Monday began with jitters over the market's reaction to a raise in the U.S. discount rate. In other words, the Federal Reserve increased the rate at which select banks can borrow from it.

The so called 'discount window', was intended to be an emergency lending facility. The lender of last resort. Instead, it's become the lender of any resort. The increase in the discount rate means it won't be as cheap to borrow money from the Fed.

The relevance to you shouldn't be underestimated. Aussie banks get much of their funding from overseas, so they are affected by what happens in the global interbank market. If the increase in the discount rate is a signal that the broader interest rate is going to be raised as well, then this would affect the availability of funds and their cost.

In a debt drugged, liquidity obsessed world, a change in interest rates can go from affecting profitability to affecting solvency very quickly. And it's not just the banks that are high on cheap credit. Take a look at a listed company's balance sheet. Most of them use leverage to boost their returns.

Low interest rates encourage this.

The reason the western world economy has become particularly interest rate sensitive is because of the way it uses debt. Instead of funding an asset with debt and then paying it off with the increased revenue, more debt is used to pay off the previous borrowings as they come due. This is referred to as rolling over debt.

By doing this, a company (or government) is able to sustain a high level of leverage over time. The debt is never truly repaid.

But, if interest rates rise, then the cost of borrowing goes up. Traditionally, this would have decreased the amount of borrowing. In our modern economy more must be borrowed in order to pay off the old debt. That means companies have no choice but to accept a change in rates.

The financial market reaction to a potential increase in the more important Fed Funds Rate would not have been pleasant. However, this unpleasantness didn't eventuate, indicating that financial markets expect rates to sit tight for some time to come. Based on this, Dan Denning is a step closer to declaring victory over our Money Morning editor Kris Sayce, with several beers at stake.

Neither editor is being suspicious enough in their analysis. Let's take a trip down memory lane with a former Federal Reserve economist, Michael Belongia. What happened in the past when the discount rate was changed?

In this podcast, Mr Belongia talks about how a change in the discount rate can lead to a change in the actual interest rate without FOMC approval, or much media attention. Going behind the back of the FOMC, which is supposed to set the interest rate, is scandalous. That didn't stop it from happening regularly, according the Belongia.

He explains that the spread between the discount rate and fed funds rate should be kept constant according to Fed policy. So, if the Fed's Board changes the discount rate, then the Fed Chairman can march down to the Fed's trading desk and instruct the traders to change the Fed Funds rate to maintain the spread. This conveniently avoids the often less complicit FOMC.

Belongia's accounts are shocking to anyone who believes in the integrity of that particular institution and sickening to the sensible people who don't.

As mentioned, governments around the world are also exposed to the problem of having to roll over debt. To Senator Joyce's delight, the lucky country is no exception. Dan Denning points out that "... according to 2008 data, over $400.1 billion dollars of Aussie foreign debt - or 35.4% of the total - matures in 90-days or less. Nearly half the debt total - $514 billion - matures in one year or less."

That's a lot of debt to refinance on such a regular basis, so any change in interest rates will be felt quickly.

The press often refers to the shortening maturity of government debts. This implies governments will have to roll over debt more often. Such shortening has occurred in the U.S. and is now a major concern. Former Federal Reserve Chairman Alan Greenspan has referred to it as the "critical Achilles heel".

The "greatest financial crisis globally ever"

On Tuesday, Bloomberg reported the confession of Kingpin Alan Greenspan. At least, we consider it a confession. Low interest rates have largely been blamed for the financial crisis by those who warned of its imminence. Greenspan set those rates artificially low. Often in a cunningly deceptive way, according to Mr Belongia. Anyway, here is how Greenspan's conscience was finally cleared on Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said the financial crisis was "by far" the worst in history and called the recovery from the global recession "extremely unbalanced."

The world economy has undergone "by far the greatest financial crisis globally ever."

Greenspan said that while the economy was in worse shape in the Great Depression, the recent financial crisis was potentially more harmful than that in the 1930s because "never had short-term credit literally withdrawn."

Greenspan also said "fiscal affairs are threatening this outlook" for recovery, as Congress and the White House face difficulty raising taxes or cutting spending."

So, not only is his reconciliation late, but his diagnosis is too.

Speaking of confessions, our other 'favourite' economist, former Enron adviser and Nobel Laureate Paul Krugman, has declared his ignorance publicly:

"I'm craving the chance to do some deep thinking, and I haven't been doing a lot of that."

While this fact is familiar to most, it does not excuse Krugman's behaviour. Having consistently advocated the inflation of economic bubbles, to the devastation of homeowners, employees and shareholders around the world, he now advocates a level of government debt that would make Senator Joyce faint, or pop, whichever comes first.

But best of all is this part of Krugman's article:

"I guess doing the really creative academic work does require a state of mind that's hard to maintain throughout your whole life."

Creativity! Economics and creativity? Economics is about understanding timeless principles. Perhaps this is where he went wrong - too much creativity. We have seen the results of Krugman's creative solutions, indicating he doesn't understand the economy, or wishes to indebt future generations beyond help.

Resources Comeback

RBA governor Rick Battelino explained that the resources boom has overcome an interruption known as the GFC:

... now that has passed, the underlying dynamics of the resource boom are starting to reappear...

It's hard to put a finger on exactly how much investment is going to take place, but I don't think it's unreasonable to expect mining investments to rise to 6 per cent of GDP over the next few years. That would be about twice as high as it got to in the previous boom. It's a very big boom.

It certainly is big. But so are China's resource reserves.

In an article on oilprice.com, Dave Forest of the e-letter Pierce Points, warns of the potential price reaction should China decide to begin using those reserves, or even selling them. In fact, they may have already started, with vast steel exports going to Europe.

The effect a short term fall in commodity prices could have on Aussie resource investment and development could be pivotal to the future of the Australian economy.

China itself is of course an economic basket case, as cleverly shown in this business spectator slideshow.

Nevertheless, it seems a BRIC barbeque is roasting the PIIGS and may provide demand for resources to fuel their fire. (Thanks to Daily Reckoning reader Wayne for the inspiration on that one!)

Confidence

Confidence indicators took a hit in the U.S. and Germany, while U.S. new home sales dropped to a record low. This is particularly striking, as central banks often tout these two factors as their primary focus. "Restoring confidence in the market" and "supporting house prices" are phrases that echo through the halls of the central banks on a continuous basis.

Meanwhile, the US unemployment figures are proving disastrous, let alone the unemployment itself. The American Bureau of Labour Statistics has its own numbers in such a mess that the pollster Gallup has decided to help out.

The Poll informed the BLS that "nearly 20 percent [of the 20,000 adults in the work force polled] were working part time in January because they couldn't find a full-time job or had no work at all, and that they are having trouble affording basic necessities like food, shelter and health care."

This tells a different story from the BLS estimates of below 10% unemployment.

U.S. banks continue their slide into oblivion, with 4 of the 161 bank failures since 2009 recorded last week. The outlook isn't much better. Bloomberg reports that "hundreds of banks may face insolvency as losses mount on commercial real-estate loans, according to a Feb. 10 report by the panel appointed by Congress to oversee the U.S. bailout program."

Meanwhile The Telegraph uses some spectacular phrases in an article titled "Failure to save East Europe will lead to worldwide meltdown". It even breaks the language barrier with the following: "...set off round two of our financial Götterdämmerung." Götterdämmerung roughly translates to Godly twilight, implying an age of saviourless darkness.

