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

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To understand what's taking place in China today, we need to rewind the clock about a decade. At that time the Chinese government chose a policy of growth at any cost. To achieve that, it kept its currency (the renminbi) at artificially low levels against the dollar -- this helped already cheap Chinese-made goods become even cheaper than its competitors'. The US and global consumers were eager to buy them. China turned into a significant exporter to the US. Normally, if free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, if China let its currency appreciate, its exports would have become more expensive and the demand for Chinese products would have declined, and its economy wouldn't have grown at 10% a year.

But China isn't your local democracy, and it needed to grow at any cost. So instead, through the government-controlled banking system, China accumulated a couple trillion dollars of foreign reserves in US dollars and euros. This had an unintended consequence: It helped keep US interest rates at very low levels, and lent a friendly hand in the financing of a huge consumption binge by the US consumer (i.e., China's largest customer).

The more China sold to the US, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. The US consumer was in turn happy to leverage its future (through the "always" appreciating asset, its home) and delighted to consume cheap Chinese-made goods.

This symbiotic match made in heaven between China and the US consumer worked great as long as housing prices kept rising and the financial machine kept multiplying dollars. But all good things come to an end, and great things come to an end with a bang. The financial meltdown erupted upon us and, well, you know how that story played out.

So now let's fast-forward a year. Today the global economy is stabilizing. But the US consumers of Chinese-made goods are now deleveraging, unemployment is high, US banks aren't lending.

Despite this, the Chinese export-based economy has clocked growth of 8.7% in 2009. The rest of the world looks at the Chinese growth miracle with envy; it seems that China has got economics figured out. But don't hurry to trade your democracy for an authoritarian system. The Chinese grass is not as green as it appears.

First, one shouldn't believe all the economic numbers that are put out by the Chinese government. This is the government that magically managed to report 6% to 8% GDP growth in the midst of the financial crisis, when its exports were down more than 25%, tonnage of goods shipped through its railroads was down by double digits, and its electricity consumption was falling like a rock.

Second, China will do anything to grow its economy, as the alternatives will lead to political unrest. A lot of peasants moved to the cities in search of higher-paying jobs during the go-go times. Because China lacks the social safety net of the developed world, unemployed people aren't just inconvenienced by the loss of their jobs, they starve (this explains the high savings rate in China) and hungry people don't complain, they riot. Once you look at what's taking place in the Chinese economy through that lens, the decisions of its leaders start making sense, or at least become understandable.

Unlike Western democracies, where central banks can pump a lot of money into the financial system but can't force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The Chinese government controls the banks, thus it can make them lend, and it can force state-owned enterprises (one-third of the economy) to borrow and to spend. Also, China can spend infrastructure project money very fast -- if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good.

China has spent a tremendous amount of money on infrastructure over the last decade and there are definitely long-term benefits to having better highways, fast railroads, more hospitals, etc. But government is horrible at allocating large amounts of capital, especially at the speed it was done in China. Political decisions (driven by the goal of full employment) are often uneconomical, and corruption and cronyism result in projects that destroy value.

Infrastructure and real estate projects are where you get your biggest bang for the buck if your goal is to maintain employment, because they require a lot of unskilled labor; and this is where in the past a lot of Chinese money was spent. This also explains why the Chinese keep building skyscrapers even though the adjacent ones are still vacant.

Though Chinese economic growth in the past was very high, more recently the quality of growth has been low. For example, in an echo of past Chinese government asset-allocation decisions, China built the largest shopping mall in the world, the South China Mall, which is still 99% vacant years after construction. China also built a whole city, Ordos, in Inner Mongolia, on spec for one million residents who never appeared.

The inefficiencies are also evident in industrial overcapacity. According to Pivot Capital, Chinese excess capacity in cement is greater than the consumption of the US, Japan, and India combined. Also, Chinese idle production of steel is greater than the production capacity of Japan and South Korea combined. Similarly disturbing statistics are true for many other industrial commodities. The enormous stimulus amplified problems that already existed to financial-crisis levels. China is a less shiny but more drastic version of Dubai.

There is speculation that the Chinese consumer will pick up the demand slack for the US and European consumers who are deleveraging and buying fewer Chinese-made goods. This may happen, but it will take decades. The US and European consumers are two-thirds of much larger economies. The Chinese consumer is only one-third of the Chinese economy.

