Gold didn't move yesterday. It remained at $1,139.

Mortgage delinquencies hit a new record in the third quarter. And producer prices came in lower than expected. These are both indications of a weakening, deflation-prone economy.

Perhaps this is what prompted Mr. Ben Bernanke to tell the world that he may keep rates lower, for longer, than he thought...and perhaps forever.

"Bernanke signals 'extended' low-rate period may become longer," reports Bloomberg.

Today, we discover that "1 in 6 hungry in America last year." That is the headline in the USA Today. If you believe the report, 49 million people went hungry at some point in 2008, the highest number since the government began keeping track in 1995.

Meanwhile, we learn - in the same paper - that "Rising obesity will cost the USA $344 billion." That's what fat people cost the nation annually, equal to 21% of health-care spending.

The two problems should cancel each other out, shouldn't they?

Oddly, the states with the greatest girths are also the poorest. Mississippi is number one in fat. It's also the poorest state. Could it be that fat people are going hungry? Is this a good thing; or a bad thing?

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Lending Rates Will Go Up With Inflation
• Things That Matter in the Economy are Going in the Wrong Direction
• Consumers are Suffering Because European Governments Boosted Spending
• IMF Deems Gold An Idle Asset
• Eurozone Drops GDP Bombs

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

"We are sinking in a sea of debt," he admitted. And on the very day when France's president, Nicolas Sarkozy, said he would not raise taxes, Osborne said that he would not lower them. In order to lighten Britain's debt, he'd leave Labor's 50% maximum tax rate right where it is.

Voters don't like hearing about debt. Politicians don't like talking about it. And economists don't want to think about it. And in a kind of collective suicide pact, they have all agreed not to worry about it. But debt is at the center of the world's financial troubles.

Paying off debt is like dying. You try to put it off as long as you can. But nobody runs an open tab forever.

This week brought news that Maine-based luxury yacht maker Hinckley, which has been building boats since 1928, is sinking. The problem is neither technical nor operational. It is philosophical. No one complains about the quality of the boats. Or even the prices (if you have to ask, you can't afford one). The company sailed along nicely until 1997. Then, the private equity hotshots from Boston took the helm. The old Hinckleys who ran the shop looked upon debt as though they were looking at a bottle of whiskey. A drink now and then did no harm. But watch out. Too much will sink you. In the 70 years they ran the place, they accumulated only $1 million of debt. But the new owners were dipsomaniacs; they multiplied Hinckley's debt 20 to 40 times. (Exact figures are not available.)

For much of history, failing to repay debt was regarded as not merely a breach of contract, but a crime. People who failed to repay their debts in timely fashion were thought to have stolen from their lenders; they were put in prison. In the Middle Ages even a dead debtor's children could be sent to prison.

Now, bankruptcy laws allow individuals and businesses to go to rehab. Then, they can stiff creditors again. Neither sin nor crime, debt is now just a cost of doing business.

But few creditors are as forgiving - or perhaps as forgetful - as those who lend to governments. That is the conclusion of a new book by Carmen Reinhart and Kenneth Rogoff, This Time It's Different. The two professors document the history of eight centuries of "financial folly." What we learn from it is what we already knew - that borrowers are often perfidious, crises are usually insidious, and bankers are morons.

Just five years ago, Ben Bernanke looked out on the calm seas of the Bubble Era. "The Great Moderation," he called it. Bernanke took the credit. It was due to "improved macro-economic policies," he said. In retrospect, he probably should have said it was just luck and left it at that. His macro-economic policies made things worse, encouraging all sectors of the economy to borrow. We know what this did to Hinckley. Riding low in the water, with too much debt heaped on its deck, the yacht maker struggles to stay afloat.

But what's new, ask Reinhart and Rogoff? Always and everywhere, debt leads to trouble. Too much debt caused France to default on its sovereign debt eight times. Spain defaulted six times before 1800 and then another seven times later.

Latin America, as the authors point out, would have been safer for bankers if the printing press had never made its way across the Atlantic. Between hyperinflation, defaults and banking debacles - over two centuries - the banana republics scammed banks out of billions. In the '80s, Nicholas Brady tried to rescue New York bankers with his US- backed "Brady bonds." Readers of these back page columns can guess what happened next. Within a few years, seven of the 17 countries that had undertaken a Brady-type restructuring had as much or more debt than they had before. By 2003, four members of the Brady bunch had once again defaulted and by 2008 Ecuador had defaulted twice.

Even non-existent countries go broke. In 1822, "General Sir" Gregor MacGregor issued bonds from a fictitious country he called Poyais, whose capital city, Saint Joseph, was described by the offering prospectus as having "broad boulevards, colonnaded buildings and a splendid domed cathedral." The bonds sold at lower yields than those of Chile. But it didn't matter whether the country was real or imagined, all of them defaulted.