Next up it suggests a "Monetary Stalingrad" and Eastern Europe "blowing up right now." A more surgical approach was taken by Latvia's central bank governor, who declared the Latvian economy "clinically dead", while protesters "trashed the treasury and stormed parliament."

Needless to say, an excellent article.

Strangely enough, stock markets remain comparatively buoyant and Australia seems to be trundling along happily. Whether Mr Market has sucked in enough suckers before another crash is unclear. Daily Reckoning editors would probably be more concerned if the media was more optimistic, as this indicates complacency.

The Economic Climate

Former IMF economist Jeffrey Sachs provided some creativity of his own in a recent article:

Climate change science is a wondrous intellectual activity. Great scientific minds have learned over the course of many decades to "read" the Earth's history, in order to understand how the climate system works. They have deployed brilliant physics, biology, and instrumentation (such as satellites reading detailed features of the Earth's systems) in order to advance our understanding.

The Guardian, points out otherwise:

Scientists have been forced to withdraw a study on projected sea level rise due to global warming after finding mistakes that undermined the findings.

This article was previously put forward as proof of claims made in the infamous IPCC report. The official withdrawal included the statement that "... it's one of those things that happens. People make mistakes and mistakes happen in science."

While we are in agreement that mistakes happen, we do not agree that government policy should be based on anything quite so mistaken. This is especially so, as government policy is more often than not an inherent mistake as well.

In keeping with brilliantly balanced and fair journalism, the Guardian published the article of Jeffrey Sachs two days before the article about the withdrawal of the study. I wonder what readers think of that.

In the name of financial stability!

Dan Denning also reported on the latest government scheme to support its funding aspirations:

Yesterday's Financial Review even mentioned the possibility that a shrinking government bond market would be a problem for Australian banks. That's because a new regulation proposed by the Australian Prudential Regulatory Authority (APRA) would require a certain percentage of bank assets to be made up of high credit quality bonds. And MBS.

MBSs are Mortgage Backed Securities, those things that have a habit of blowing up when house prices fall.

Acropolis Now

According to Porter Stansberry, the publisher of Stansberry and Associates Investment Research, the Greeks have pulled off a feat that would make Sun Tzu jealous. Greek military spending has been excluded from the annual budget, because it is a "state secret". So, according to Stansberry, about 30% of the Greek governments' spending isn't even declared.

Nickolai Hubble
The Daily Reckoning Week in Review

• Hike in Fed Funds Rate Would Cause Damage to Collateral on Books of America’s Banks
• Gold Standard Doubles as the Greenspan Fed Makes Real Interest Rates Negative
• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• Alan Greenspan’s “Smallish” Injections
• Federal Reserve to Withdraw its Support of U.S. Mortgage Market?

Not that we are going to defend the investment banks. But Washington should make up its mind. The Rubin Treasury had a clear economic philosophy. It thought up the academic jargon of the day, it "privileged" Wall Street over Main Street and Detroit (manufacturing).

The U.S. ran a capital account surplus and a massive current account deficit. Wall Street thrived and booked record profits (as a percentage of S&P 500 earnings) and stocks soared. The wealth effect even trickled down into 401(k)s during the dot com boom. And it was all good.

But now, it's not all good. Banks are bad. And fresh from a third-straight trip to the electoral woodshed, the American president is prepared to go populist. We don't know if the President's proposals will pass, or if they will fix a banking sector that's still saddled with debt. But we doubt it.

Regulatory reforms deal with the future. In the "now", banks still have massive exposure to falls in residential and commercial real estate. Accounting tricks have forestalled the realization of losses. But not even Moses could hold back the tide forever, we reckon.

Speaking of rising tides...another 482,000 Americans filed for unemployment benefits for the first time. That was a 36,000 increase over the previous month. Economists expected a decline.

Stock prices, under siege as Washington attacks the only profit engine in America's economy still firing away, were also hammered by growing concern over tighter Chinese bank lending. That concern, ironically, was even stronger when China reported that fourth quarter GDP came in above expected at 10.7%. If inflation gets loose in China, the central bank will have to be even tighter.

Thus gold's fall and the zombie-like rally of the U.S. dollar. We've seen this before in the last two years. When bad news gains momentum in the investment press, the dollar rallies and gold and stocks fall. The dollar gets a strange "flight to familiarity" bid. What does this say about gold?

It says that dollar rallies are great chances to enter or add to your positions in precious metals or precious metals stocks. Even base metals like copper might be worth a look on the dips, says Diggers and Drillers editor Alex Cowie. Alex sent us the first draft of his January letter late last night.

Commodities will retrench on dollar strength but these dollar rallies on uncertainty and gloom shouldn't be confused with any kind of real dollar strength. On an interest rate basis, the dollar is still getting clobbered by the Aussie and other commodity currencies.

Or, if you prefer to view your currencies as proxies for an entire economy and its growth prospects, you could do worse than look at Brazil. Granted, there aren't a lot of highly liquid options to the USD that don't also suck (the yen, the Euro). But we read in the wee hours of the morning that the Russians are loading up on some of Canada's money and lightening their load of USD.

The main point? The United States is a worsening fiscal trap. Washington confusing the markets about policy and being alternatively negligent and belligerent won't help anything. But then, this is government we're talking about.

Nope...we have not forgotten our promise to investigate the structure of the Financial Claims Scheme that's been proposed by APRA. It's a subject we've been circling around for a few months...trying to figure out if it really does transfer responsibility for guaranteeing the banks to the public balance sheet. But it's a big subject. So be patient, we'll get back to it. Until then...

Dan Denning
for The Daily Reckoning Australia

• 4 Ways to Protect Against a Falling Dollar
• Transfer of Wealth
• Trickle of Chinese Money into Australian Housing and Equities Small Compared to Growth in Bank Lending
• Banks Could Face Serious Trouble from Losses on Residential and Commercial Real Estate
• DMCC and their Precious Metals Vault

But even the quality view has not improved our chances of getting to the bottom of plunging U.S. bond yields. Is it the carry trade? Are traders selling emerging market stocks and high-yield currencies and parking the profits in short-term U.S. notes? There are no corresponding down moves in other asset classes that we can detect. It remains a riddle.

In the meantime, the capital crisis in banks we wrote about yesterday has moved from the West to the East. The Financial Times reported overnight that the surge in Chinese bank lending in 2009 led to a fall in core bank capital. Now the banks need to buffer up. That sounds familiar.

And while we're on the subject of China we should relay that Citic Pacific Ltd, which is an arm of China's largest state-owned company, is set to spend more on magnetite iron ore projects in Australia. Magnetite is a lower grade ore than the hematite ores that BHP and Rio have all but locked up in the Pilbara.

Citic is seeking to guarantee supply and diversify its suppliers. It's not alone in chasing the lower-grade magnetite projects either. ABARE says up to $18 billion will be spent on magnetite projects, a 36% increase over last year. So why the rush to dominate the lower-grade ore market?

"Hematite is first choice, but the Chinese objective is probably a little different," Sydney analyst Grant Craighead tells Bloomberg. "They've got more the 100-year view that 'we need to be putting our foot down on resources." It could also be the case that China's trying to build an iron ore supply network that doesn't rely so much on BHP or Rio Tinto.