We look at China and are mesmerized by its 1.3 billion people, its achievements of the last decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. This was the case with railroads in the US in the late 19th century: The railroads were supposed to change the landscape of the US, and they did, but that didn't prevent a lot of them from going out of business first. The Internet was supposed to change how we communicate, and it did, but in the process it generated a tremendous bubble, followed by the loss of wealth for many. The Chinese economy is no exception. Its long-term future may be bright, but in the short run we've got a bubble on our hands.

Everyone wants a shortcut to greatness, but there isn't one. It would be great if the word (economic) cycle only existed in a singular form, and the only cycle we had in the economy was happy expansion. If there were no cycles, there would be no painful recessions. But as heaven couldn't exist without hell, or capitalism without failure, economic expansion can't exist without recession. China has been trying to bend the laws of economics for awhile, and with the control it exerts over its economy it may seem, at least for a short while, that the laws of economics work differently in China. But this is only a temporary mirage, which must be followed by huge pain and drastic consequences. No, there's no shortcut to greatness - not in politics, not in personal life, and certainly not in economics.

Regards,

Vitaliy N. Katsenelson
for The Daily Reckoning Australia

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Bloomberg reports that RGH Ltd. (formerly Rams Home Loans) may default on nearly $2.5 billion in loans. The possibility was triggered by a ruling of the New South Wales Supreme Court. In that ruling, the Court said that RHG was already in default on $324 million in notes held by a German lender that were used to finance new Australian mortgages.

The default on the $324 million in notes may trigger "cross defaults." That's a fancy way of saying other lenders to RHG may force the sale of their securities held by RGH in order to recoup the money they've lent. Or as Moody's analyst Arthur Karabastos puts it, "The secured creditors may wish to take steps to enforce their security including the appointment of a receiver to the underlying pool of mortgages."

Bloomberg says the court case hinged on whether a pool of mortgages pledged as security to a loan made by German bank HypoVereinsbank has breached a "maximum level of arrears." The case apparently hinged on what the definition of "in arrears" was. The court said RHG's method of defining what "in arrears" meant was, "reminiscent...of Humpty Dumpty."

Without knowing the details of RHG's loan portfolio it's hard to say if this is indicative of a wider problem in Australia. What it DOES show, though, is how no amount of time can make a bad loan go good if the underlying asset was over-priced to begin with. The idea that you can avoid a loss by holding a loan-to-maturity (and not marking the loan to market today) is absurd if underlying assets (residential housing) are losing value.

Time and again we come back to the solvency of the banking system. It's on both sides of the balance sheet. Liabilities secured by damaged collateral threaten to swallow assets, which are themselves dependent on a huge recovery in house prices (which frankly isn't happening). U.S. banks are still incredibly exposed to housing, not to mention commercial real estate.

What about Westpac? It bought Rams in October 2007 after the Rams realized it couldn't fund new loans through securitization in a credit depression. It isn't clear how much - if any - exposure Westpac has to RGH. Westpac shares were down slightly. This is what we meant though, on Monday, when we said that the Big Four still have exposure to the higher-risk mortgage market.

It's a dangerous financial liaison. The banks want exposure to this sector of the housing market (because it's profitable). But they prefer to compartmentalise the risk (if possible) and keep the affair under someone else's name (like registering into a hotel with a different name to conceal your identity).

Also in the Department of Aussie-banks-exposed-to-default risks is the National Australia Bank. Only this time it's not bad mortgage risk, it's sovereign debt risk. In documents published late last night, NAB revealed it has $12.78 billion in exposure to Italian government debt. Its Italian exposure is about 2% of its total asset base of $654 billion.

NAB came by the bonds because it accepted them as collateral for what it described as an "interbank reverse repurchase agreement." Got that? From what we can gather, NAB may be obligated to take on certain loan obligations of its bank partner "under certain circumstances." The Italian sovereign debt is collateral against those potential obligations.

