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

• US Dollar a Sort of Monetary Brand
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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

• An Edifice of Pure Economic Crapola
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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

• It Wouldn’t be a Real Bear Market Rally if it Didn’t Test Your Confidence in Your Position
• Were the Government’s Stress Tests a Bogus Exercise in Deception?
• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• A CAP to Replace the TARP
• Stress Testing the Banks

Today, investors in financials have lost nearly everything and before this is over, I suspect the majority of banks in the West will be nationalized. This would mean a total catastrophe for those who invested in bank stocks or corporate bonds. So, no matter how strongly your private banker pushes you to load up on "cheap" financial stocks, please DO NOT go "bottom fishing" in this bankrupt industry. Banking is no longer a growth industry and financials will disappoint investors for many years. Furthermore, if you have any exposure to hedge funds, structured products, accumulators or derivatives of any kind, I sincerely urge you to get rid of all this highly toxic garbage. Such Ponzi schemes were very good for the private bankers (due to the huge amounts of commissions involved) but they are a disaster waiting to happen. Today, our planet has roughly US$600 trillion worth of derivatives and this is roughly 10 times the size of the global economy! So, please get rid of your derivatives based "investments" immediately.

Even though the financials are getting killed, our fundamentally sound stocks in solid sectors continue to report good operating results and their stock prices are much higher than the lows recorded last fall. So, this is a positive divergence and shows that the market's internal breadth is improving with fewer stocks breaking down to new lows. Another positive sign is that the Asian markets are faring much better and are nowhere near the lows recorded last fall.

During such turbulent times, it is worth remembering that your stocks represent partial ownership in underlying businesses with real assets (plants, reserves, land, machinery, technology, cash and human resources). And even though the stock market's current appraisal is not favorable, it has no connection with the intrinsic value of your holdings.

Various central banks continue to steer this economy like drunken sailors and they are injecting TRILLIONS of dollars into the system. I would argue that many nations in the West are already bankrupt (US, Britain, Germany, Spain, Iceland and Ireland come to mind) and the ONLY thing they can do now is to print even more money. For example, America's total debt is worth US$54 trillion and there is no way the US can ever hope of repaying its debt in today's money. In other words, either the US will default (highly unlikely in my view) or it will print and inflate so that this huge mountain of debt feels much smaller in the future due to the loss of its purchasing power. Remember, the best way to make debt more manageable is by inflating the supply of money in the system. And this is precisely what the various central banks are doing.

It is worth noting that nations like Germany and the United States have already started using the printing press and more nations will soon follow. When the entire planet is covered with oceans of paper "money", its purchasing power will sink and hard assets will sky-rocket. At least this is what has happened throughout history. So, please don't be fooled by this temporary contraction in hard assets and hold on to your positions. If anything, take advantage of the ongoing fire-sale and if your financial situation permits, convert more cash to quality assets in the resources sector.

A bunch of turkeys have hijacked our monetary system and all they know is how to print money. Rather than let the market clear itself out, central banks continue to use taxpayers' money to bail out insolvent institutions. This brilliant strategy has NEVER worked in the past and it will not work this time around. Instead of robbing innocent people of their savings, the establishment must allow the weak banks to go bust. For example, if Citibank is on the verge of collapse, then the US Treasury must let it go bust! All Mr. Geithner needs to do is to protect the customers of Citibank, allow Citibank's investors (shareholders and bondholders) to suffer and sell the bank's book to another institution. This is all that needs to happen. This way, depositors will not lose anything and only investors in Citibank will suffer - and they should! Why should the public share the losses with these investors? When Citibank did well in the past, did its shareholders and bondholders distribute the profits to the public? Of course not! So, why should the reverse occur now?!

Personally, I find these bailouts absurd, unethical and a total waste of valuable resources! Who gave these politicians the authority to act like investment bankers? Mr. Geithner is not a qualified 'merger & acquisition' expert, so how does he have the audacity to use other people's money to take over insolvent banks? Likewise, Mr. Bernanke is now using American taxpayers' money and buying distressed debt! I find this outrageous! Is he going to act like a debt collector when people default on their loans?