As for the present slump, the authors offer no predictions, but some guidelines. In the run-of-the-mill crisis, real housing prices generally go down 36% over a six-year period. GDP, in real terms, per capita typically goes down 9.3% while unemployment rates go up for five years, with a 'normal' increase of about 7 percentage points. But the closest parallel to the present circumstance, which they call 'the Great Contraction,' is the Great Depression of the 1930s - which was much worse. Unemployment in Germany and Denmark rose over 30%. Building activity fell 82% in the United States. Chile saw a 90% collapse in its exports.

Tax revenues fall in an economic slump. Government expenses increase (especially when the authorities are ready to do 'whatever it takes' to stir a recovery). Typically, say Reinhart and Rogoff, public debt increases 86% over a three-year period following a financial calamity. Then come more catastrophes, caused by too much debt in the public sector. Both Britain and America are now running deficits of more than 10% of GDP. Neither has a creditable plan for reducing debt or deficits. So stay tuned. Much more trouble lies ahead.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Fed Will “Monetize the Debt”
• We Expect No Recovery from the Economy
• U.S. Treasury Auctioning Off $81 Billion in New Debt
• US Dollar is Getting Trashed
• Cash is Created When the Feds “Monetize the Debt” by Buying US Treasury Bonds

Starring Ben Bernanke, Tim Geithner and a cast of millions...

The new movie - Zombieland - about a group of survivors in a world of zombies, was the biggest grossing film in America and Canada over the weekend. It must reflect the zeitgeist of the North American public...a deep feeling that we are living in a decaying world.

Maybe it comes from the growing awareness that the old bubble economy of the 2002-2007 period is dead. Now, survivors must defend themselves from the zombies.

Survivors are being attacked in the streets, in their homes, and at their workplaces. Zombie banks - kept alive by artificial stimulants provided by the feds - take their money and their houses. Living-dead companies block new competitors. And the zombies at the Fed and the Treasury department try to gnaw on their savings, encouraging inflation to eat away the purchasing power of the dollar.

As to this last point, the feds have gotten nowhere. They wear down their teeth for nothing. Prices are going down, not up. Houses are 30% cheaper than they were in 2006. Hotel rooms are 20% cheaper than last year. You want a luxury room? Just ask for an upgrade. Chances are good that no one is renting the luxury suites. Just make them an offer. Discounts are available almost everywhere. The Sony Playstation, for example, is now available - 25% off.

Stocks are cheaper too. They've been going up for the last seven months, but they're still about a third less than they were in 2007.

Stocks fell again on Friday. Investors began to fret that maybe...just maybe...the authorities don't have this zombie problem under control.

"Jobs news gets worse," The New York Times tells us.

Since the stock market began going back up in March, the United States has lost 2.5 million jobs. It has lost jobs every month since December 2007. Now, unemployment - officially at one in ten workers - is the worst it has been in 26 years.

What kind of recovery is this? We don't know, but if it continues much longer we'll all be unemployed.

But not to worry, dear reader. Secretary of the Treasury Tim Geithner says the signs of recovery are "stronger" than expected.

We wonder what signs he's looking at. Of course, this is the same doctor who was on the scene at the New York Fed when strange things began happening. The financial industry started acting funny in the bubble years...spending money like there was no tomorrow. And then, wouldn't you know it, there wasn't any tomorrow. They dropped dead in the crash of '07-'08. But with huge injections from the Fed, they've turned into Zombies.

Of course, Tim Geithner missed the whole thing. So maybe he's not the best source of recovery sightings.

A survey by Business Roundtable tells us that the ranks of the unemployed are likely to swell. Only 13% of employers have plans to hire more workers. The rest are either sitting tight...or turning workers loose.

Naturally, of all those people cut off from paychecks, more than a few are looking a little peaked. Their eyes sink back in their heads. Their skin turns grey. Soon, they're starving for raw meat.

"Personal bankruptcies soar," says The Wall Street Journal.

And not surprisingly, when they become desperate, they tend to default on their mortgages. We know already that auto sales drove off a cliff when the summertime 'Cash for Clunkers' program came to an end. Now, summer's over. Housing sales should decline too - forcing more homeowners into default and foreclosure.

The zombies are having a depressing effect everywhere. The stock market went down again on Friday...the Dow fell 21 points. The oil market didn't do much better, with the price of the black good still below $70.

As for gold, the yellow metal continues to hold above $1,000. It fell below $1,0 00 for just a couple days. On Friday, it was back to $1,004.

The $1,000 level used to be a ceiling for the gold price. Now it seems like a floor. Are the Chinese buying below $1,000? Maybe. Do we have a Beijing put option available to us? That is, has the risk been taken out of the gold market by China's desire to stock its vault with something other than dollars? It is an intriguing thought. We don't know the answer.

We are holding onto our gold. It's insurance - protection against the feds. If they do something really stupid, the price of gold will soar. If they don't do anything really stupid, well, we'll be surprised. After all, they've already turned America into Zombieland.