Is it such a bad thing owning Italian government debt? S&P says the debt is rated A+ and stable. Italy's public debt-to-GDP ratio is 115%--bigger than most but smaller than some. Its annual fiscal deficit is 5.3% of GDP. Again that's smaller than some, but not hardly the level that inspire confidence in the soundness of your monetary policy or your sovereign debt.

None of this means NAB is in imminent danger of losing $12.78 billion. Italy would have to default on its debt. Or the market would have to begin re-pricing the sovereign debt of countries like Italy, Greece, Ireland, and Portugal to reflect the unsustainable nature of fiscal and monetary policy in those places.

But for NAB, it all comes down to debt again. Sure, there's good debt and there's bad debt. And you'd think that sovereign debt is generally pretty safe (especially since the FSA and APRA have concluded that only sovereign debt meets the liquidity requirements under consideration for bank assets). But sovereign debt isn't safe if the financial crisis is turning into a sovereign debt crisis. And in 2010, it sure looks like funding model of nation states will be under severe pressure.

All of which is a big argument for staying away from the banks. But to be fair, a whole heap of Aussie stocks are treated as "risk assets" to be bought when the U.S. dollar is weak and sold when the dollar rallies. With the dollar rallying, the Santa Rally may falter.

Speaking of melting Santa Rallies...it's a sunny 15.5 Celsius here in Colorado. Growing up in the mountains, the winters were full of monster snow drifts and grey skies. But Colorado gets heaps of sunshine. And though the Rockies were blanketed with white as we flew over them yesterday, today's weather is nice enough to have a barbecue in, which we'll do with family in a few short hours. Until tomorrow!

Dan Denning
for The Daily Reckoning Australia

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The term, "unintended consequences" was probably invented to describe such tools. Give the feds a saw and they will cut off their fingers. Give them a pistol and they will blow off their toes. Give them a chainsaw...please!

The private sector debt crisis of 2008-2009 will almost certainly lead to a public sector debt crisis sometime between now and eternity, if not sooner. In the standard narrative, governments must stimulate their economies out of the slump. Leading economists propose it, then defend it...and then, when it doesn't work, they call for more of it.

Now those economists are claiming victory and many are calling on the Fed to withdraw its monetary stimulus before it shows up as consumer price inflation. They're hoping the Fed can head it off by sopping up the surplus liquidity before it is too late.

Optimists expect mild inflation in a decent recovery. Pessimists fear the feds may have waited too long; they think they see higher rates of inflation coming. Here on the back page we see no recovery...nor any inflation. At least, not yet. Instead, we are blind. We see nothing. But as for what is coming...a slow motion depression wouldn't surprise us. Neither would the collapse of the public debt market.

There is always a wide gap between the feds' reach into the economy and their grasp of what they are really doing. When the Fed increased reserves in the banking system, the idea was simple enough. More reserves would allow the banks to lend more. In turn, more credit would allow consumers to spend more. Ergo, the recession would soon be over.

But the more reserves the Fed pumped into the banking system, the more reserves the bankers didn't lend out. In 24 months, excess reserves (beyond what was needed for loans) expanded 500 times from the level they had been for the previous 30 years. If the banks chose to lend these reserves they could multiply them into another $10 trillion to add to the money supply. Instead, in the third quarter, the US suffered a record contraction of bank lending, according to the Federal Deposit Insurance Corporation. Lending to households and business is in a steep decline. Nothing like it has happened since WWII. Total credit outstanding is falling too. The banks are barely even lending to the US government from which they got the money in the first place.

"Banks, in aggregate, just absorbed the additional reserves by allowing their ratio of reserves to deposits to balloon," reports Charles Goodhart in The Financial Times, "...so the multiplier collapsed to zero... Why?"

Quantitative easing had "unintended consequences." Bankers competed for yield with the deepest pockets in the monetary universe - the central bank itself. When the feds bought Treasury bills they drove yields down to such skimpy levels that the incentive for risky private loans was nearly lost all together. Better to leave the money on deposit at the Fed.

No loans, no multiplier. No multiplier, no recovery. Instead, the feds take a dollar's worth of supposedly "idle" resources out of the private economy (actually, savings that people hoped to spend or invest later); squander it on bribes, bailouts or boondoggles; and get 90 cents worth of 'recovery.' Then, when a real recovery doesn't come, they spend two dollars.