Hmm. 100-year view? It could be. But the ten-year view could be that China has way too much steel-making capacity already and that securing more ore now for an industry that's already oversupplied doesn't show much foresight. But hey...when you have two trillion in U.S. dollar currency reserves...you have to do something with them. Digging a hole in the ground to find iron ore will do.

And speaking of digging holes in the ground, gold miners say gold production will fall in the coming years, despite a rebound in 2009. The miners are singing the same tune: existing deposits are played out and we aren't finding any new big ones.

"2009 is the outlier as far as the trend,"Omar Jabara, spokesman for US-based Newmont Mining, tells the AFP. "It's a fact that gold production from mines has been in decline since 2001 and has gone roughly from 85 million ounces to about 75 million ounces a year," says Vincent Borg, a spokesman for Barrick Gold.

Everyone talks his own book. And with gold futures up $23 in the futures market, the gold price is hovering just below US$1,200. You'd expect the gold producers to be beating their chests and pounding the table right about now.

Whatever is going on, gold seems to be giving some comfort to investors who are having a hard time figuring out what to expect from financial markets. This fits David Einhorn's theory that gold does well when monetary policy is poor and poor when monetary policy is good. Monetary policy is not so good now.

Finally, our host here in New Zealand thinks he knows what might be behind the low short-term U.S. yields: an accounting change. On January 1st, 2010, Federal Accounting Standards revision 167 comes into effect. It requires banks to bring off-balance sheet assets back on to books.

If the assets were bad, or even if they were just large, the banks would have to set aside more capital to satisfy capital adequacy ratios. One way of doing that in advance, we speculated yesterday, is loading up on short-term U.S. debt. It would bolster the asset side of the balance sheet.

It's not so clear that loading up on short-term U.S. debt actually improves a bank's capital position, though. At least it's not clear to us. So we'll investigate it and get back to you. Until then, a happy Thanksgiving to all you U.S. citizens celebrating abroad today. Just remember, wherever you are, the idea of America is too.

Dan Denning
for The Daily Reckoning Australia

• Trickle of Chinese Money into Australian Housing and Equities Small Compared to Growth in Bank Lending
• China Has Stopped Stockpiling Metals
• Chinese Surge in Construction Explains Pickup in Base Metals Stocks
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Oil Prices Under $70

But a warning about what? Sure, stocks, oil, and gold were all down yesterday and the U.S. dollar was up. But is it really the end of the dollar carry trade? And if it is, what happens next?

More cow bell!

We should back up a second. What is the dollar carry trade? It's the engine of bank profit growth this year. It's what's given the illusion that the financial system has recovered from its brush with death last year.

But as you'll learn today, the bankers, the Fed, the media...the whole lot of them...have learned nothing from last year. The hangover was just beginning to set in, so everyone began drinking again heavily. And now the party is wild and out of control. Even the cops are drunk.

Incidentally, this complete abandonment of monetary sobriety and fiscal prudence shows up every day in real life, where the declining value of money is paralleled by a general decline in public behaviour. For example, on Sunday morning we were tucking into a breakfast of banana caramel pancakes (with a scoop of vanilla ice cream on the top) when three incredibly drunk but fairly well dressed middle aged men had a seat next to us at the cafe.

They wanted to chat about the John Birmingham book on the table. They wanted to smoke. They wanted to laugh, and did so loudly to the point where they began upsetting the various dogs assembled in the sun. They ordered a pitcher of beer. They were served. It was 9am and they hadn't been to sleep.

Our cow bell tells us that the financial party thrown by Ben Bernanke may soon be ending. The dollar carry trade, by the way, is where financial firms and speculators borrow cheap money in the U.S. and use it to buy higher yielding assets elsewhere (like the Aussie dollar).

The carry trade is a bubble enabler and balance sheet stabiliser in the short-term. The Fed keeps rates low, the banks borrow and then buy U.S. bonds (which helps the U.S. fund its deficit), buy stocks, and buy commodities. The dollar carry has fuelled the world-wide rally more so than any phantom recovery in the real economy, where employment hasn't recovered and wage growth is hard to find.

What the carry trade has not done is fundamentally improved the balance sheets of the very financial firms that were at risk of insolvency last year. Why not? First, the earnings rebound in the first three months of the year was not driven by better business conditions. Speaking to the Financial Times earlier this week, George Soros said, "Those earnings are not the achievement of risk-takers...These are gifts, hidden gifts, from the government."

The banks booked profits from trading stocks and bonds. And because the Fed, through quantitative easing, was supporting bond prices directly, it was as close to free money/a rigged market as you can get. With enough leverage, even small gains in bond prices were bankable.

But now there is an enormous, gut busting irony to the position the banks find themselves in. Remember that the original idea to repair bank balance sheets and restore their capital positions to healthier levels was to replace toxic mortgage-backed debt with safe, sound, and liquid U.S. Treasuries. Snort. Guffaw.

The irony is that those same Treasuries could be the next big blow up, wiping out the banks thin equity capital sliver all over again, and plunging the financial sector into a second wracking round of forced deleveraging and asset sales. Round two of the recession, morphing into a Depression as the public sector ramps up deficit spending to make up for the collapse in household and business spending.

We all know how much serious the cycle of deleveraging and asset sales was last time around, so it's not a claim we'd make lightly, or without some evidence. So let's get to the evidence. First is an article from Gillian Tett, also in yesterday's FT, titled "Rally fuelled by cheap money brings a sense of foreboding."

"Earlier this month," she begins, "I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets - and was feeling deeply shocked."

" 'Forget about the events of the past 12 months ... the punters are back punting as aggressively as ever,' he wrote. 'Highly leveraged short-term trades are back in vogue as players ... jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.'"

" 'Oh, I am sure the banks' public relations people will talk about the subdued atmosphere in banking, but don't you believe it,' he continued bitterly, noting that when money is virtually free - or, at least, at 0.5 per cent - traders feel stupid if they don't leverage up.

" 'Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,' he added. He finished with a despairing question: 'Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?'"

This 'latest bubble' is in evidence across all asset markets-bonds, stocks, commodities, property, and cash. Free money does not discriminate on the basis of asset class. But nowhere has the bubble been more generous than in the U.S. Treasury bond market. Short-term U.S. bond yields are vanishingly low. The Fed just purchased $14 billion more in mortgage-backed securities last week and now holds $776 billion in MBS and $773 billion in Treasuries. All up, the Fed's balance sheet is at $2.1 trillion.

But here is the thing: the Fed says it's ready to end its program of buying Treasuries and MBS. It realises it will have its hands full funding big U.S. deficits. But if the Fed withdraws its support for bond prices...you can expect bond prices to fall and yields to rise. This may happen even if the Fed keeps buying bonds...but creditors like the Chinese and Japanese stop (as they have done with agency securities.)

All sorts of interesting things begin to happen now, if by interesting you mean terrible but fascinating. Falling bond prices and rising yields would make perfect sense in a U.S. dollar rally. And a U.S. dollar rally makes perfect sense if the carry trade ends and the dollar shorts cover. Speculators take profits in oil, gold, stocks and jump back into cash and the greenback. This is roughly what happened last time the wheel's came off the financial system.