Bill Bonner
for The Daily Reckoning Australia

• A Dispatch from the Zombie Wars
• Where, Exactly, is this Economy Headed?
• Funny Business at the Banks
• Economy Has to Grow at 1% to Stay Even With Population Growth
• Unemployment Rate at a Five Year High

First, Goldman's buy on the banks seemed to buoy the market. The Dow finished up 112 points and is just under 9,600. Meanwhile, Aussie stocks shrugged off that sense of impending doom and rallied 43 points yesterday. The ASX 200 is at 4,622 and thoughts of 5,000 by the end of the year must surely be dancing like sugarplums in the heads of some investors.

Ho! Ho! Ho!

But seriously. The banks? Really? Aren't you the least bit suspicious that Goldman is talking up the banks? Doesn't this mean Goldman is probably already short on the banks?

We have been hanging out at what we now call the "Trading Nebula" in our new offices. Our research department is growing, so we like to drop by and see what the traders think is happening. Often, it seems nebulous to us, given the peculiar vocabulary of indicators and charts the guys are using. Hence the "Trading Nebula."

But Murray Dawes was especially clear this morning when he told us that his screens are producing all sorts of warning signals on the banks. He is obviously running a different trading algorithm than Goldman. But then, he's producing trading leads for our new Slipstream Trader, which is designed to produce long and short ideas on ASX 200 stocks. In our chat this morning he told me that two banks showed up, although neither were part of the big four.

If Murray is suspicious that the banks can lead the market to higher highs, at least he's in good company. Bear heroine and noted financial analyst Meredith Whitney wrote in the Wall Street Journal over the weekend that, "Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting."

You don't say?

"Access to credit is being denied at an accelerating pace," Whitney adds. "Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan...In the U.S., small businesses employ 50 percent of the country's workforce and contribute 38 percent of GDP...Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business."

What then, has the regulatory and policy reaction actually produced? It's propped up large institutions that still have heaps of bad assets and have used the last six months to increase their leverage. But at the regional and local level, real businesses with real customers and real capital needs can't get credit.

To summarise: We have saved the zombie companies with zombie assets at the expense of the living, breathing engine of the free market; the small business. This leads Whitney to conclude, that "We are only in the early stages of the second half of this credit cycle...I expect another $1.5 trillion of credit-card lines to be removed from the system by the end of 2010."

What will happen to the economy then? And what will happen to Australia then? Will it matter? The ability to extend credit to small businesses and households is concentrated in the hands of the Big Four. Does that make us safer? Or does it concentrate the risk in a few major players, jeopardising the whole system of credit?

What's clear is that the supply of commercial credit is more concentrated now than ever before. Will the Big Four shun risk and build a capital cushion by cutting off small business credit? Will they double down on their housing lending in order to support house prices; a scheme which supports the value of the assets the banks carry on their balance sheets?

If we're making it sound like the market and the economy are at a critical inflection point, it's because they are. The complacency of the last six months is giving way to some real questions about what to do with troubled assets that are still troubled and bad debts that are still bad. Can a global economy really grow when the financial system is weighed down by so much debt?

Professor Michael Hudson is coming to Australia and he says "No!" If you're interested in hearing what he has to say in person, check out his schedule here. You can RSVP for the event near you, provided seats are still available. If you can't make it, there's a good You Tube video of his ideas here.

We're not familiar with everything Dr. Hudson has to say. We're planning on catching up for lunch and will report back to you how it goes. In the meantime, he gave an interview with the folks over at Business Spectator and put his views lucidly: "There's a basic mathematical principle; a debt that can't be paid won't be paid."

Talking about the explosion in consumer debt world-wide, including here in Australia, Hudson says, "These debts are beyond people's ability to pay and so we're going to see breaks in the chain of payment and this means that a lot of debts are going to go bad. It means that people are going to hesitate to realise that they can't pay, a kind of cognitive diffidence [sic] that people have about the fact that they really can't pay their debts."

"They're willing to run down their savings, they're willing to sell off their assets and do everything, but in the end they default and this is what breaks the back of an economy. The houses are defaulted on, they're put up for sale, that crashes real estate prices all the more and, again, the commercial real estate is even in more serious condition than residential real estate right now."

Coming back to Barofsky and Goldman then, and if Hudson is right, is this the time to buy the banks? Barofsky's report concluded that not all nine of the banks that received $125 billion in capital infusions from the U.S. government here as "healthy" as Ben Bernanke and Hank Paulson made them out to be.

The nine institutions combined had over $11 trillion in assets. But Paulson made it sound as if the capital infusion would not only stabilise the banking sector, it would prompt the resumption of credit flows in the economy. That turned out to be...not true.

So what is the truth? Well, as we suggested at the time, the TARP was just a massive delaying tactic. The capital infusions (putting aside that it wasn't really capital but money the Federal government borrowed that must be repaid) were designed to prevent the banks from going insolvent on further asset write downs. But the whole logic of the deal was that asset values would stabilise and even improve, meaning the banks wouldn't have to take losses or raise more capital.

