and thousands of businesses all over the country. Millions of people would lose their jobs. Stocks would crash down to 3,000 on the Dow...maybe lower. There would be keening by widows, whose husbands had jumped in front of trains or slit their wrists...there would be gnashing of teeth by millions, whose hopes of getting something for nothing were suddenly dashed...there would be mobs in the street and revolution in the air.

A few days later, banks that were still solvent would pick up the pieces of those that had gone bust. And gradually, the economy would pick up...building on a much more solid base.

But don't trouble yourself about it, dear reader. That won't happen. Instead, Mr. Obama will take the more cautious route... More below.

*** What can the Obama team really do? He plans a rescue for banks - above and beyond the $825 billion fiscal stimulus. He will "reform" health care - our guess is that he will want to make a system of European-style national health care his legacy contribution. He will offer more guarantees, more bailouts, more stimulus. He will probably turn the banks into quasi-public utilities...heavily regulated, with little appetite for risk and little taste for capitalism.

"Creeping nationalization," is how Bloomberg describes the process. In Britain, the Royal Bank of Scotland will serve as a 'guinea pig.' It's lost 3/4 of its share value in the last two days. The government will keep it alive...but it will become a 'zombie' - more dead than alive...more ward of the state than independent financial institution.

Of course, these fixes will do more harm than good. They will retard, delay, and detour the inevitable correction. Which will cause the Obama Administration to turn to other, more desperate measures. Here's the real story...

Yesterday's front page headline from the Financial Times:

"Treasury gives go-ahead to 'print money.'"

We felt like saving the paper. Like the Times edition that announced the German invasion of Poland in 1940, it is probably the start of something big. Something catastrophic.

*** GM announced yesterday that it would probably run out of money in March. As to a bailout, we turn to a letter that appeared last week in the Manufacturing and Technology Journal. It is from a man who seems to have grease under his nails and a brain under his hat. Greg Knox, president of Knox Machinery in Franklin, Ohio, explains why he is not in favor of a bail out for Detroit.

"Politicians and Management of the Big 3 are both infected with the same entitlement mentality that has spread like cancerous germs in UAW halls for the last countless decades, and whose plague is now sweeping this nation, awaiting our new 'messiah', Pres-elect Obama, to wave his magic wand and make all our problems go away, while at the same time allowing our once great nation to keep 'living the dream'... Believe me folks, The dream is over!

"This dream where we can ignore the consumer for years while management myopically focuses on its personal rewards packages at the same time that our factories have been filled with the worlds most overpaid, arrogant, ignorant and laziest entitlement minded 'laborers' without paying the price for these atrocities...this dream where you still think the masses will line up to buy our products for ever and ever.

"Don't even think about telling me I'm wrong. Don't accuse me of not knowing of what I speak. I have called on Ford, GM, Chrysler, TRW, Delphi, Kelsey Hayes, American Axle and countless other automotive OEM's throughout the Midwest during the past 30 years and what I've seen over those years in these union shops can only be described as disgusting. Troy Clarke, President of General Motors North America, states: 'There is widespread sentiment throughout this country, and our government, and especially via the news media, that the current crisis is completely the result of bad management which it certainly is not.'

"You're right Mr. Clarke, it's not JUST management...how about the electricians who walk around the plants like lords in feudal times, making people wait on them for countless hours while they drag ass...so they can come in on the weekend and make double and triple time...for a job they easily could have done within their normal 40 hour work week. How about the line workers who threaten newbies with all kinds of scare tactics...for putting out too many parts on a shift...and for being too productive (We certainly must not expose those lazy bums who have been getting overpaid for decades for their horrific underproduction, must we?!?)

"Do you folks really not know about this stuff?!? How about this great sentiment abridged from Mr. Clarke's sad plea: 'over the last few years ...we have closed the quality and efficiency gaps with our competitors.' What the hell has Detroit been doing for the last 40 years?!? Did we really JUST wake up to the gaps in quality and efficiency between us and them? The K car vs. the Accord? The Pinto vs. the Civic?!? Do I need to go on? What a joke!

"We are living through the inevitable outcome of the actions of the United States auto industry for decades. It's time to pay for your sins, Detroit.

"I attended an economic summit last week where brilliant economist, Alan Beaulieu, from the Institute of Trend Research, surprised the crowd when he said he would not have given the banks a penny of 'bailout money'. 'Yes,' he said, 'this would cause short term problems,' but despite what people like politicians and corporate magnates would have us believe, the sun would in fact rise the next day... and the following very important thing would happen...where there had been greedy and sloppy banks, new efficient ones would pop up...that is how a free market system works...it does work...if we would only let it work..."