Where does that leave banks and their massive new hoards of U.S. Treasury bonds? An article called "Bank Insolvency Is Not A Dead Issue" by Daniel Aaronson and Lee Markowitz shows that banks have dramatically increased their holdings of U.S. Treasury securities. When you add their existing exposure to U.S. real estate (facing an Option-ARM crisis over the next twelve months) you have a huge swathe of bank collateral that could face another massive write down.

What do you think that might do the global economy? Aside from putting a few more banks out of business, it would again cut off the flow of credit to small businesses and the rest of the economy. It might again cut off the flow of bank credit from international lenders to the Big Four here in Australia. And this time, what kind of aid can the Feds really offer when their last attempt at help (exchanging Treasuries for RMBS) set the banks up for precisely the implosion they were trying to avoid?

As you can see from the chart above, banks have grown assets again with the Fed's borrowed money. You know have a freshly steaming pile of recovering asset prices supported by a thin wafer of equity capital. It's a fraud with a cherry on top. As the charts below, U.S. banks own nearly $1.5 trillion in government securities. And they are gobbling them up like there is no tomorrow.

There is always a tomorrow. But corporations and institutions live and die just like species. Only the earth abideth forever.

We reckon that the entire financial industry is still dangerously close to a species-destroying event. It's leveraged model of asset growth and debt accumulation imploded last year. But the Fed has brought it back, and like a Zombie/Frankenstein mash-up, it's here to torment us all again.

Soros told the FT this sequence of events is causing a lack of confidence in governments. "There is a general lack of confidence in currencies and a move away from currencies into real assets," he told the FT. "There is a push in gold, there's strength in oil and that is a flight from currencies."

So in the short-term, don't be surprised to see a stronger rally in the USD, which would take some of the starch out of oil and gold prices. As the dollar carry trade unwinds a bit, stock markets will fall and so will other asset classes that have zoomed up on the speculation.

But the bigger story playing out is this: the entire method by which the fiscal welfare state funds itself is blowing up. More on how this will happen and what it means tomorrow. Until then, we hope you heard the cow bell.

Dan Denning
for The Daily Reckoning Australia

• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• Greek Banks Playing the Carry Trade and Investing in Government Bonds
• Fed Announced it Would Buy up to $300 Billion in Treasury Bonds
• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy
• The US Dollar Showing Signs of Life

- Edward Gibbon

Warren Buffett famously says that people do not make money by betting against the US economy. But two years ago we decided to take a chance.

"We are short the United States of America," we announced from the comfort and safety of our headquarters in London. "Sell its stocks. Sell its bonds. Sell its money. Sell its real estate. Sell the equity. Sell the debt. Sell everything."

What we saw was an over-stretched empire getting ready to snap. But we were also allowing ourselves to be lazy. Rather than deconstruct the capital structure of the world's largest economy, we decided to sell the whole damned thing.

All Hell broke loose in September 2008. Since then, US stocks have gone down about a third. Real estate too. Unemployment has doubled. Consumer prices are going down at the fastest rate since the '50s. And the economy is in the worse recession since WWII.

Meanwhile, Americans' per capita wealth has fallen from $172,000 in September from $212,000 two years earlier. And the UN reports that the quality of life in America has gone down too...from #5 on its list in 2000, it fell to #13 in 2007. No doubt it is below #20 now.

Buffett has lost billions betting on the US economy while our gold positions are handily up; gold was the most profitable major asset over the last ten years.

So you see, we were right; America was a sell two years ago.

And now it is the dollar that is falling. It's gone down 12% in the last six months - a huge move for a major currency.

"Asia tries to slow dollar fall," is the lead story in today's Financial Times.

Today, a buck and forty-seven cents will buy you only 1 euro. Ten years ago, you could have gotten a euro for less than a single dollar. A falling dollar makes imports more expensive, say analysts...raising the cost of living in the homeland. But you wouldn't know it from walking around on the streets of Miami or Las Vegas. You can get a house at 50% off its price three years ago. As for the breakfast special - for less than 3 euros you can get enough food to kill a Pakistani.

By European standards, America is cheap.

"Europeans again interested in Florida houses," says a headline in The New York Times.

House prices are down 30% to 50%. The dollar is down about a third too. That makes the United States a bargain.

But is the United States of America about to become even cheaper?

One thing we were wrong about when we issued our 'sell America' call two years ago was US debt. Treasury bonds have resisted the general downward trend of things with the stars and stripes on them. Bonds have not gone down; they've gone up.

Private households are buying them for their retirements. Banks are buying them for risk-free profits. Speculators are buying them in anticipation of deflation.

David Rosenberg:

"The big story yesterday was the further massive $12 billion decline in outstanding consumer debt in August - the consensus was looking for an $8 billion contraction. This was the seventh month of debt retrenchment in a row. In other words, the tidal wave of the credit collapse continues unabated, and this is the primary reason why bond yields are still in a fundamental downtrend.

"Over the past year, consumers have run down their debt by a record $113 billion (and this does not include mortgages). This is an absolutely epic shift in household attitudes towards credit and discretionary spending."

Americans are saving. And they're buying US Treasury bonds. (More below...) But how safe is their money? Is it a good idea to buy US debt now?

On Wednesday, Latvia tried to raise a trivial amount of money. It offered $17 million worth of 6-month bonds. How likely is it that Latvia will default before Easter? We don't know, but investors judged it not worth the risk. Not only did the bond auction failed, it failed with no bids.

That's what happens when lenders lose faith in a government. They refuse to lend it money - except at high rates of interest. But the high rates of interest work like a noose on the neck of a cattle rustler. They block the vital flow of oxygen - not to mention breaking his neck.

Note that the US federal government is still functioning like an empire at the peak of its power. The Pentagon is still rustling up trouble all over the world - at a cost of trillions. US government employees are growing more numerous and richer - with twice the annual incomes of the private sector. And the Obama Administration - apparently unaware that the total unfunded debts and obligations of the federal government have soared to nearly $120 trillion - is considering new ways to get rid of cash.

Remarkably, investors still lend the US government money - asking only 4% annual yield on a 30-year loan. As for 91-day money, they practically give that to the feds for free; it sports only a yield of 0.066%.

This will surely be a point of puzzlement for the financial historian of the next century. It is certainly a point of puzzlement for us.

Yesterday, gold hit a new record at $1057. Doesn't gold go up when inflation rates rise? And don't bonds go down when inflation goes up?

So why are people buying bonds with such puny yields?

There is a lot of whispering in this market. Gold is trying to tell us something. Bonds are trying to tell us something. The dollar seems to have something on its mind too. Stocks are just babbling.

If gold is trying to signal that inflation is coming, the bond market is not paying attention. Bonds seem to be saying that it is deflation we should be worried about; but the stock market doesn't seem to hear.

And there's the dollar. The greenback is in the same choir with stocks and gold, as near as we can tell. They all seem to be chanting about inflation coming back.

But what if they're all wrong?

Just look at what is going on in Washington, if you can bear it.

The feds have a budget that anticipates inflation and growth. Spending is supposed to remain flat until 2013. Tax receipts, which are no higher today than they were 10 years ago, are supposed to rise, gradually filling in the Grand Canyon of deficits. The number crunchers think we're headed back to the Reagan years - when the tough-love policies of the Volcker Fed squeezed out inflation and created a real boom. Then, tax revenues rose 9% per year between 1984 and 1989.