Mark my words - the establishment is only making matters worse and prolonging the pain. Moreover, by printing insane amounts of paper, the politicians are setting everyone up for an inflationary nightmare! One thing is for sure - before this drama ends, the viability of the U.S. dollar as the world's reserve currency will come under question. When the U.S. dollar starts to implode, hard assets will go through the roof. Remember, commodity prices went ballistic in the late 1930s as well as during the 1970s. We should expect similar action in the years ahead

Regards,

Puru Saxena
for The Daily Reckoning Australia

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U.S. stockowners got a break yesterday...the Dow rose 236 points. News reports tell us that investors were listening to Ben Bernanke. He's speaking to Congress...intending to boost investor confidence. But we can't find anything in Bernanke's remarks that would give us much confidence.

In fact, consumer confidence is at a record low. And investors couldn't have taken much comfort from the Fed chief. Bernanke said the economy would start to grow again in 2010...and then, only if the banking system is stabilized. Of course, Bernanke is talking nonsense. He doesn't know when the economy will begin to grow in earnest again, and if it does begin to grow it won't be because the banking system is stabilized. You can stabilize a comatose person. You can stabilize a battlefield. You can stabilize a ladder. But stabilizing a crummy bank won't help the economy grow. For that you need a healthy bank. And the only way a bank can be a healthy bank is if it holds healthy assets and can earn decent money when it makes a loan.

Banks aren't making loans now because they don't know who will be able to pay them back...and don't know what the collateral is worth. They'll have to wait until this period of price discovery settles down. And that won't happen until deflation has done its work...until prices have been knocked down to their lowest level. That could happen quickly...or it could take years.

AIG now says it is facing a $60 billion loss. How much is its stock worth? Citigroup is nearing bankruptcy, with the U.S. government getting ready to up its stake to 40%. What will the shares be worth when the operation is over? GE finance says it will get by - maybe. Micro Tech is laying off 2,000 more people in Idaho. And Italy is officially in recession.

One by one, company by company, country by country...the whole world slips into depression.

Oil traded at $39 yesterday. And gold lost $25.

What's ahead?

We'll give it to you straight - darned if we know. Stocks could rally from here...or collapse. We have our 'Crash Alert' flag up...just in case. The Dow will probably get down to the 3,000 - 5,000 range before this crisis is over. If we're right, it's got to lose another 2,000 plus points. You don't want to be holding stocks when that happens. Might as well get rid of them now - even at the risk of losing out on a rally.

As for gold...

Chris Wood says it will reach $3,500 by next year. Chris is more right than most analysts. In his newsletter, Greed and Fear, he warned that the bubble in sub-prime lending was going to blow up... The Wall Street Journal says he's the "man who saw it coming."

Why will gold soar? "It's the only form of money or credit not contaminated by the credit system," says Chris. Which explains why it has risen - even while inflation expectations are so low. Investors are not buying gold as a protection against inflation; they're buying it to protect themselves from deflation. Yesterday, as deflation expectations subsided, so did the price of gold.

Wood is primarily an Asian analyst. Which is to say, he spends most of his time trying to figure out what it going on in the Far East. He's watched Japan for decades. And now he sees the threat of the entire world entering a Japan-like slump. How to avoid it?

Nationalize the banks, says Wood. And create a 'bad bank' where you can dump all the toxic assets. That's what is already underway...more or less.

Wood believes nationalization is the only way to get the rottenness out of the banking system - quickly. He's not the only one. Nouriel Roubini is for it. So is Nobel Prize winner Paul Krugman. They believe, as we do, that the banking system is still resting on the sand of trillions in bad loans and radioactive investments. Taken as a whole, the entire banking industry in America is insolvent. That's another reason banks aren't making loans - they don't have any money. And deflation continues to wash out the loose sand and expose the weak foundations of the banks' assets. It will also undermine their collateral. Until this process is over...the system cannot begin to put itself right.

The banks mustn't be stabilized as they are, in other words. They need to be cleaned out first.

We don't disagree. But if it were up to us, we'd give nature a chance. The market seems to be doing a decent job, as near as we can tell. The value of everything on earth put together is about $100 trillion. In the space of less than two years it has wiped out about a third of the entire capital value of the planet.