Where this will end up? With the multiplier out of action, consumer price inflation - and a recovery - seem far away. And the feds are helpless. What? What about more government spending? Or dropping hundred-dollar bills from airplanes? But those tools have self- mutilating effects too. They jeopardize governments' access to deficit financing.

"Britain risks becoming the first country in the G10 bloc of major economies to risk capital flight and a full-blown debt crisis over coming months," said an article in Tuesday's Daily Telegraph.

Sooner or later, lenders will worry about inflation and the risk of default. They'll demand higher interest rates. Treasury bond yields will rise, in real terms, even in a deflationary world. These higher rates affect public finances like a cold draft on a pneumonia patient. As governments pay more to borrow, their condition deteriorates. The odds of default increase. Some, like Dubai World, will be forced to postpone payments. Others just shake and shiver. The slow motion depression continues. If we are lucky...and nothing goes wrong.

Regards,

Bill Bonner
for The Daily Reckoning Australia

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Furthermore, this losing trade would also have been the most baffling. Throughout the year, it seemed as if the pieces were falling into place for a big spike in short-term interest rates. The Fed was printing money like there was no tomorrow; the dollar was tanking, which raised fears that the Chinese would dump US debt; and gold - that well-known inflation barometer - kept powering higher.

A jump in short interest rates seemed like an easy bet. It was almost a no-brainer. Except that it wasn't...We suspect a lot of smart investors got hurt on this trade. What they did not count on was the possibility that fear and risk-aversion would cause investors to herd into short- term instruments like T-bills...and that investors would continue herding into these instruments even after rates fell dramatically.

With the benefit of 20/20 hindsight, it is easy to see why short-term interest rates plummeted this year. After the economic collapse of 2008, the Fed had one goal and one goal only - to recapitalize the banking system. TARP was just the first step. The only way to achieve banking health after the terrible implosion of the real estate market was to "guarantee" profits for the major banks. The Fed pursued this objective by extending massive amounts of credit to the banking system at interest rates near zero, thereby enabling banks to replace high- cost financing and capture a healthy spread on their loan books.

This gimmick has worked well...too well.

Big money-center banks are borrowing money from the Fed's discount window at 1/4 percent and then turning around and buying 10-year Treasurys yielding 3.2%. This represents a "risk-free" profit of just below 3% in an environment that is still more deflationary than inflationary. Of course, if long-term rates run were to run higher, these plump interest rate spreads would turn negative and produce losses. But that's a problem for another day.

As long as short-term interest rates remain at rock-bottom levels, banks will continue to buy T-bonds and other higher-yielding instruments. In other words, the Fed is subsidizing the purchase of Treasury notes and bonds, which is helping to keep long-term rates low. (The Fed may tell the public that it is keeping rates low to encourage bank lending, but in so doing the Fed is actually DIS-couraging it. Why lend to small business when you can make a guaranteed 2.9% return lending to the government?)

But this game won't last forever. We doubt the Fed will be able to maintain low short-term interest rates indefinitely. Market forces may force the Fed's hand as early as next year. As inflationary pressures build and/or the dollar continue to weaken, the Fed will be forced, if not to raise rates directly, then to tweak its policy statement so that expectations of continuous, rock-bottom rates are disrupted. Either event could have far-reaching consequences for all of the markets...especially the Eurodollar market that tracks short-term interest rates.

We expect the Fed will hike short-term interest rates if the bull market in gold and/or the bear market in the dollar get out of control. Or should we say, MORE out of control.

Rather than wait for this event to occur, we are advising our clients to position for it now by buying long-dated put option spreads on Eurodollar futures. We prefer options that expire in 2011 so that there is plenty of time for the trade to work.

Obviously, there is no guarantee that short-term rates will rise soon from today's extremely low levels, but we like the odds.

Regards,

Steve Belmont
for The Daily Reckoning Australia

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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
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Even in the world of finance, there are momentous conversions. As they say on Wall Street, a rally ends when the last bear gives up. An old friend had been a source of inspiration for tech bears for many years. He suddenly saw the light and gave up in 1999. Shares he had formerly scorned - often dotcoms with no revenue and no business plans - were suddenly added to his own portfolio. This also heralded a big change - the end of the tech bubble. Tech stocks collapsed. Most disappeared. Then, Stephen Roach became vaguely bullish in 2007, after a long period of doubt and misgivings.