"But for some nondescript reason we are now deciding that the rest of the world is right and that capitalism doesn't work - that we need the government to step in and 'save us"'...Save us my ass. Hell - we're nationalizing...and unfortunately too many of our once fine nation's citizens don't even have a clue that this is what is really happening...But, they sure can tell you the stats on their favorite sports teams...yeah - THAT'S really important, isn't it...

"Does it ever occur to ANYONE that the "competition" has been producing vehicles, EXTREMELY PROFITABLY, for decades in this country?... How can that be??? Let's see... Fuel efficient... Listening to customers... Investing in the proper tooling and automation for the long haul...

"Not being too complacent or arrogant to listen to Dr. W. Edwards Deming four decades ago when he taught that by adopting appropriate principles of management, organizations could increase quality and simultaneously reduce costs. Ever increased productivity through quality and intelligent planning... Treating vendors like strategic partners, rather than like 'the enemy'... Efficient front and back offices... Non union environment...

"Again, I could go on and on, but I really wouldn't be telling anyone anything they really don't already know down deep in their hearts. I have six children, so I am not unfamiliar with the concept of wanting someone to bail you out of a mess that you have gotten yourself into - my children do this on a weekly, if not daily basis, as I did when I was their age. I do for them what my parents did for me (one of their greatest gifts, by the way) - I make them stand on their own two feet and accept the consequences of their actions and work through it. Radical concept, huh... Am I there for them in the wings? Of course - but only until such time as they need to be fully on their own as adults.

"I don't want to oversimplify a complex situation, but there certainly are unmistakable parallels here between the proper role of parenting and government. Detroit and the United States need to pay for their sins. Bad news people - it's coming whether we like it or not. The newly elected Messiah really doesn't have a magic wand big enough to 'make it all go away.' I laughed as I heard Obama 'reeling it back in' almost immediately after the final vote count was tallied...'we really might not do it in a year...or in four...' Where the Hell was that kind of talk when he was RUNNING for office.

"Stop trying to put off the inevitable folks ... That house in Florida really isn't worth $750,000... People who jump across a border really don't deserve free health care benefits... That job driving that forklift for the Big 3 really isn't worth $85,000 a year... We really shouldn't allow Wal-Mart to stock their shelves with products acquired from a country that unfairly manipulates their currency and has the most atrocious human rights infractions on the face of the globe...

"That couple whose combined income is less than $50,000 really shouldn't be living in that $485,000 home... Let the market correct itself folks - it will. Yes it will be painful, but it's gonna' be painful either way, and the bright side of my proposal is that on the other side of it all, is a nation that appreciates what it has...and doesn't live beyond its means...and gets back to basics...and redevelops the patriotic work ethic that made it the greatest nation in the history of the world...and probably turns back to God.

"Sorry - don't cut my head off, I'm just the messenger sharing with you the 'bad news'. I hope you take it to heart.

"Gregory J. Knox, President, Knox Machinery, Inc. Franklin, Ohio"

Bill Bonner
for The Daily Reckoning Australia

• Ranting Against Free markets and Wall Street
• After the Bailout of Wall Street, Everybody Wants Cash
• Wall Street Gets the Boot
• Gold and Silver Demand Unprecedented
• A ‘Bloodbath’ on Wall Street

"Oh...about $6.50."

That's the joke that is making its way around London this morning.

Iceland has melted down. Now, the government has pledged to save the banking sector - but at a cost of nearly $500,000 per citizen! In Europe, the cost so far is estimated at about $7,000 per citizen. But experts insist that much of that money - loaned to the banks - will come back to the government.

And in America? Who knows...?

The subject is on every pair of lips. It has replaced the weather as the focus of casual conversation.

"How 'bout what is going on at the banks," say farmers to one another.

And on the radio, talk shows are alive with recriminations, conspiracies and finger pointing. The man on the street is like a palm tree in a hurricane, wondering what makes the wind blow so hard.

On Monday, the wind shifted. The Dow shot up - along with the rest of the world's stock markets. People looked up and saw sunshine. But was it a genuine end to the storm...or just the eye of the hurricane that was passing over?

Then, yesterday, the clouds came back. The feds announced that they had to force an evacuation. Capitalism would have to leave town - at least temporarily. They partly nationalized nine U.S. banks.

The Financial Times recorded the scene at the Treasury Department as they told the world:

"America is a strong nation. We are a confident and optimistic people," declared Hank Paulson, Treasury secretary.