Give it time baby. Time heals all asset values, right?

No. It all goes back to what you mean by "troubled." And this is the real heart of the issue behind our mistrust of the stock market rally. There has been no real improvement in the quality of troubled assets in the last year. In fact, they are more troubled than ever. The financial system remains troubled, and not much in it has really changed.

This leaves the highly-leveraged banks in the same precarious position as they were before, albeit with slightly more confidence from a gullible public. But at the balance sheet level, have things really improved? And more importantly, have the trillions in assets in the financial system related to residential and commercial real estate really become more valuable in the last six months? Or is just a Ponzi Finance pyramid of junk waiting to go up in flames?

In our view, the last year has been a policy and regulatory sham to cover the retreat by bankers. The people heavily invested in the old system of debt-based asset appreciation are stalling for time. They hope that the passage of time will improve earnings for a quarter for two.

And if they are the religious sort, they pray that some other scheme will be established to take the troubled assets of their hands. But time cannot heal troubled asset values. Faith healing doesn't work in financial markets. We'd humbly suggest that the day of reckoning is still out there, hiding somewhere on the calendar, waiting to rise again. Until then...

Dan Denning
for The Daily Reckoning Australia

• Normally Small Businesses Lead the Economy Out of Recession
• Meredith Whitney and the Buy Recommendation on Goldman Sachs
• Rising in Defense of Goldman Sachs
• Warren Buffett is Buying Four Percent of Goldman Sachs
• Is the Macquarie Model Dead?

On the latter, here's what Addison had to say:

"'Deflation now, inflation later' is a mantra we've adopted at The Daily Reckoning. The Federal Reserve, through it's program of quantitative easing, is busting the seams of its own balance sheet in order to fight a deflationary trend in the West. At some point, the tide will shift. Mr. Bernanke assures the world he's watching inflationary indicators like a hawk. We have our doubts whether those indicators will do him any good. As Paul Volcker, the great inflation slayer of the early 1980s, said when we interviewed him for I.O.U.S.A. 'Once inflation gets started, it's very hard to stop. And there's a strong flavor of that at the moment.'

To read Addison's full interview, see here.

"Global trade rose at its fastest rate in more than five years in July," The Financial Times reports, "suggesting the economic recovery is feeding through into commerce."

"I've been worried about the effects of protectionism in shutting off different markets and making a weak economy even worse off," says colleague Chris Mayer. "Commodity markets especially need open markets to function well. The EU, for example, just put a 40% tariff on Chinese made steel pipe. That's not good for steel pipe demand and hence, the steel makers and the commodities that go into steel. If we see widespread adoption of such measures, we'd have to re-think some things.

"But so far, it looks like we've got a recovery of some kind in global trade. When I look at the global economy, many of the bright spots stem from surging trade along old trade routes (such as China and Arab world)."

Racehorse prices are in freefall, says a report out yesterday. But collectible cars are still doing well.

Yesterday, we saw someone drive by in a huge, gaudy pink Cadillac from the 1960s. It had magnificent fins and enough chrome to stagger a blind man. In it were a middle-aged man and woman, looking very comfortable and proud. They were traveling in style...in a rolling sculpture.

Old cars are not only holding their values, they're still going up. But not all old cars. Detroit's muscle cars have been falling in price for the last three years. Not very green?

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Dubai and Abu Dhabi: Newcomers to the Global Finance and Trade
• How to Trade Gold Shares
• The Aussie Dollar as a Measure of Global Risk Appetite
• Australian Trade Deficit Grows for 75th Consecutive Month

We said we were doing some serious thinking this week. Maybe it is the season. But more and more, our thoughts become grayer. Less black. Less white. Less hard. Less soft.

A few years ago, it looked to us as though the world financial system had gone to war. We cheerfully awaited the victory parade. We figured Mr. Market would whup the feds good and hard. It hasn't happened so far.

On one side, are the forces of a natural market correction...following a long, long period of expansion. The easier money gets, the more people tend to misspend and mis-invest it. Then, inevitably, their mistakes must be corrected. That's what bear markets and recessions are for.

But the feds don't like bear markets or recessions. And at least since the Keynes outlined his general theory back in the early 20th century, they've believed that they don't have to put up with them. Keynes took a page from the Old Testament. Government should act like an enlightened Egyptian Pharaoh, he didn't say, but should have. It should run surpluses in the fat years and deficits in the lean years...thus flattening out the pattern of boom and bust.

Pharaoh was no dope. He stored up grain for seven years, when the harvests were bountiful. Then, when the seven lean years came, he released the grain to the people. Problem solved.

Keynes believed that modern government could do the same thing. But Pharaoh was not running a democracy. He had no voters to answer to. So, if he wanted to store grain in the fat years, he could do so.