Now it is Jim Grant who has changed his mind. A generation of investors has gotten used to Grant's 'doom is nigh' warnings. Now, he says, it's a boom that is nigh.

What is remarkable about the Grant conversion is that his vision gives off so little heat and light. His WSJ article shillyshallies around; rehearses the history of previous recessions and comes to rest in front of a flickering match: "The deeper the slump, the zippier the recovery."

Many were the sheep in Grant's flock. They feel betrayed, as if their shepherd had gone over to the wolves. Here at The Daily Reckoning, we take no personal offense. In the following few words we merely stoke up the fire.

We will not argue with Newton's Third Law. For every action, there is a reaction. Every boom has a bust. And every busted bubble has a bounce. Even the Titanic's stern rose, before she slipped below the waves.

First, we consult the facts. But facts are survivors. They will tell whatever tale their interrogators want to hear. As for opinions, after six months of a stock market rally, the once half empty glass has become half full. We predicted it ourselves. But we'll let Robert Prechter say, 'I told you so.' Even before the rally began, Prechter foretold its story:

"Regardless of extent, it should generate feelings of optimism. At its peak, the President's popularity will be higher, the government will be taking credit for successfully bailing out the economy, the fed will appear to have saved the banking system and investors will be convinced that the bear market is behind us."

As to Mr. Obama's popularity, Prechter was wrong. But 4 out of 5 ain't bad.

Grant's brief tour of recession history seems to confirm his Newtonian position: the further an economy falls, the further up it rises to get back to normal. This downturn has clipped nearly 4% off America's GDP, substantially more than any previous downturn since WWII. Therefore, it will come back strong.

Today's slump in the United States hardly compares to the one of '29- '33, which took 27% off the GDP. Then, in the ranks of the unemployed, stood one out of every four able-bodied workers, as opposed to just one out of every 10, according to today's statistical legerdemain. Still, the depth of the drop did not prevent a vigorous bounce; on the contrary, it seemed to demand it. After '33, the US economy grew by nearly 10% in each of the next four years.

In the slump of '82, GDP sank at a 6.4% rate. Again, the reaction was nearly equal and opposite to the action. "Not until the third quarter of 1984," says Grant, "did real quarterly GDP growth drop below 5%."

Of course, even a US Congressman will bounce, if you push him down the Capitol steps. But not every one will get up again. In the '33 example, the US economy, still youthful and vigorous, got up nicely. But then it fell again. By the end of the decade he was still on his back, with 15% unemployment and 2% deflation. Only later, after four years of world war, did the economy begin a sustained recovery.

Now it is 2009. The poor fellow is down again. The feds rushed to help him to his feet. They gave him a combined fiscal and monetary shot-in- the-arm seven times stronger - in terms of GDP - than the average postwar countercyclical stimulus. The juice opened his eyes. But he still staggers. He has put on some weight over the years; he now carries three times the debt/GDP as he had in '82. His stocks are three times as expensive, in P/E terms, too. His bones are more brittle and his mind a little slower. What's more, in '82, he had been on a deleveraging diet for more than a decade. In '09, he has just begun.

What will happen next, we don't know. But if we turn bullish on this economy and urge you to buy stocks, it will surely be time to sell them.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

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"Banks recover to their levels before the fall of Lehman," is a headline in this Monday's El Pais from Madrid.

"Public assistance enables the world's largest 15 financial firms to return to the capitalization they had in September 2008," the article continues. The largest of the largest, HSBC, is now judged to be worth $186 billion, according to the stock market. China's ICBC is on its heels, with a market cap of $178 billion. BNP Paribas is 7th at $87 billion.

We will overlook the compromising detail that banks actually lost money in the last quarter - more than $3 billion. And let's forget that China's major banks are sitting on mega-losses from more than eight years ago (to say nothing of the more recent losses). Western banks, too, still have billions in assets whose real worth is an open question...and subject to quick reconsideration...

El Pais goes on to report something intriguing: "The two big Spanish banks leave the crisis stronger."