"Our confidence is born out of our long history of meeting every challenge we face." But then reality reared its ugly head. "There is a lack of confidence in our financial system...it poses an enormous threat to our economy. Investors are unwilling to lend to banks, and healthy banks are unwilling to lend to each other."

So was America confident or terrified? Apparently, it was confident that it could stop being terrified - but only if the government came to the rescue.

Deputy undertaker Ben Bernanke, Federal Reserve chairman, stared grimly into space; Sheila Bair, head of the Federal Deposit Insurance Corporation, nodded occasionally. Tim Geithner, president of the New York Fed, stood with both hands in his pockets, looking concerned.

Mr. Bernanke's turn came next, promising to do whatever it took to save the nation from disaster while letting slip that even yesterday's giant intervention might not be enough. Then up strode Ms. Bair, her head barely visible above the podium Mr. Paulson had towered over, to detail the "extraordinary steps" the government was taking to save its banks.

Saving the economy would require "a sustained and coordinated effort by government authorities". People may have lost faith in the private sector but not the power of federal authorities to rescue them. "Above all else, there must be no doubt in our government."

Ronald Reagan must be turning in his grave, the FT concluded.

But the deed was done with hardly a peep of complaint. Those few who were inclined to peep were pushed aside and ignore.

The Dow fell 76 points on Tuesday - a bad sign. Usually, following such a bad week, you'd expect the dead cat to bounce for several days. This one had a good bounce on Monday and then lay as still and as silent as a tax collector's tomb.

This is an 'emergency;' everybody says so. All very well to take the high road when the weather is fine. But when storms come, people look for shelter wherever they can find it.

How bad will the storm get? This from Nouriel Roubini, Professor of Economics at the NYU Stern School of Business:

"The crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity where excessive leveraging and bubbles were not limited to housing in the U.S. but also to housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: an housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression.

"At this point the recession train has left the station; the financial and banking crisis train has left the station. The delusion that the U.S. and advanced economies contraction would be short and shallow - a V-shaped six month recession - has been replaced by the certainty that this will be a long and protracted U-shaped recession that may last at least two years in the U.S. and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown, the probability that the outcome could become a decade long L-shaped recession - like the one experienced by Japan after the bursting of its real estate and equity bubble - cannot be ruled out.

"At this point the risk of an imminent stock market crash - like the one-day collapse of 20% plus in U.S. stock prices in 1987 - cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown.

"A vicious circle of deleveraging, asset collapses, margin calls, and cascading falls in asset prices well below falling fundamentals, and panic is now underway."

And, looking in our old book, Financial Reckoning Day, written with Addison Wiggin, we find this remarkable forecast:

"If the US were to repeat the Japanese experience, stocks would be expected to return to their 1995 trend line, with the Dow below 4,000 in the year 2012, at the very moment when America's baby boomers will most need their money."

Get out your galoshes, dear reader...

*** We're rushing to the airport - on our way to the Frankfurt Book Fair, where we hope to receive a prize for our latest book - Mobs, Messiahs and Markets. Paul Krugman got his Nobel. We're hoping for something too...perhaps a little smaller.

But we are working hard on our Special Emergency Report, where we hope to present a clearer picture of what this crisis really means and how you can survive it...and even enjoy it. Look for it soon.

*** In the meantime, we are getting in the spirit of saving money. Last week, we rode a bicycle home from the office.

"You must have looked like the nutty professor," said our daughter when we described the scene to her. Bicycle riders feel a sense of superiority and invulnerability that you can't get in a car or on foot. The rider-propelled, two-wheeled vehicle gives a sense of liberation to scofflaws...and a sense of power to poets. Your editor nearly ran down at least two pedestrians who got in front of him. As for the automobiles, he ignored them...and traffic signals too. Bicycles always seem to have the right of way...and never get traffic tickets. So, he zoomed down the Rue de Rivoli, ringing his bell to get the pigeons and old ladies out of his way. And then he glided through roundabout at the Place de la Concorde...right through six lanes of traffic. Drivers honked at him. Even other bicyclists seemed alternately alarmed or annoyed. But he got home. Safely? Probably not, but at least he was saving money.

Until tomorrow,

Bill Bonner
The Daily Reckoning Australia

• Government Could Succeed in Reflating the Bubble
• The Collapse of the U.S. Housing Market and Mortgage Bubble
• “Deflation” Remains the Watchword for 2009
• Beliefs That Central Bankers Will Save the Day
• GM, Ford and Chrysler Decline 20%