How likely is that today? Not very. Instead, what is likely to unfold is a deflation story. Instead of staying flat, federal expenses are likely to rise as one failed stimulus gives way to another failed stimulus. Then, instead of going up, tax revenues will go down...digging an even grander canyon between out-go and income.

Then, or long before, there will be a panic out of bonds, the dollar, stocks - practically everything. Everything goes down!

At this point, the US will be in about the same situation as the Roman Empire as it approached retirement. Expenses kept rising. Rome had to pay the Blackwater-type military contractors of the era...in addition to keeping Roman mobs supplied with food stamps and unemployment benefits...while its tax base fell. Gradually, the empire lost the ability to defend itself.

When Edward Gibbon began his history of Rome's decline and fall, Roman real estate had probably been in a bear market for at least 1300 years. Rome's population fell from over a million to under 20,000. Politically, Italy had broken apart more than 1,000 years before Gibbon was born, and it wouldn't be put back together again until nearly 100 years after he was dead.

It's far too early to write the story of America's decline and fall. That job will fall to some future historian, perhaps seated on the ruins of the Lincoln Memorial, wondering how people made such a mess of things.

Our guess is that he will come to the same conclusion we have: Stocks? Bonds? The dollar? Investors should have sold them all!

Bill Bonner
for The Daily Reckoning Australia

• America’s Decline as a Great Empire
• Deleveraging Will Give Us a Bout of ’30s-Style Deflation
• Warren Buffett Says American Economy is a Shambles
• Mistakes Made By America Are the Same Mistakes That Empires Make
• The Major Difference Between Rome and the U.S. – Electronic Transfers

"What?" we replied to one of our analysts this morning.

"He's the only Storm Trooper named in the Star Wars movie. I bought a card board cut out of him pointing his laser rifle at you. It was on sale the Science Works exhibit. I've put him behind your desk to remind you that you're under the gun."

True enough. It's not just your editor under the gun, though. What's at stake this week is whether attempts by governments and central banks to prevent more credit writedowns have succeeded. If they have, it could prevent the further transmission of the credit crisis from the financial sector to the real economy. And for investors, it could kick off a Great Releveraging.

Are we changing our tune, then, about what to expect from markets? Not one bit. But the question now is timing. The collapse of 2008 was so severe because of the sudden reduction in leverage in the financial sector. As assets fell in value, the most highly leveraged firms (or lenders who raised money by selling debt) went out of business.

This kicked off a chain reaction in which other market players were forced to sell assets and preserve capital. Banks preserve capital by not lending. This is how the credit crisis "jumped" from the financial sector the medium and small businesses (those not big enough or politically connected enough to qualify for government bailouts). And from businesses the deleveraging crisis went straight to households, who began saving more and cutting back spending.

And now it comes full circle. When households cut back, it eats into corporate profits and bank profits. Households with members who've been fired get behind on bills. Securitised credit card receivables, car loans, and mortgages - a large chunk of bank assets - start to go pear shaped. And banks face more credit writedowns, accelerating the cycle.

This is the cycle the Feds and global monetary authorities set out to short circuit this time last year. Their main objective: increase asset prices to stabilise bank balance sheets and prevent the spread of the credit crisis. How did they do it? TALF, TARP, CAP, the suspension of mark-to-market accounting rules, and the maintenance of low interest rates (in the States especially).

All these clearly did support asset prices, and especially allowed banks to post a quarter two of quarter over quarter earnings growth. This has created the appearance of stability. But what has not improved one bit is the quality of those bank assets purchased with borrowed money. There will be more writedowns to come. But when?

We should entertain the possibility that the Feds can support asset prices for some time. Take Australian housing for example. This week the Federal government announced that it would chuck another $8 billion in taxpayer money to purchase residential mortgage-backed securities (RMBS). Treasurer Wayne Swan says he's doing it to support "the home lending market."

We'd say he's doing it to keep money flowing into the housing sector so builders stay busy, banks stay profitable, and house prices stay high. Remember, this subsidy to non-bank lenders in the RMBS market is there because other investors won't fund these lenders. And why would they when the government is happy to put your money on the line.

The government says the securities are collateralised by high-quality residential real estate. But that's what pretty much anyone who was hawking this kind of debt said in the U.S. for the three years of peak mortgage issuance. This is how real estate - traditionally a local industry where prices vary from place to place - becomes a national market - through the nationalisation of the mortgage bubble. A national mortgage bubble can inflate house prices across the board-making the entire country vulnerable to higher interest rates and/or a credit crisis.

Here you see the public sector adding debt while the private sector scales back. Also, in Australia, there is still widespread public belief that house prices only ever go up. That means the government can support lending because borrowers are still borrowing. This just makes the inevitable house price correction much more devastating. The borrowers with the smallest margin for error are going to be hurt the most.

Here's something else to think about: what happens when the stimulus spending dries up? Treasury Secretary Ken Henry says that the economy could lose another 100,000 jobs and that the withdrawal of stimulus spending will shave 1.5% off Australian GDP in 2010. This is another way of saying the peak effect of the stimulus (in terms of supporting both consumer demand and employment) was in middle two quarters of the year.

So how will Aussie consumers and businesses behave when the stimulus is withdrawn? Did the Rudd government give the economy just enough free money smack to keep its credit high going? Or will the comedown be just around the corner around Christmas? If they're cautious, Australians will put away their wallets and cut up the credit cards and reduce spending growth to match income growth. The retail sector and retail stocks will be hit hard.

There's one other big question for investors heading into the end of the year. We know the government can support some sectors more effectively than others. Big ticket items like housing and cars can be subsidised with tax rebates or, in the case of housing, with a fresh injection of credit to support politically connected non-bank lenders in the RMBS market.

But you have to reckon the economy boosting effects of supporting the housing market are limited. The main beneficiaries are the banks and the builders. Granted, if you're a politician, those are two important constituencies to keep happy. But what about the rest of the economy?

The basic question is how much of it will stand on its own two feet once you remove the stimulus. The stimulus, the FHOG, the government backing of the RMBS market...these are all attempts to revive an economic growth model that's dependent on asset inflation and credit bubbles. That's the model that led to the bubble that led to the bust.

Papering offer the holes blasted in bank balance sheets by the credit crisis seems to have worked in terms of restoring confidence. Call it a successful psychological operation by the government spin doctors and their buddies in the media and banking. The whole purpose of the operation was to appear to recapitalise banks to healthy levels. But really it was to prevent the banks from having to take further credit writedowns, which itself feeds the process of forced asset sales, declining asset prices, and more household deleveraging.

One immediate risk to watch for is Australia's resource export industry. Export volumes are down year. But for the largest export categories, last year's contract prices are still in effect. Looking forward, 2010 could see lower export volumes AND lower prices for bulk commodities like iron ore and coal (especially if Chinese inventory restocking is complete). This would make the current valuations on resource earnings look pretty generous. You'll read more this week on which sectors are going to thrive and fail in this Great Releveraging.

Back to gold and the dollar and the new world currency order. A simple question: what was all the fuss about last week with a new reserve currency anyway? Here is an answer. If OPEC demands payment for oil in something other than U.S. dollars, then people who buy oil (and who doesn't?) have to stockpile the other currencies in which oil is priced and traded. That would be pretty tough on America.

To support its oil appetite, the U.S. would have to buy the currencies in which oil is priced. It couldn't use good old greenbacks. How do you buy foreign currencies?