If our hotline rings and Mr. Obama is on the phone, we know what advice we will give: Let the banks fail. Let them go broke. Let them be liquidated. Then, the surviving banks could buy up the decent assets and emerge stronger than ever.

*** With tax season upon us, everyone is scrambling to figure out what they can and can't count as deductions. Turns out, with some clever accounting, cat food and even swimming pools can be added as deductions on your federal income taxes. But what about a brand-new car? Gunner and Jim at Penny Stock Fortunes have the answer, below...

"The folks in Washington are ready to make that happen now with plans to make the total cost of auto loans tax deductible - along with other rebate and incentive programs - to try to persuade those with older vehicles to trade in their junkers for new rides.

"The Senate's tax deduction bill is pretty straightforward. Those with a new auto loan would earn an above-the-line deduction for loans up to $49,500. The second proposal supposedly has environmental benefits. Those who sell an older vehicle for scrap would receive a voucher to aid in the purchase of a newer, more-efficient vehicle.

"It's difficult to say if either of these proposals will actually help revive auto sales. Some industry experts believe that a more effective fix would need to include measures to make it easier for buyers to secure auto loans in the first place.

"Of course, these are mere proposals - not new laws. And it is unclear at the moment whether any of the measures will become official, or for how long. But the fact that legislators are discussing the problems of the auto industry is a crucial step. Auto stocks will begin to turn around once investor confidence turns. Legislation - whether it will be effective or not - could very well spark a rally in this sector."

As for right now, the data look bad at best. According to estimates from the National Automobile Dealers Association, 900 dealers closed their doors in 2008. That's bad for them, but potentially good for one of the companies in the Penny Stock Fortunes portfolio...which is up to the double digits in just a couple weeks.

To check it out, and to find out how you could double your money in just six months with their special system, see here.

*** A 'Slumdog Millionaire' DR reader writes:

"Thank you for making me feel like the biblical Noah. I am Dinakarananda from India and I am grateful to the entire DR team. I have been an avid reader of DR for the past two years. I am very happy that I stumbled on DR soon after I landed in Melbourne and looking for some Australian business news website that was sensible and truthful. I have been an avid investor in India since 1993 and in the US since 1999.

"I cashed out almost all my investments in equities and bought 130Kg of gold back in October-November of 2007. DR was one of the major factors that influenced my decision and I am happy every minute of my life now to have found DR.

"Thanks a lot to Dan Denning, Bill Bonner, Mogambo guru and all of you in the DR team for guiding my ark and investments. One of those slumdog to millionaire stories inspired by DR I presume. I would be happy if my email finds its way to the reader email that is occasionally published and if it helps a few more slumdogs around the world."

*** Is the new U.S. president a Daily Reckoning reader?

In his first address to a joint session of Congress last night, President Obama said, "That day of reckoning has arrived, and the time to take charge of our future is here."

Hmmmmn...if you missed it, you can catch the video here on our site. And let us know what you think - is Obama going to be able to make good with all of his promises, or is he just blowing smoke up the country's collective you-know-what? You can leave your comments in the space provided underneath the post...

Bill Bonner
for The Daily Reckoning Australia

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Our old friend, Lord Rees-Mogg, writes in the TIMES :

"Daniel Webster's opinion should never be forgotten. Of paper money he says: 'We have suffered more from this cause than from every other cause or calamity. It has killed more men, pervaded and corrupted the choicest interests of our country more, and done more injustice than even the arms and artifices of our enemy.'

"In the 1930s some nations tried to beat the slump by competitive devaluations. In the present crisis, Britain has already experienced a very big devaluation of the pound, taking it down by a quarter against the dollar. Every country, led by the United States, has been issuing money, often in very large amounts, in order to bail out its banks. No one knows the total value of these national injections of cash into the banking systems. As the earlier injections have not restored stability to national economies, further injections inevitably will be made. All will be made in unconvertible currency, and over-issue will occur.

"Governments need to create a new world system, in which gold, as a stabiliser, should play its part. For individuals, gold remains the best insurance against future shocks and the best store of value."

Yesterday, the Dow fell another 297 points...as the market continued to react to Obama's $787 billion bailout. "Too little," say some. "Too late," say others.