In theory, the US government could do the same. But, in fact, it never runs significant surpluses. There are too many people who want too much bread and too many circuses. And you don't win votes by denying the voters what they want. So, in practice, the feds run deficits even in the fat years! Last year, before the downturn really started to bite, the US federal government ran the biggest deficit in history - nearly half a trillion dollars.

Now, let's imagine how that would work for a bad Pharaoh. He would give out grain in the fat years. This would encourage farmers to produce less grain. Then, when the lean years came, Pharaoh would have no grain to give out...and the farmers would have less grain stored up themselves, since they grew less during the boom years. The famine would be worse than ever.

Then, if we can imagine that Egypt was trading with China at the time, perhaps Pharaoh could borrow grain from the Zhou dynasty to help ease the peoples' pain. Perhaps he could mortgage the pyramids. Whatever, he - and the Egyptian people - would have been in much better position if he had done as Joseph told him in the first place...lay up stores in good times, then draw them out in bad times. How difficult is that?

But Bernanke didn't see the famine coming. Neither did Geithner. Or Greenspan. Or any of the other savants Pharaoh used to interpret his dreams. None of them expected hard times. None of them warned the public. None of them encouraged the government to save money for the recession. Nassim Taleb asks why Bernanke was reappointed after he clearly failed the most critical test. But heck...the federal government is an equal opportunity employer. Employees aren't let go just become they're incompetent.

Anyway, getting back to our thoughts...

..it looked like a battle to us - between the forces of inflation (the feds)...and the forces of deflation (the market). But battles usually have clear winners. One side is master of the field and the other retreats. One side is victorious; the other is defeated.

Alas, some wars produce no hosannas of success...and no wailing widows of failure. Some end in draws...or in confusion...or in disgrace and bankruptcy for both sides.

Like the bad Pharaoh, the feds saved nothing. Now, they have to try to work their Keynesian magic on credit. This puts them in a weak position; like a government that wages war on borrowed money. They can continue their campaign only as long as lenders allow them. They can't wage the war as effectively as they'd like. Then again, maybe they can't lose it as spectacularly as they might.

For the moment, their credit is still good. The bond market foresees an inflation rate of less than 2%. Bankers, taking money from the government, are happy to lend it back to them.

But the forces of the correction are giving up little ground. While stocks rally, the real economy remains in a funk.

"Sharp drop in start-ups," is a news headline from yesterday. New business start-ups are a major source of new jobs. Bad omen.

Even glamour publisher Conde Nast is forced to make cutbacks. It has told employees that they may not spend more than $1,000 a night when they are traveling.

A Pimco economist says savings rates are still going up...and may exceed 8%. This represents hundreds of billions of dollars taken out of the consumer economy. Oddly, while it makes the slump worse, it also helps finance the government's battle against it. Savers buy US debt (albeit indirectly).

So, the battle is still going on...and the outcome is still in doubt.

Bill Bonner
for The Daily Reckoning Australia

• On the Evidence, Stimulus Programs Aren’t Working
• Who’s Afraid of a Financial Meltdown?
• Cattle Prices Have Risen Only 1% This Year
• Historically, the Only Reserve a Central Bank Can Trust is Gold
• The Battle Between the Forces of Inflation and Deflation Wages On

"The incoming economic data in both the US and Canada have improved and for the most part [are] bettering expectations. The dilemma is that market pricing has moved far beyond the fundamentals. Despite the temptation to jump into a 'liquidity-induced' rally...they cannot be sustained without a durable organic economic expansion. The problem is that the global economy in general, and the US economy in particular, is operating on so much medication that it is difficult to conduct an appropriate examination of the patient at the current time. All we know is that the markets seem to have very rapidly now priced in three years worth of recovery.

"The S&P 500 is now up more than 60% from the lows, which is truly amazing and kudos to those who called it. But the question is whether the fundamentals will ever catch up to this level of valuation - usually after a 60% rally, we are fully entrenched in the next business cycle. Never before have we seen the stock market rise so much off a low over such a short time period, and usually at this state, the economy has already created over one million new jobs - during this extremely flashy move, the US has shed 2.5 million jobs (as many as were lost in the entire 2001 recession)."

The markets rise. The economy sinks. It is not sinking as fast as it was. But it is still going down. Month after month, the number of people without jobs increases. Even Paul Krugman says that unemployment won't reach its peak until 2011.

And house prices? Hard to tell what is going on. As Rosenberg puts it, this patient is so hyped up on drugs it's not possible to make a diagnosis. Still, he doesn't look good. There are millions of mortgages that still haven't been tested. Interest only...Alt A...commercial...even prime mortgages. They are facing reset...and refinancing...with collateral prices down 20-30-40%. How can you refinance when you are underwater?

Let's look at the basics. We had a nice thing going. From 1945-2007, consumer spending and credit increased. As long as lenders were willing to lend...and consumers were willing to go further into debt...the economy expanded.

Towards the end, it got a little crazy. And then it blew up.