Well, you can sell your assets (gold, real estate, stocks) and use the money to pay for oil. This is what Australia does. Or you can borrow in a foreign currency (did anyone say future Chinese bond market?) It's also possible you can use earnings on your foreign-owned assets - provided those assets generate enough money to support your oil habit.

These are all options within the free market system. The main point is that all other things being equal, you have to sell something to pay for something. This is why the foundation for economic health is always wealth production, not consumption. Production creates the goods that facilitate the trade that creates the profits to increase purchasing power for the things you don't produce.

But outside the free market system, you could opt for just taking the oil by force. By that we meant that should the U.S. be put in the position of having to pay for oil with new borrowings or asset sales, it might take the geopolitical path of least resistance and resort to a good old fashioned overt resource war. The declining Empire will strike back with its principal remaining asset, its military.

Likely candidates for an oil war? Not Iran. It's too far away. There are too many U.S. troops in Iraq and Afghanistan that would become targets. And the effect of a Middle East war would be too destabilising on oil prices. But Venezuela, on the other hand, is much closer to home.

Granted, comrade Obama is a peace maker. He was a won a price for it. Peace be upon him. And it would not seem like he's not likely to attack his good friend Comrade Chavez.

But if the current president flounders in the fiscal morass he finds himself in, he'll be a one term savior. Some pundits are already calling him "America's Gorbachev." He's the man who will preside over the swift fall from grace of a Superpower.

There will be no second coming (term). And that leaves room for a challenge from a more hawkish member of his own party (Hillary Clinton) or a populist Republican with a handy doctrine of liberty within the hemisphere (let's call it the Palin Doctrine). If Obama is America's Gorbachev, who is America's Putin? That's what Glenn Reynolds at www.instapundit.com is asking.

Naturally all of this is pure speculation. But our main point is that the oil game is not just a currency game. It's a power game. And it's silly to think the U.S. would relinquish its control over the oil market so easily. There will be a fight.

Not that the U.S. could maintain the reserve currency status quo by force. But sooner or later someone at the policy level in America is going to realise that once the reserve currency status is lost, the country loses a huge strategic and competitive advantage. Its standard of living, already in major decline, would face a major body blow.

Just how American policy makers plan on maintaining that advantage is yet to be seen. Of course maybe they don't plan on it at all. The Empire could be so narcissistic and full of false confidence that few people fail to see the inevitable chain of events the country faces. You'll just get more spending and more chest-thumping and more fiddling. Or more war.

Dan Denning
for The Daily Reckoning Australia

• Banks Could Face Larger Asset Writedowns and Losses than IMF has Modelled
• Gold Sales Cost Europe’s Central Banks Billions
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Everyone is Busily Debasing Their Currency
• Shadow Banking System: A Murky World of Credit, Securitisation and Derivatives

Uncertainty...chaos...bad decision making. This is what makes individual planning so hard in a world with fiat money. The supply of money (and thus the value) is always changing. Economic decisions that made sense with interest rates at one level make a lot less sense with interest rates at a different level. Mis-calculations are made. Good investments go bad.

Will the Reserve Bank's decision to raise interest rates for the first time in 19 months expose people who didn't plan for it? Of course it will. The housing sector is where we'll find out. And you already know what we think, don't you?

We think the Federal government behaved shamefully by suckering first home buyers in with free cash when interest rates were historically low. Now that rates have begun moving up, the most marginal buyers will begin feeling the pinch. And what will happen to house prices?

As far as stocks go, there might be an even bigger rates-related story playing out. The RBA becomes the first G-20 central bank to lift rates. Whether it's stupid or prescient no one knows. But we have to consider the possibility that it could ignite a reversal of the trend in global bond yields. Yields on government and corporate debt could be headed higher now.

Mind you we don't think the Fed will be raising short-term rates in America any time soon. It would crush what little chance there is for a recovery in U.S. housing. But on the longer end of the yield curve (the part the Fed does not control), investors might begin sending interest rates up and bond prices down. Relatively speaking, this makes stocks a lot more attractive.

Maybe that's why stocks in New York rallied over night. And maybe that's why Aussie stocks were up after yesterday's announcement and are up again this morning. It could also be that investors are buying the "recovery has begun" story, which would be goofy but possible. But for whatever reason, stocks are suddenly looking a lot more compelling than bonds.

But let us not forget gold. And how could we? It's so shiny. Gold hit an all time high of $1,040 yesterday. It won't make a new high in inflation-adjusted terms until it clears US$2,000. But the question on everyone's mind is whether gold is going to make higher highs from here...or corrects.

The case for the correction is simple. Check out the chart below. It's the commitment of traders report from the New York futures market. You can see from the figures at the bottom that both the number and the percentage of large speculators who are bullish is at record levels. That alone would dictate some short-term trading caution.

Click to enlarge

What's more, the emergence of the gold exchange traded funds (ETFs) has put a huge portion of the gold market in a very small number of hands. If the ETFs sell...who will they sell to? Or more succinctly, a lot of the gold demand is coming from a few institutions. If other institutions (central banks and sovereign wealth funds) don't pick up the slack, there will be more sellers than buyers and prices will fall.

But not so fast says the world of geopolitics. Gold could go much higher if the world's entire monetary order (or disorder) shifts away from the U.S. dollar. And that's just what the Independent's Robert Fisk wrote yesterday in an article that set the internet all a-twitter. He called it, "The demise of the dollar."

Fisk wrote that, "Gulf Arabs are planning -- along with China, Russia, Japan and France -- to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Cooperation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar...The transitional currency in the move away from dollars, according to Chinese banking sources, may well be gold."

Well then, that changes everything. In this role, gold becomes a hedge against devaluation in the U.S. dollar. It's not so much a hedge against inflation (a systematic increase in the supply of dollars printed to hold up the U.S. banking sector and finance a grasping Federal government) as it is a move to protect assets against a sudden dollar collapse.

Granted, in the ho hum developed Western world we live in, currencies simply don't suddenly collapse. They erode over time. And one fine day you find your purchasing power is not what it used to be.

But in emerging markets, basket case economies with massive fiscal imbalances do have sudden currency crises. FT writer and economist Willem Buiter calls them "sudden stops." And then, if you're an American or a Brit, he makes the somewhat terrifying point that these two developed economies have all the characteristics of an emerging market basket case economy.

Buiter writes that, "The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the 'sudden stop' - the cessation of capital inflows to both the private and public sectors. . . . But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world's leading reserve currency. A large fiscal stimulus from a government without fiscal credibility could be the trigger for a 'sudden stop'."

One important aspect of these "sudden stops" is that they are almost never events you would choose to participate in. But you have to anyway, or monetary events overtake your investment portfolio. This is why these episodes in monetary history are so chaotic. And it's why-if we're entering one of those episodes now (or at least the most unstable period of it as we move from one reserve currency to a basket of currencies)-the price swings in asset markets are going to be impressively volatile.

All that said, the move up in the Aussie cash rate has sent the Aussie dollar higher. Thus, the Aussie gold price went down overnight, not up. It could be that in the short term, the migration of global capital flows out of the USD favours Aussie equities more than gold (from an Australian perspective).

So about that 5,000 on the All Ordinaries....Does it now look a lot more likely given the events of the last 24 hours? Or are we on the cusp of a significant correction to the rally of the last six months? More on that tomorrow from the trading nebula.