But the worst may not be over for this market. Earnings are falling...for the very simple reason that people are spending less money. People spend less. Business makes less. Lower revenues; lower earnings. As we mentioned yesterday, for the first time in history, S&P stocks are losing money.

Savings rates are climbing in the United States. The trade deficit is falling. These are healthy trends for the long run. But they are hard to take in a depression.

Not only are earnings falling, P/Es are falling too. Stock prices are adjusting not only to the lower earnings, but to the new psychology of a depression era. There are times when people will pay $20 for one dollar's worth of earnings. Other times, they'll be reluctant to pay even $5. We've seen the $20 figure as recently as a couple years ago. Now, the trend is moving in the opposite direction. We're headed towards 5 bucks. That's what people will pay for $1 of earnings when this market finally reaches its bottom. Or thereabouts.

The combination of falling earnings and falling P/Es does to stock prices approximately what the Romans did to Carthage in the third Punic War. That's why we have our Crash Alert flag flying. Stock prices delenda est.

Typically, depressions come with bear markets. And bear markets come with bounces and rallies. We expected an O! Bama! bounce after the election. We got one...but much less than we expected. Stocks only rallied about 15%.

A stronger bounce will come, sooner or later. But we've put up our Crash Alert flag again - just in case. Stocks could go down another 30% - 50% first.

The news from the economy is not all bad. The shipping index has rallied - up 147% from its bottom. So, somebody must be moving something.

Beyond that, the headlines are grim. The automakers are headed down a dead end road, say the papers; they say they need $18.5 billion. Where are they going to get that kind of dough? The corporate bond market - to which corporate borrowers turn to raise money - is dead. When it comes to borrowing money, private borrowers just can't compete with the U.S. federal government. Even the states can't compete; they don't have printing presses either. California is facing a "lockdown" of public services, Bloomberg reports.

All over the world, the search for the bottom continues. Ireland seems to be edging towards default. And Japan is in a "dreadful state," says the Economist .

Things are so bad in Japan that the finance minister, Shoichi Nakagawa decided to drown his sorrows in drink. Alas, he chose the G7 meeting - at which he represented his country - to get drunk. Now, according to the New York Times , he is being forced to quit.

From what we can tell, Nakagawa is the only G7 finance minister who should stay on the job. The rest of them clearly don't know what's going on. Otherwise, they'd be drunk too.

*** Gold, as Lord Rees-Mogg notes, is the "best insurance against future shocks." A lot of people seem to think so. Gold rose $25 yesterday, to $967, and soon will be crowding $1,000 an ounce again.

Technical analysts are warning that gold is headed for a correction. "What should we do?" asks a colleague. "It looks like gold might go down in the near-term...but we don't want investors to sell out and risk being out of the market when the big move comes."

Unless you enjoy the thrills and spills of trading in and out, we don't recommend that you try to time the gold market. It's too treacherous. Yes, gold may go down in the next few months. But that has been true for the last 10 years - ever since we began recommending it. It goes up. Then, it corrects. And then, before you know it, it goes up again.

We don't think that pattern is going to change anytime soon. Gold is in a bull market that will only end when the final bubble pops - the bubble in paper money. How that will happen is anyone's guess. When it will happen is a matter of guesswork too. But the dollar delenda est too. In the meantime, we hold onto our gold and await developments.

And we suggest you do the same. Yes, the price has gone up in the past couple of days...but that doesn't mean you can't still get the yellow metal at a bargain. In fact, you can still buy an ounce of gold with the change you find under your couch cushions...no joke. Learn all about penny-per-ounce gold here .

*** Here's an interesting little item: "US Military Will Offer Path to Citizenship," says the New York Times . Why not? It worked for the Romans - for a while. Then, when the barbarians in the ranks became numerous and powerful, they took over.

Richard Florida, writing in The Atlantic :

"'One thing seems probable to me,' said Peer Steinbrück, the German finance minister, in September 2008. As a result of the crisis, 'the United States will lose its status as the superpower of the global financial system.' You don't have to strain too hard to see the financial crisis as the death knell for a debt-ridden, overconsuming, and underproducing American empire - the fall long prophesied by Paul Kennedy and others.