As predicted, the feds rushed in to save the situation. But they only have one trick - adding more cash and credit. That works every time...until it stops working. And it stopped working in 2008.

Banks don't want to lend against falling house prices. And consumers don't want to borrow when their incomes are going down.

Ergo...the end of consumer credit expansion. Get over it.

But the feds keep at it. And with their help, the markets have bounced up. Of course, a bounce is one of the most reliable features of a market economy. A 50% bounce in the Dow - roughly equal to the bounce after '29 - would take the index to 10,300. We're not there yet.

So, there's nothing unusual or unexpected about this situation. The markets have done what they were supposed to do. The feds have done what they're supposed to do.

So what next?

Ah...dear reader...if only we knew the answer to that question...

Here we are in uncharted territory...terra incognito...

Never before has there been an international monetary system based purely on paper. And never before has it been run by people who believe they can force the market to do their bidding. They are convinced that they can avoid the Japan situation - where the economy dragged along for twenty years - by adding more cash and credit. Bernanke said he would drop it from helicopters if necessary.

Just one problem.... Bernanke can inflate...but only until the Chinese tell him to stop. When China pulls the plug on the bond market, the party comes to an end. That's why the helicopters are still on the ground. And it's why they will only take off when the situation becomes desperate.

In the meantime, we await the ordinary...that is, an ordinary end to a post-crash bounce. That will come with another crash. And another. And another. Until stocks finally hit bottom...and bubble-era delusions are finally all crushed out.

Bill Bonner
for The Daily Reckoning Australia

• The Economy is Getting Worse Not Better
• U.S. Economy is Still Growing but GDP Growth Rates Are Mostly Fraud
• Feds’ Plan is to Reflate the Economy
• Alan Greenspan Says “the Seeds of a Bottoming” Becoming Visible
• Take Away Stimulus Spending and You’ve Got an Economy Entering Depression

..well, maybe not our souls...but at least our convictions.

But look at gold this morning!

Yesterday, we got word that the PPI rose 1.7% in August. Let's see, if producer prices are rising...consumer prices follow, right? Well...usually...

..but these are strange times...

We also got word that retail sales were up...that's UP...2.7% last month - the biggest increase in three years.

Now hold on. We've been saying that retail sales were going down. Not up. Our view of the big picture has a consumer in the center of it. And it's a consumer who is NOT increasing his spending. Instead, he's reluctant to buy anything.

There's a reason for that. He's a guy who didn't save anything over the last 10 years. Now, he's 10 years older...facing retirement with insufficient funds...and scared to death that he'll run out of money before he runs out of time.

The US consumer was counting on rising house prices to pay for his retirement. Now, he's disappointed...and worried. What can he do? He has to cut back. He has no choice. He can't depend on his house. He can't expect pay increases. Having neglected his savings during the fat years...he has to tighten up in the lean ones. He has to save at the worst possible time - in a downturn!

We don't see any way around this situation. We don't see any shortcut. We don't see any way to make it disappear or ignore it. THE CREDIT CYCLE HAS TURNED...from expansion to contraction.

Meanwhile, the feds are muddying the waters. They're trying to fool the consumer...to trick him...to make him think that up is down and down is up. They want him to believe that the fat years are coming back...that he doesn't have to save. In fact, they want to cause inflation...to encourage him to get rid of his money as soon as possible. That's why that PPI figure is important. If they can successfully inflate consumer prices (not just producer prices) the whole picture might change. Then, we'd have an inflationary depression rather than a deflationary one.

Our commodities man, Alan Knuckman, was on Bloomberg Television yesterday, talking about this very phenomenon. (You can watch the whole interview here.)

"What do you make of the PPI numbers?" the host asked him. "They did come in higher than expected. Is inflation going to be a concern for the market?"

"That is always a question," answered Alan. "The fed was trying to spark inflation and get money moving again. There is a delicate balance there, but we're coming off record lows and inflation numbers from last month. That is to be expected. I am not that concerned, but I think you are touching on something very important as far as the market momentum. If the market momentum is so strong right now - the one disconnect is crude oil. It is failing to make the highs, even though the market is. That is something to really pay close attention to I think."

For now, it appears to us that retail prices are still going down. And we doubt that the feds can cause a genuine recovery - simply by throwing money into the economy. You can boost spending when you're in a credit expansion...but not when you're in a credit contraction.

That's why we're suspicious of that retail-spending figure. How much of that is just spending funded and coaxed out by the feds? 60%? 80%? 100%?

David Rosenberg says it's 100%. He's probably right. And what would the economy look like without the phony demand ginned up by the feds? It would be shrinking at a 6% rate. And what will happen when the feds stop goosing it up? It will fall back.