And by the way, has there ever been a better time to figure out what gold is really all about? These are serious and far reaching issues. It's high time for a serious and far-reaching discussion of them. If that sort of thing interests you, make sure you read about the upcoming gold conference in Canberra early next month. You can read more about it here.

Dan Denning
for The Daily Reckoning Australia

• Gold, the Aussie Dollar, the Greenback and You
• AUD Price of Gold a Measure of Gold’s Strength Against Other Currencies
• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• Gold and Oil are Acting as Though They Expect Higher Rates of Inflation

"The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I'd give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s.

"The Smoot-Hawley tariff of June 1930 was the catalyst that got the whole process going. It was the largest single increase in taxes on trade during peacetime and precipitated massive retaliation by foreign governments on U.S. products...beginning in 1932 the lowest personal income tax rate was raised to 4% from less than one-half of 1% while the highest rate was raised to 63% from 25%. (That's not a misprint!)... By the end of January 1934 the price of gold, most of which had been confiscated by the government, was raised to $35 per ounce. In other words, in less than one year the government confiscated as much gold as it could at $20.67 an ounce and then devalued the dollar in terms of gold by almost 60%. That's one helluva tax....

"Inflation can and did occur during a depression, and that inflation was strictly a monetary phenomenon..."

"The 1933-34 devaluation of the dollar caused the money supply to grow by over 60% from April 1933 to March 1937, and over that same period the monetary base grew by over 35% and adjusted reserves grew by about 100%. Monetary policy was about as easy as it could get. The consumer price index from early 1933 through mid-1937 rose by about 15% in spite of double-digit unemployment. And that's the story."

We had no doubt that inflation can occur during a depression; hey, we read the papers. Anyone who has followed the Zimbabwe story knows that you can have a deadly depression...and dizzying levels of inflation at the same time.

But there's always more to the story. Devaluing the dollar in terms of gold had the immediate effect of increasing the money supply - it was like adding zeros to the currency.

In our wallet is a ten trillion dollar Zimbabwean bill, with a picture of stones on it. Those words - 'ten trillion' - did not get printed on that bill by accident. We assume they got printed on their by a printer in the employ of a government that figured that the cost of printing a ten trillion dollar bill was less than the cost of not printing it.

That is, by a desperate government that had so fouled-up the economy that a period of hyperinflation might seem like an improvement. Besides, hyperinflation might have a therapeutic, purgative effect.

But let us not get sidetracked by hyperinflation. It is nowhere in sight. Nor is its more civilized cousin - normal, polite inflation. The money supply in America - as measured by M2 - is contracting. The banks get money from the feds, but they don't pass it along. The chain of reflation is broken - or at least temporarily stretched. Currently, it takes a long time for money to get from one end to the other. The cash tends to get waylaid -either by the bankers...or by consumers themselves. It stays in bank vaults...or in bank accounts. Money is not being multiplied by the speed by which it changes hands. Instead, it is divided by immobility. It sits. It shrinks. It waits for a real boom.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Oil and Gold Prices Linked for Most of Recession Period
• Climate Change and Hyperinflation Reader Mail
• Will Gold Have Another Great Year in 2010?
• Brazil is a Good Place to Become Rich
• Gold is More Like a Religion or a Political Position

Apparently the current set-up of having the US dollar as a reserve currency isn't working very well.

They're quick learners at the UN obviously!

Their report makes some of the right noises, "The dollar-based reserve system is increasingly challenged." Hmm, a slight understatement there. If "increasingly challenged" is a euphemism for "dead" then we'd agree.

But we don't think that's what they mean.

So, what do they plan replacing it with?

Special Drawing Rights, or SDRs. If you've got no idea what that means, it's simple.

An SDR is something made up by the boffins at the International Monetary Fund (IMF) to act as an "international reserve asset."

The rationale for the creation of the SDR was that "the international supply of two key reserve assets - gold and the US dollar - proved inadequate for supporting the expansion of world trade and financial development that was taking place."

Look, your editor won't pretend to be a grade 'A' student of monetary theory, but to us the creation of the SDR is part of the reason the global economy is in the current mess.

That gold was deemed to be inadequate for "supporting the expansion of world trade and financial development" tells you that's when the Western world begun its massive spending spree.

Back in 1969 with the creation of the SDR.

A spending spree that couldn't be achieved just through stealing money from citizens through the tax system, but one which could only be kept going by the creation of more money.

It was, you could argue, the beginning of the 'consume, don't produce' Western economies.

The problem that SDRs 'solved' was the ability to crank up the printing press. Of course that didn't happen straight away. There's always a transition with these things.

First, as it happens, like the US dollar, the SDR was backed by gold. But if you're creating a new reserve that you want to be more flexible than gold (ie. You want to print more money and spend it), then backing it with gold isn't going to work.

Because backing a currency with gold helps to maintain the value of the paper currency. If you know that your $1 note is redeemable for a set quantity of gold then it will maintain value.

It means the banks can't - or shouldn't - create more paper money than the reserves they have in gold to back it up.

Simply put, it creates and requires discipline. Something that bankers and governments in the 1960s weren't happy with. The 'inflexibility' of gold makes it harder to for governments to spend and makes it harder for banks to lend.

Therefore the creation of the SDR was a stepping stone to abandoning the reserve status of gold. And sure enough, four years after the SDR was invented, US President Richard Nixon closed the gold window at the Federal Reserve and there was no longer any obligation for US dollars to be exchanged for a fixed weight of gold.

Instead the US dollar was backed by nothing, and so the SDR was backed by the US dollar and other currencies which were also backed by nothing.

Yet it is this 'worthless' SDR which is being touted as the new reserve currency.

But why should the SDR make any difference? It won't. An SDR is just a weighted basket of other currencies. Unless it is backed by something tangible, such as gold, then it will prove to be equally as worthless as the US dollar it is replacing.

Perhaps, bankers and governments will see the error of their ways and make a call for these new SDRs to be back by gold...

Not a chance.

There are several reasons for that. One, as I mentioned above, is that gold forces a government and its central bank to be disciplined. It cannot circulate more money without having a corresponding increase in its gold reserves.

If it were to do so then the paper money - or certificates - would not be fully backed by gold. This would cause the value of the paper to decrease - the greater supply of one thing relative to another devalues it.

If people got wind that the central bank was printing more money without increasing its reserve of gold, there would be an increased demand for physical gold. There would be a run on the banks.

The other problem gold has is an image problem. Take this comment from a recent article by Alan Kohler over at Business Spectator:

"But while there's no doubt the gold will continue to be underpinned by the demise of the dollar, it is not a currency. I can't go into JB Hi-Fi with a lump of it and buy a TV."

"Central banks around the world own about 26,000 tonnes of it, which represents 8.5 per cent of total reserves, but it's not legal tender. It's just a commodity they got stuck with because it used to be a currency a long time ago and will never be again."

It's fairly common of the attitude the mainstream press has to gold. They don't understand that it is a store of value.

Kohler claims you can't go into JB Hi-Fi and buy a TV with a lump of gold. He's quite correct on that score. But it wasn't so long ago that is effectively what consumers did. Maybe not for TVs but for other items.

Under a gold standard where your dollar was backed by gold, consumers were exchanging a gold backed dollar for goods. It was an exchange of gold for goods, only that a paper note was used as a proxy.