Ah. What doesn't kill you makes you stronger. The world economy is recovering, or so people believe. Stocks are going up - led by the banks. But are the undead of the banking world really stronger?

Ha ha...don't make us laugh.

But the world seems to believe it. The Wall Street Journal reports that just five big financial stocks are behind the stock market's rally. Fannie Mae, Citigroup, Freddie Mac, Bank of America and AIG account for nearly a third of market's daily turnover. Seems everyone is speculating on the banks...and moving them higher.

You will recall, dear reader, the banks made a fortune during the bubble years. You may also recall that they made so much money that when the bubble years came to a close, that they were almost all broke. Without hasty action from the feds, it would have been the end of the road for every major bank on Wall Street. As it was, even with government help, none of them survived intact. They all either went bankrupt, were sold off, or got bailouts with strings attached.

What busted the banks was too much of a bad thing. They made their money by peddling debt. In order to move the stuff, they convinced clients that their products were good safe investments - even leveraged derivatives backed by subprime mortgages! Such good salesmen were they that they even convinced themselves. When the crisis came, they realized that they had been buyers of the debt...as well as sellers of it. What could they do with it...except sell it to the feds?

But the whole financial industry is coming back to life. According to El Pais, it's back...and it's better than ever.

But wait? How could that be? Hasn't the world entered the worst recession since the great depression? How could lending money be such a good business? People don't borrow in a recession.

Strategic Short Report's Dan Amoss is just as skeptical. "The banking system has no experience managing through the current 'negative home equity' environment," he tells us. "This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

"This problem will cap the upside of bank stocks for years to come, so the sector will offer lots of short selling opportunities."

Borrowing by households has fallen off a cliff. Instead of borrowing, they're paying back debt at the fastest rate since the '50s. No money to be made there.

How about commercial and business loans? Are you kidding? Businesses are cutting back too. Businesses borrow to expand...and there is no expansion going on. This is a contraction. Credit is contracting along with everything else.

Then, how could the banks make money? Let's refer to that news item again. Oh...there are the magic words: "Public assistance enables..."

The banks are making money the same way Detroit is making money...dishonestly and temporarily. Instead of doing honest deals with willing and able counterparties, the banks are pulling a fast one. Their money comes, ultimately, from the poor taxpayer...the poor sap who funds all the government's giveaways. The private sector lived far beyond its means during the bubble years. People wasted their money they didn't have on things they didn't need. Now, they try to save their money. But now the government wastes their money for them.

Speaking of which...a quick note on the Cash for Clunkers program. Numbers to be released today are expected to show a peak in sales in August caused by the feds' incentives. President Obama calls the program a showcase, proving how effective government can be at getting the economy back on the road.

But let's go back to basics. It's a sham when people waste their own money. It's a crime when they waste other peoples' money. Prosperity comes from accumulating (saving) capital...and using it to increase productive capacity. The formula is pretty simple: Save your money. Invest it in productive business. The Clunkers program encouraged people to do the opposite - consume capital, other peoples' capital.

'Nuff said.

Bill Bonner
for The Daily Reckoning Australia

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"So, from now on, no exchanging dollars for gold for you either! Hahaha! You believed us when we guaranteed our promise about the value of the dollar in terms of gold, and then let us keep the gold at our house? Hahaha! Morons! So just come and try to get it, chumps!"

The problem was that the government was being bankrupted by maintaining the foolish Leftist stupidities of Johnson's "Great Society" and the sheer stupidity of the Vietnam war (among other governmental stupidities), and lots of dollars were being created by the Federal Reserve and multiplied by technology increasing the velocity of money through the banking system, resulting in a lot of inflation and a lot of dollars piling up overseas.

Fortunately, it was France making all the noise, and real Americans - who hate the French for their snotty attitudes - were smart enough to be alarmed, since the French knew that the buying power of the dollars that they held - and would be getting in the future - would all be losing valuable purchasing power. Naturally, they wanted to exercise their option to exchange the dollars for gold!

This was okay for a while, but pretty soon there was a torrent of gold leaving the country, causing Nixon to reveal just what kind of country does this kind of lowlife deal breaking.