"Big international economic crises - the crash of 1873, the Great Depression - have a way of upending the geopolitical order, and hastening the fall of old powers and the rise of new ones. In The Post-American World (published some months before the Wall Street meltdown), Fareed Zakaria argued that modern history's third great power shift was already upon us - the rise of the West in the 15th century and the rise of America in the 19th century being the two previous sea changes.

"But Zakaria added that this transition is defined less by American decline than by 'the rise of the rest.' We're to look forward to a world economy, he wrote, 'defined and directed from many places and by many peoples.' That's surely true. Yet the course of events since Steinbrück's remarks should give pause to those who believe the mantle of global leadership will soon be passed. The crisis has exposed deep structural problems, not just in the U.S. but worldwide. Europe's model of banking has proved no more resilient than America's, and China has shown that it remains every bit the codependent partner of the United States. The Dow, down more than a third last year, was actually among the world's better-performing stock-market indices. Foreign capital has flooded into the U.S., which apparently remains a safe haven, at least for now, in uncertain times."

We remember our Five Big E's from a couple of years ago.

They were the underlying trends that we thought were unstoppable. Let's see...

1. Our Experimental money system - with faith-based paper dollars at the foundation - was doomed
2. The U.S. Empire was peaking out
3. Energy was becoming more expensive
4. Wealth and power were moving to the East.
5. And the Economy was headed for a crisis.

The only one of those that looks like a bad bet is number 3. Energy is a lot cheaper now that it was a year ago. But does that mean that the trend towards more expensive energy is over? Maybe...maybe not.

The price of crude oil dropped below $35 this week. Yesterday, it traded at about $37.
"I think we've seen the bottom," says colleague Simone Wapler.

Simone explains that many of the projects that were supposed to bring more oil on line have been abandoned. That will mean shorter supplies than forecast. Economic growth forecasts have been cut too...which will cut consumption. But inevitably, Asian economies will grow...and they will use more energy. There are 700 cars per 1,000 people in the US, she points out. In China, the figure is barely 20. One way or another, Asia is probably going to use more energy in the future...which is probably going to increase the price of oil.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

P.S. Colleague Byron King warns that although it's easy to be lulled into believing that low energy prices are here to stay, he wouldn't get too used to the idea. In fact, Byron thinks we are heading into what could easily be the most vicious and unpredictable financial cycle of the past 150 years. Learn how to prepare yourself (and even profit) from the 'forever oil crash' by clicking here .

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"The Treasury has proposed a $500,000 cap on executive compensation... Many of you have complained that you will lose your top talent. Are those the same people that helped lose your banks billions?"

Oh, you jokers at the NYT . Touché!

Yes, it's "open season" on bankers. And check the new dictionary. The word 'banker' has become synonymous with "reptile" or "scalawag." Drivers will soon be using it on the street. "F**** banker!" they will yell to the car that cuts them off. "Scumbag Millionaires," the Sun called them.

English bankers got slapped around on Monday. Then, on Wednesday, it was the Americans' turn. They were summoned to Washington by Congressman Barney Frank; be prepared for a "public flogging," the New York Times warned them.

In Paris, meanwhile, the bankers tried to stay ahead of the lynch mob by proposing to cut their own bonuses.

Everybody wants to kick the bankers when they are on the ground. Heck, we'd do it too...but the crowd around them is so thick; we can't get a boot in edgewise. Besides, there are bigger charlatans still standing. After all, bankers were just doing their jobs - separating fools from their money. What about those who were supposed to be protecting the fools?

But we are in a depression. And everyone has to play his part. The politicians feign moral outrage. The bankers feign contrition. The spectators feign to know what was going on and have a good time. It's a show with a subplot, we think. In the interest of seditious mischief, here we undertake to deconstruct it.

First we begin with a critic's remark: this is a well-rehearsed storyline. When the losers are unhorsed, they are almost always spat upon. Louis 16th's severed head was held up and subjected to "atrocious and indecent gestures"...Mussolini was hung on a lamp post. The bankers seem to be getting off easy.

