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
• Fed Announced it Would Buy up to $300 Billion in Treasury Bonds
• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy
• It Wouldn’t be a Real Bear Market Rally if it Didn’t Test Your Confidence in Your Position
• The Only Thing Really Going Down Right Now is the U.S. Dollar

- 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
• Warren Buffett Says American Economy is a Shambles
• Mistakes Made By America Are the Same Mistakes That Empires Make
• Deleveraging Will Give Us a Bout of ’30s-Style Deflation
• Biggest Problem With US Economy is Too Much Debt

"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
• The Greatness of a Depression is Commensurate to the Government’s Efforts to Prevent It

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

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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
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• A Gold Standard, Without Gold
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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

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"Cash is for buffers, not for wallets," says the headline. Mr. Turner is making the point we have made many times. The US system of capitalism has become a system where the capitalists have no capital. The big banks have too little in savings...not enough 'buffers' to protect them from unexpected crises. They made a fortune during the boom years - loading consumers up with debt. But instead of holding onto the money to protect themselves against emergencies, they paid it out in bonuses and salaries. Then, when the crisis came - one they caused - they were without sufficient funds.

What do you do when you're a major bank and you are insolvent? Hey, you already know the answer. You turn to the government! Which is why Mr. Turner's comment is both very smart and very dumb at the same time. He's right; the banks should hold more capital. But the reason they don't is obvious: they know the government will bail them out. They figure they don't need much capital; the feds have plenty.

This is the problem economists call "moral hazard." If you protect people from their own excesses they will become even more excessive. On the other hand, if they have to pay for their errors, they'll be quicker to correct them.

Okay...well...maybe the banks still wouldn't save enough. But that would take care of itself. If the feds didn't intervene, the insolvent banks would go under; those left would - by definition or accident - be better run.

Bill Bonner
for The Daily Reckoning Australia

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

'Nuff said.

Bill Bonner
for The Daily Reckoning Australia

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"Friday's edition of The Wall Street Journal picks up on the theme of the long road of pain ahead for bank shareholders in the US," colleague Dan Amoss tells us. "In 'Banks on Sick List Top 400,' the WSJ details several ugly highlights from the latest FDIC Quarterly Banking Profile, published last Thursday.

"Here are a few:

"1. The FDIC's Deposit Insurance Fund is now promising to insure $6.2 trillion in deposits with just $10.4 billion in reserves. Expect to see another "special assessment" cutting a few billion dollars out of bank earnings later this year.

"2. Credit card losses are at a record: 9.95%

"3. 416 banks, or 5% of the nation's banks, are on the 'problem' list.

"4. FDIC-insured banks are sitting on $332 billion in loans more than 90 days past due, up from $290 billion in the first quarter.

"5. Nonperforming loans now make up 2.77% of the entire banking industry's assets. This is up from 1.4% in June 2008 and 0.47% in June 2006. As these loans get 'worked out' in today's credit environment, the market will start to realize how severe net charge-offs will be.

"In this new report, the FDIC published updated figures for the combined noncurrent loans and loan loss allowance at all FDIC-insured institutions. Here is an updated version of the chart we published in the Aug. 14 alert. The new figures - the moves from December 2008 to June 2009 - are highlighted in the dotted lines at the far right of this chart:

"You can see how problem loans are increasing at a much faster rate than the rate at which the banking industry is adding to its loss allowance. This means that published capital ratios are misleadingly high."

Dan's latest short idea for Strategic Short Report is building up its loss allowance at a glacial pace compared with its skyrocketing delinquencies and nonperforming assets. Its management team likes to highlight its strong capital ratios. But when adjusted for the inevitable growth in provision expenses - and the leaner operating income that its shrinking balance sheet will generate - its capital ratios looking ahead to mid-2010 don't look so strong.

Bill Bonner
for The Daily Reckoning Australia

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