Then Nixon said, "No more exchanging stupid paper dollars for real gold!" The reason Nixon was forced to act like a lying, thieving little creep is partly because he WAS a lying, thieving little creep, but mostly because he mirrored America perfectly since Congress allowed it, nobody at the Federal Reserve was hung, imprisoned or even received a stern lecture, and there were no street riots at the sheer shame of it all.

This is not about how I am glad that Roy Rogers and Hopalong Cassidy are dead so that they would not see the kind of embarrassing, black- hat, bad-boy bunch of dad-burn, sidewinding, backstabbing, ornery, polecat bushwhackers we have become, but to show you how good the French were in predicting the fall in the value of the dollar.

And for that we only have to look at the essay titled "The Day the Dollar Died - and the Day Gold was Reborn" by Bill Downey of technicalcommoditytrader.com, who has researched a handy comparison between then and now.

He compares "How Much things cost on Aug 15th, 1971" to what they cost today.

Dow Jones Industrial Average 890 or 25 oz. gold in 1971, versus 9,000 or 10 oz. gold today.

Average Cost of new house $25,250 or 721 oz. gold in 1971, versus 250,000 or 277 oz. gold today.

Average Income per year $10,600 or 302 oz. gold in 1971, versus $70,000 or 77 oz. gold today.

Average Monthly Rent $150 or 4.3 oz. of gold in 1971, versus $824 or 1 oz. of gold today.

Datsun 1200 Sports Coupe $1,866 or 53 oz. gold in 1971, versus $28,400 or 31 oz. gold today.

Naturally, I am looking over this little chart with some puzzlement, and I am thinking to myself, "It seems that there should be a message in there somewhere, but what?"

Fortunately, before I could think about it some more, and wonder some more about what the "message" was, and then get a headache from all the thinking and the frustrations of failure, and then decide to go out for a drink to clear my head, or maybe take an afternoon off to play a round of golf, both of which get me in trouble with my boss, Mr. Downey reveals it as, "Conclusion: If your money is dollars, you live in an inflationary world. If your money is denominated in gold, you live in a deflationary world."

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

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Isn't it ironic how creatively regulators were interpreting Reg FD laws with all of this week's leaks to the press? The leaks may not be very relevant, but they are yet another sign that this stress test was designed for public consumption. It was intended to bolster public confidence in the banking system, and I'm shocked at the lack of skepticism among the professional investment community.

Once it was announced that bank executives were pushing back on regulators about their forecasted losses, the stress tests instantly lost a great deal of their credibility. What kind of test in school allowed you to argue with your teacher about the correct answer?

Just like a student either knows their subject or does not, a bank's capital will be sufficient to weather this crisis without obscene levels of government subsidies, or it will not. If it is not, the FDIC should resolve it at a measured pace to minimize taxpayer losses. With Bear Stearns more than a year in the rearview mirror, there's no excuse for top regulators to not have a mechanism for unwinding complex bank/brokerage institutions - in which losses would be borne by shareholders and bond holders - rather than taxpayers. Instead, the authorities are trashing the value of the U.S. dollar and blowing up the deficit to potentially unmanageable levels.

Independent regulators - not bank executives - should be the sole judges of capital adequacy under a stress scenario. We all know what kind of biases bank executives tend to hold about their own loan books.

We have probably not seen the end of the stress test process. If the future data flow on loan delinquencies comes in higher than the current "stress" scenario, then we may see a scenario where a major bank (or three) gets massively diluted. For a model of what night happen to shareholders at the most toxic of the megabanks, consider the proposed exchange offer for GM bondholders, which would leave current GM shareholders with a 1% equity stake in the "new" GM. Why any professional can justify investing client capital in such megabank stocks is beyond my understanding.

The market's reaction to the stress test - in the form of soaring bank stocks - tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy.

Most of us do not have magic predictive powers - only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

The stress test's estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending.

The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much.

Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital). Here's the illustration I used in the March 27 Strategic Short Report alert:

"Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that's cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators allow the water level to fall to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels. There's a risk that if the optimists are wrong about the amount of new water coming in, we'll be stuck with a Japanese-style "zombie bank" situation.

After this week, I think the risk of the zombie bank scenario is much higher. We'll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) - rather than write new commercial or consumer loans.

Regards,

Dan Amoss
for The Daily Reckoning Australia

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