But can't the feds continue stimulating the economy indefinitely? Maybe. Even so, the lesson we learned from the Japanese is that even with huge inputs from the government (the Japanese passed 11 separate stimulus measures totaling some $30 trillion yen) the real economy won't budge. Over nearly 20 years, the Japanese economy went from on- again, off-again recession to on-again, off-again deflation. The government muddied the waters. Still, consumers saw clearly what they needed to do. They had lost money in the crash of '90. Their Bubble Era stocks went down first. Then, their property went down too. They needed to save money for their retirements. This they did, resisting all of the government's efforts to get them to save.

Will the situation be any different in the United States?

Probably not.

Without extra earnings, the only way the consumer can increase his spending is by going further into debt. He is unwilling and unable to do that himself. The banks won't lend him money and he wouldn't take it if they would (at least, that's our view). So what's happening? The feds are borrowing big time - IN HIS NAME. They're running up federal debt - that he'll have to pay, one way or another. This money is then funneled to him in various devious and mostly ineffective ways...resulting in enough activity to make it look like something is happening in the economy.

It's a fake. It's a fraud. It's fundamentally counterproductive. But it's all it takes for people such as Ben Bernanke to believe the economy is recovering. Today's headline news:

"Bernanke says recession 'very likely' has ended."

And so, our convictions are put to the test. Everything seems to be improving. The numbers - many of them - show an increase in business and retail activity (New York's manufacturing index is at a 2-year high...).

The commentators, economists, and analysts all say things are getting better (except for those who know what they are talking about)...

And the stock market is still going up. The Dow finished up 56 points yesterday. Gold closed at $1006 yesterday. This morning, it's up to $1017. (More about gold later in the week...we've done a lot of drinking on the subject...) And oil is just under $71.

So, who's right? Who's wrong? Us? Or them? We say there is no real recovery going on...and there won't be one. They say the recovery is already here.

Stay tuned.

"You can still sell property," said brother Jim. "But only if you're willing to discount it."

Jim is visiting from Virginia. He is a real estate agent of some renown in Charlottesville, VA, dealing only with large farms and estates. His customers are on the golden side of the light spectrum; they tend to pay cash.

"Yes, these are not people who need to mortgage property. But the story is not very different. They still have their lives...and their problems.

"What's happening now is that there aren't many buyers and those who are buying expect to get very good deals. So, you can still sell a nice property, but only if you're willing to heavily discount it.

"Prices are down, say, 20-30% from where they were a few years ago. But the buyer wants another 30% discount. Not many sellers are willing to give up that much, so in my area there aren't many sales that go through.

"I'm lucky because I've been at it a long time. People know me. So when they want to move a property...or to buy one...they contact me. But I have to tell them what's going on. And I tell them that if they're not willing to sell at a big discount, it will be hard to sell at all.

"As I said, most people just sit tight. But a few get into situations where they don't have a choice. One poor woman has gotten sick. She is going into a nursing home and apparently the children need the money to pay her medical expenses...so they're forced to sell. Sometimes there's a divorce that forces a couple to sell a place. Otherwise, not much activity.

"And I feel sorry for all those real estate agents who came into the market over the last ten years. What do they do? There aren't enough transactions to keep them in business. But what else can they do? They're not a lot of jobs open in other areas either.

"My guess is that they are all treading water...hoping for a change...living off savings...until they have to make a big change."

We wonder how much of the economy is treading water...hoping for a lifeline...hoping that all this talk of 'recovery' is going to make it possible to avoid any unpleasant changes... hoping that things go back to the old normal...that somehow, everything will be all right again...

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Baby Boomers Face Early Retirement With No Money Saved
• What’s a Consumer Economy Need in Order to Keep Growing?
• Recession for the Japanese Economy Once Again
• Zero Percent Interest Rate Didn’t Work for the Japanese
• Lending Money Below the Inflation Rate

Thus sang one of the characters in an operetta by Jacques Offenbach. But that was in the mid-19th century.

But hey...what goes around...

Guess what happened last year? According to a study from Boston Consulting Group, the only area of the world that got richer last year was Latin America...led by Brazil!

The rest of the world got poorer by 11%, according to BCG. Down in the rum and sun zone, on the other hand, they got 3% richer.

So maybe our investments in South and Central America will turn out all right after all.

Meanwhile, back in the developed world...what's going on? There are two main schools of thought. Ours. And theirs.

Who's right? You decide.

'They' say, 'The crisis is over.' We can thank our lucky stars - and the feds.

Now, we're getting back to 'normal'...or maybe a 'new normal,' with lower growth rates than before. Janet Yellen, San Francisco Fed governor, says the recovery will be 'tepid.' Others say it will be weak...soft...drawn out.

"The slowest recovery since 1945," says a Bloomberg report.

It may be slow, they say, but it's sure. The stock market proves it.

Stocks are up 65% worldwide, with the United States a laggard...stocks in the US are up barely 40%. The Dow rose 21 points yesterday - still a long way to go to get to the 50% rebound mark, at 10,300.

Gold closed down, but still over $1,000. And the dollar continued falling - reaching $1.46 per euro.