Now, a comparison: the farce of '09 is nothing compared to the great show put on following the '29 crash. The weakness of the present spectacle is the cast. The chief American protagonist - Barney Frank - is no match for his role model, Ferdinand Pecora. Pecora was "the most brilliant lawyer of Italian extraction in the US," said the TIME magazine report of March 6, 1933. He "finished public schools at 12. At 18, after loping through his brother's law books, he was managing clerk of a law firm. Even on the most complex cases (which he, tireless, likes best) he never needs notes, never forgets a word of testimony once it is on the record... At 47, his black eyes flash, his black hair bristles."

But then, the victims are no match for Charles Edwin Mitchell either. "Billion Dollar Charlie" earned more than a million dollars in '29, when a million dollars was still real money. Senator Carter Glass said that he "more than 50 other men is responsible for this stock crash." But, as TIME reported, "neither the directors nor any other Manhattan banker knew anyone who, they believed, could do an equally good job of carrying the bank safely through storm and strife. That he has done the job, Ferdinand Pecora would be the last to deny. The statement of National City Bank [Mitchell's] was, on Dec. 31, 1932, the envy of nearly every bank in the US."

Still, the depression was on and Mitchell was damned for it. By 1933, he was out of a job. And now Jamie Dimon, Lord Stevenson, Andy Hornby, John Mack, Vikram Pandit, and Sir Fred Goodwin are in the dock.

'Yes, we have erred and strayed like lost sheep,' the bankers chant. "We are profoundly, and I think I would say unreservedly, sorry..." said Lord Stevenson, formerly of HBOS, on Tuesday. But "UK bankers find sorry is not enough," judged a headline on Wednesday morning. "I want groveling," wrote an opinionist to the LA Times . "I want show-trial sweating and stammering. I want their nine-figure bonus checks endorsed over to the rest of us...I want blood..."

Be careful not to over-act, is our advice. Viewers might catch on. In London, the Guardian announced its own 12 questions to put to the bankers, including "why should profits be private, but losses be socialized?" Uh...that is a good question, but it is put to the wrong person. Why the bankers would want to offload their mistakes is a question even a Guardian reader could answer. Why else would they humiliate themselves publicly? Why would not a one of them dare show any fight? The pols control the money now; the bankers know it.

The question is better put to the inquisitor than to his victim. Why would the government wish to take on the losses? There, the answer is fairly easy too - power. Besides, it's not their money; it belongs to the same mouth-breathing yahoos who are enjoying the show. In fact, we have other questions we'd like to put to Barney Frank, John McFall and the rest of these sanctimonious meddlers: How many of you jackasses went short the financial sector? And if you're so smart, why didn't you warn the public about the housing bubble and the toxic asset meltdown? If your committees...and your armies of regulators at the SEC, FHA, FDIC, FSA or other agencies...could do nothing to prevent the crisis, what good are they? And how cometh it to be that the biggest financial fraud of all time took place right under your own employees' noses?

So you see, dear reader, how deliciously the plot turns? In the bubble years, the bankers ripped off the public...pretending to make them rich, of course...while the regulators looked the other way. Now, the politicians create a distraction, pretending to punish the bankers, while together they pick the public's pocket for $3 or $4 trillion more. The bankers are judged guilty; but the audience hangs.

Enjoy your weekend,

Bill Bonner
for The Daily Reckoning Australia

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Yes, the Inauguration was historic in many ways. It was definitely a blend of many things. There was classic Americana, with the Stars and Stripes snapping in the stiff breezes. There was the Army's Old Guard unit marching to fife and drum, along with respectful references to George Washington and the Founding Fathers. Then there were elements of modern culture. We saw the now elderly veterans of the 1960s Civil Rights movement, as well as the more youthful proponents of hard environmentalism whose chief focus is climate change. There was even a "Green Inaugural Ball."

So we saw the old and the new. I think that's a key theme of this administration. How much of each? That's the big question. So stand by.

Meanwhile, what else can we discern about the incoming Obama administration? I had a long talk with an old friend who is a self-described "rabid Democrat." Let me rephrase that. He's a rabid Democrat in the way that Pittsburgh Steelers team owner Dan Rooney is a rabid football partisan. This friend of mine loves his Democratic Party. Just as Mr. Rooney wants his Steelers to win the Super Bowl, this guy's focus in life is for his political tribe to do what's right for the country. This friend of mine is also privy to the inner circles of Democratic politics. He's just plain plugged in. He's on a first-name basis with many on Team Obama.