What's so crazy about that? Nothing.

But if you look at Kohler's other comment about 26,000 tonnes of gold being only 8.5% of total reserves it gives the game away for the real reason bankers and governments don't want a gold backed currency.

Inflation.

It's no coincidence that since the early 1970s global paper currencies have lost about 90% of their value. Virtually every currency you name is worth significantly less today than it was thirty-odd years ago.

That's not because prices have risen, it's because currencies have become devalued.

As Kohler, perhaps unwittingly admits, central banks and governments have embarked on a massive money printing exercise.

If paper money still had the backing of gold then global economies would not have one-tenth of the current problems we are currently facing.

The fact that the UN and other government organizations are proposing to replace one currency backed by nothing with another currency backed by nothing signals they are either ignorant or are intentionally pursuing policies guaranteed to deliver economic destruction.

And more importantly to you, to guarantee the continued devaluation of your money and wealth.

Kris Sayce
for The Daily Reckoning Australia

• US Dollar Declining as China’s Currency Rises
• Special Drawing Rights Used as the World’s Reserve Currency?
• An International Currency Not Just on Paper
• A Gold Standard, Without Gold
• The U.S. Dollar vs Inflation, Americans Vote for the Dollar

Probably most incredible is that the dollar has NOT collapsed. It has lost ground, and was trading at $1.43 per euro on Friday, but no one laughs at you when go to exchange dollars...or offer to pay in dollars rather than the local currency.

For the last 10 years, the money supply in the United States has expanded at roughly twice the rate of GDP growth. And the Fed doubled its balance sheet in just the last 18 months. This last bit of information is stunning. It took the central bank nearly 100 years to build a balance sheet of $1 trillion. Then, under the leadership of Ben Bernanke, it added another $1 trillion in just a few months.

What does that mean, exactly? It means they bought a lot of debt from US agencies and the financial sector. It means also that they "monetized" this debt...transforming it into cash by paying for it with money especially created for that purpose. It also means that the whole financial sector has a bigger financial base against which to lend. The Fed lends against its balance sheet to member banks. These banks then lend to other banks who lend to business and consumers. So the amount of potential credit - as well as the amount of actual cash - has gone up.

There is an iron law in economics. Quality and quantity vary inversely...which is another way of saying that when you add more of something...each unit is worth less than the unit that preceded it (assuming everything else remained unchanged.) Certainly, this is true of money. The more money in a financial system, the less each unit of it is worth. Add enough new money - as Zimbabwe proved recently - and each unit becomes worthless.

But so far, the dollar has not collapsed. It has fallen, but gently...

Meanwhile, the inflation rate has NOT gone up. Instead, it's gone down. Go figure. You add that much monetary inflation and you'd expect to get a boost in the CPI. Nope. Not yet.

On the other hand, we're already a year-and-a-half into a major recession/depression. You'd think you'd get deflation. That hasn't happened either. Prices are down. But not as much as you'd expect, given the scale of the downturn.

Related to both the dollar and inflation is the bond market. Even more surprising is that the bond market has NOT fallen apart. Let's see, a huge input of monetary inflation; that ought to kill the bond market. Then too, the biggest sales of Treasury bonds in history - needed to cover a $1.7 trillion deficit this year. That ought to kill the bond market too. And on top of it all is a projection from the White House telling us that the feds will add $9 trillion to US debt over the next 10 years. And that assumes a full recovery in the economy! Now, that ought to kill the bond market for sure.

Not at all! Bond yields have risen...but the 10-year T-note still only gives you 3.4%.

Of course, you say, it's a depression. Bond yields always go down in a depression.

But if it's a depression, how come commodities are up? And stocks are up? Above all, how come Chinese stocks are up? Everybody knows China earns its money selling products to Americans and other non-Chinese. If the rest of the world is in a depression, who is China going to sell to? How come China isn't in a depression already? But there you are - there's another thing that hasn't happened. Chinese stocks haven't collapsed.

And getting back to commodities, they're all up. Commodity prices don't go up in a depression; everybody knows that. They go down. But commodities are NOT in a bear market. Go figure.

And, of course, there's gold. The metal gave up a dollar on Friday, but it's still just $4 short of the $1,000 mark...and just a shadow below its all-time high. Gold is a commodity...but it's also money in its purest, more reliable form. Commodities go down in a depression. Money goes up. But since gold is an alternative to paper money, it tends to go up only when paper money goes down. As explained above, the dollar has NOT collapsed. So why is gold going up? It should be going down, reflecting the effect of a recession...

There are two possible answers.

First, maybe the iron laws of economics have been repealed.

Or, second...maybe the iron laws just haven't caught up to the market - yet.

Unemployment is at 9.7%. It will probably rise above 10% this month. The economy is supposed to be recovering. Now, The New York Times is talking about a "jobless recovery."

You'll remember the phrase. It came out in 2003. Then, the economy was allegedly recovering from a micro-recession. Economists were surprised that there were so few new jobs created.

What was really happening was that there was no genuine recovery. Consumers just decided to go deeper and deeper into debt - egged on by the feds. A regional governor of the Fed actually urged consumers to "go out and buy an SUV." So Americans bought more products from the Chinese...on credit...and the Chinese enjoyed a boom.

And now the boom is over. Americans are paying down their debt. And unemployment is getting worse. This time the feds are pumping trillions into the system. This time, it's not the consumer who is willing to go further into debt; it's the government. And once again, few new jobs are being created.

Without jobs, the recovery is an impostor...a phony...a fraud. Without jobs, people have no extra spending power. So they can't buy - except by going deeper into debt. They were willing to go further into debt in '03-'07. But not this time. They've reached their limit on debt. Besides, with house prices falling, who would lend to them?

No new jobs = no new income. No new income = no new sales. No new sales = no new profits = no new jobs.

But what about the government? The feds are still willing to borrow. How come federal borrowing can't create a new boom - even if it is a phony one - like the one in 2003-2007?

Federal borrowing, spending, bailouts and monetary inflation are not helping the real economy. But they are making a lot of money available for speculation. That's why so many things are NOT happening. Investors are speculating on commodities, gold and Chinese stocks - for example. And US bonds.

But this is not a durable, reliable trend. And it's not laying the foundation for a genuine recovery. Borrowing by the feds is different from borrowing by individuals. Private households can go broke. But they can't take the dollar down with them. When the feds borrow, they pledge the full faith and credit of the United States - and its currency - as security. So, as they borrow more...the value of the US currency comes into doubt...then, into play...and then into jeopardy.

Investors eventually sell off dollars and US bonds...then, what should happen finally does.

Caution: what has to happen does eventually happen. But it doesn't have to happen when you think it should. The big surprise might be how long it takes before these things happen. If we were Mr. Market, for example, we probably would not take gold much higher - not just yet. We'd let deflation take gold down for a while - long enough to separate the speculators from their money. Then, we'd let investors get used to falling prices - before bringing inflation back.

Bill Bonner
for The Daily Reckoning Australia

• Geithner Reassures China that America Takes Financial Obligations Seriously
• The Fight Between Greed and Fear, Boom and Bust, Expansion and Contraction
• Where, Exactly, is this Economy Headed?
• Gold Doesn’t Always Need Inflation to Rise
• Fed Will “Monetize the Debt”