In our view, there is no recovery. None. All of the improvement in the economy can be traced directly to bailouts. None of it - not a single penny - is organic, natural or durable. When the subsidies for new cars goes away, for example, so do auto sales.

We wrote a book, Financial Reckoning Day with Addison Wiggin, in 2003. In it, we predicted that the United States would follow Japan into a long slump. We thought it would begin after the tech crash of 2000. We were wrong about that. But it seems to be beginning now. And the government, predictably, is doing the same things the Japanese government did - despite Bernanke's assurances that he won't allow the country to fall into the Japanese deflation trap.

One thing the Japanese did was to reduce interest rates...practically giving away money to anyone who would borrow it. But Japanese consumers didn't want to borrow; they wanted to save. They had speculated on the bubble and lost money. Then, with retirement approaching they wanted to replenish their savings and rebuild their balance sheets.

So, the Japanese government put out money...and it was taken up by speculators, not by the real economy. The speculators borrowed yen, at very low interest rates, and then reinvested the money in go-go sectors elsewhere - such as the US dotcom bubble. The yen became the world's "financing currency." If you wanted to build a factory in China or speculate on Argentine bonds, you could begin by borrowing cheap money from Japan. Thus, Japan contributed to a huge boom all over the world. But not in Japan. The land of the rising sun never seemed to get up in the morning. Property investors lost 80% of their money. Stock market investors lost as much. Even now, nearly 20 years later, they're still 75% down.

And now, along comes the United States of America with super-low lending rates. But who's borrowing? Not the moms and pops of Middle America. They don't have anything to borrow against. And the banks won't lend to them. The banks need money for themselves. Besides, everybody knows the average household in America is losing income.

What's more, mom and pop don't want to borrow. They've been through 10 years of losing money on Wall Street. Stocks are no higher now than they were a decade ago. And their houses - on whose rising prices they had counted for their retirements - have gone down 20-40%. And they're still going down.

The poor moms and pops can't seem to get a break. They're now desperately saving for retirement - at the worst possible moment, when jobs are scarce and wages are falling. But what else can they do?

So, the feds push money into the economy, but it's hot money. It's money that speculators use to place bets on gold...or on Brazilian bonds...or on oil exploration companies. The money never ends up in consumers' hands. It never bids for consumer goods. It never pushes up consumer prices.

As in Japan during the '90s, America's hot money may go all over the globe. It may turn the entire world into a casino. But it won't bring about a real recovery...

..if cheap money from the government were all it took to bring prosperity, Zimbabwe would be richer than Switzerland. Obviously, it doesn't work that way.

But here's the shocker. While we know easy money policies don't create prosperity, you may be surprised to learn that they don't necessarily cause inflation either. In other words, government may be incompetent, even at what it does best.

So, why is gold rising?

Ah...we were afraid you were going to ask. We've been doing a lot of thinking about it. Partly because our Family Office partners are smart people who ask smart questions. And partly because we're wondering what to do with our own gold. Buy? Sell? Do nothing?

We spent half the night drinking and meditating on the subject. Finally, we're not sure we had a clearer idea...but at least we were able to sleep.

We've already unveiled the idea to you. The feds can cause speculation in gold; but they can't easily cause consumer price inflation. As explained above, they can get cash into the hands of speculators, but not into the hands of consumers. Not in the middle of a major consumer retrenchment.

The Roosevelt Administration was faced with the same problem. But back then, gold and the dollar were linked. Roosevelt could devalue the dollar by edict. The Japanese couldn't do that. Nor can the Obama Administration.

In a deflationary credit cycle, you may only be able to cause consumer price inflation by resorting to extraordinary Zimbabwe-style money printing. You can drop money from helicopters, as Ben Benanke promised. But as Zimbabwe demonstrated, that cure is far worse than the disease it is mean to heal.

All of that said...gold can rise...partly because people are betting on it as an antidote to inflation (not realizing that consumer price inflation may be a long way off)...and partly for other reasons.

Lately, one of those other reasons may be heavy buying by the Chinese. The Middle Kingdom wants to diversify out of the dollar. It also has a central bank with very little in gold reserves. What better to do than to diversify out of the dollar by adding gold to its central bank reserves? Word on the street is that it is buying steadily.

The Chinese have made a number of announcements on the subject. We don't really know who's in charge there, so we don't know whose comments to weight most heavily. One Chinese official has said that the government is buying gold and intends to buy more. Another says they will buy "when people don't expect it." Another says the Chinese expect gold to go to $3,000 an ounce.

The Chinese have the money and the motive. They alone could move the price of gold to $3,000 if they wanted to. And maybe they do.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Zero Percent Interest Rate Didn’t Work for the Japanese
• Recession for the Japanese Economy Once Again
• Gold is More Like a Religion or a Political Position
• The Rising Price of Oil Has Done Less Damage in Europe Than in America
• Japan and its Economy Did Not Have Secret to Everlasting Success