So what's on Obama's plate? "Well, the first thing the new group has to do is stabilize the banking system," he told me. "Things are still precarious with the banks. Liabilities exceed assets by a large margin. We will probably see more bank failures - small and even some large banks. That would hurt worldwide investor confidence and lead the stock markets down. We could test the old lows of last fall."

This Democrat insider then got into other issues. "The housing crunch still has more rope to hang out, as well. A lot of the problem is isolated in a few states and regions of states - California, Arizona, southern Florida, the New York City metropolitan area, Massachusetts and a few other places. But it affects a lot of people. We're dealing with populous, overbuilt places. We are also on the cusp of a lot of failures of government entities, from localities and school districts to counties. We're going to have a lot of municipal bond defaults. We're going to see municipal bankruptcies. Some large states are insolvent. California can't meet payroll."

And there's more from this guy. "The next big wave will be that consumer spending dries up. This will lead to a failure of retail businesses all over the country. It's going to be a huge unwinding. We spent the past 25 years spending more than we could afford. Now we as a nation have to pay some big bills. It's time to save. It's a good thing, in the big scheme, for people to save. But it's going to put a lot of pain into the retail sector of the economy. We've overbuilt retail, and everything that goes with it. Too many stores. Too many buildings. Too much inventory. Too much shipping capacity. Too many containerships unloading too much stuff made in China and elsewhere. And a lot of people are going to lose jobs. I mean a lot of people. Everywhere."

Here's more from the Democrat insider. "The next two years are going to stink for the economy. Obama will face one financial crisis after another. He's going to hate Wall Street. He's going to hate bankers. Every time he turns around, the money people are going to be screwing him. He'll try to fix one problem, and five more problems will spring up like weeds. ('Only five?' I asked.)

"The coming financial issues will test the ability of the legislative branch to act with integrity in the face of a media-driven clamor. States will be lining up to borrow money from the feds just to pay unemployment compensation, let alone to fund Medicaid and road maintenance. It will test the legal system as well. Expect more petty crime and a lot more bankruptcy. But fewer people will get divorced. Who can afford that anymore?

"And think about the foreign policy issues that the financial crises will cause. Just think in terms that when U.S. prosperity declines, it takes the world down with it. The economic contraction is going to set some societies back by decades. Will people take that lying down? Or will they riot in the streets and burn down the capitol building? Expect a rash of failed states. We'll be surprised at some of the names that fall off the map. Wow, we might look back and wish for the days when the world hated us just because we invaded Iraq. Now they'll blame us for stealing their future.

"The Republicans will make political hay out of it. Unless they are totally incompetent, which you can't rule out. Democrats will probably lose seats in the House and Senate in the 2010 elections, as well as in state legislatures and governorships. But Obama will be working his own game of building consensus. He's from a new generation of politician. He's not nearly as in-your-face confrontational as the Democrats of the 1960s and 1970s era, the Kennedys and Waxmans and Barney Franks. Obama will build coalitions out of whomever he can get on board. You might not like him on issues like gun control or abortion, but you'll deal with him on tax cuts and energy investment."

So where do we go from here? Well, here's my post-Inaugural advice. Build up some cash reserves. Got that? Hold Cash! Cash in the mattress. Cash in the bank. Certificates of deposit. Don't try to get too fancy. Just save some cash where you can get hold of it in case you need it pronto.

Next, buy precious metals like gold and silver. Bullion coins or bars are my favorites. But it never hurts to buy a few quality numismatic coins as well. Don't get spooked out of precious metals if we see a price dip in the near to medium term. The dollar is in serious trouble, and eventually the precious metals will come back. Precious metals are a way of preserving your purchasing power over the long term.

As for stocks, in the near future, we could see some severe market declines. Initially, this might look like large trading spikes up and down. Unless you are a serious trader, be careful about trying to "play" the swings. Don't be afraid to sell any stock that makes you nervous. You have to be able to sleep at night.

Until next we meet,

Byron W. King
for The Daily Reckoning Australia

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