Your editor is thinking about beer because he's going to win some of it from Kris Sayce at Money Morning. The Sayceninator was one of several colleagues last week who expressed the view, if we understand them correctly, that the Fed's decision to raise the discount rate last week was a sign of monetary tightening.

This triggered a flurry of speculation what the net effect would be. Sell equities? Sell bonds? Buy bonds? Sell gold? Buy gold? What what what?!!

Our response: don't believe the hype.

So we made a bet with Sayce: if the Fed raises the Fed Funds rate at any time in the next three months, or even fixes short term rates at 0.25% instead of today's free-floating range, we'll buy him three barley pops. If the Fed Funds rate goes nowhere, that's more beer for us.

The market seems to agree with us, so far. After an initial fainting spell on Thursday, it remembered itself and gathered its composure. Granted the S&P and Dow didn't do much on Friday. But they didn't crash, either. And today Aussie stocks have held their nerve as well and sprinted higher.

The simple, unarguable, world-conquering, completely undeniable, not-to-be-disputed truth is that the Fed cannot raise the Fed Funds rate without doing serious damage to an American real estate market that's already in intensive care. We would bet a keg of Heineken on it. Why?

A hike in the Fed Funds rate would do more damage to the collateral on the books of America's banks. It would wipe out more (already thin) capital cushions. And it would undo the work the Fed has done in other markets (securitisation) to get credit flowing. The Fed can't risk all that.

It's not the big money-centre banks in Wall Street you have to worry about. It's the smaller regional and community banks. The Federal Deposit Insurance Corporation shut four more of them over the weekend. That's 20 for this year, which is a lot less than the 140 last year. But if you wanted to see a spike in U.S. bank failures, you'd definitely raise interest rates.

Besides, why bother? The Euro is in slow-motion imploding as a currency experiment. The dollar, as the not-euro, is getting a bid. At the very least, the dollar bears are closing their shorts for now. The U.S. dollar index is still testing resistance at around 80. As Murray said last week, if it can hold 80, the next stop is 84. That's consistent with a much weaker euro.

All of this happened without a puny 25 basis point rise in the discount rate. If the Fed really wants to get tight, it can shrink its balance sheet and quite directly supporting lending and asset prices in any number of markets. Until you say a shrinking balance sheet, don't think Ben Bernanke has suddenly turned in Paul Volcker.

Long-only stock fund managers can sigh a breath of relief then. The easy-money conditions that have led stocks up since March of last year are not disappearing any time soon, as far as we can see. Not that you have an all clear to buy Aussie stocks. But where does that leave us?

It leaves us pretty much in the same position we were to start the month: having no idea what the future holds. We know what SHOULD happen. More global deleveraging ought to lead to lower prices for stocks and real estate and even commodities. We'd expect a bear market in paper money that would have a corresponding bull market in precious metals and precious metals equities.

This is how we resolve having a fundamentally bearish position on the economy but still recommending you own some stocks. Yes, it's risky. But it is a strategy nonetheless.

Still, we can't help but think that official policy makers here still underestimate how vulnerable Australia might be to another credit shock. No one is worried about Australia's sovereign debts because, by comparison, they are a smaller as a percentage of GDP than many other nations. The country's debt burden is lighter, and thus, easier to service.

But if there is another credit crunch in America due to falling commercial and residential real estate values - how eager are American and European lenders going to be to to lend money to Australian banks? Won't they want to conserve capital instead? And then where will the money come from?

This leads us back briefly to a few more facts about Australia's net foreign debt. And here we mean the debt owed by households and corporations too, not just sovereign debt. Based on the maturity schedule of the debt and composition of lender countries, we'd say Australia could have a massive debt shock rather easily.

That would put the Federal government in the position of lender or debt guarantor of last resort. And THAT could quickly lead to rising government debt-to-GDP ratios-exactly the same kind that blew out in America and Europe in the last two years due to similar circumstances. But where's the proof?

First, have a look at the chart below. It shows that the UK, the US, and Japan make up combined make up 49% of Australia's foreign debt country. To the extent the banking resources of these countries will be dedicated to saving their own hides in a second credit crisis, you can assume they might not have as much money to lend here. That leaves a huge burden on the remaining lenders, including the 32% classified as unallocated (whoever that is).

But the problem is more serious when you read about the maturity schedule of Australia's foreign debt. According to 2008 data, over $400.1 billion dollars of Aussie foreign debt - or 35.4% of the total - matures in 90-days or less. Nearly half the debt total - $514 billion - matures in one year or less. What does that mean?

We think it means two things. First, that's a lot of debt to roll over in a short period of time. It gets even harder to do when your lenders have bigger fish to fry. Second, it makes your borrowing a lot more interest rate sensitive. You may indeed be able to borrow. But it will cost you a lot more to do so. And you can be sure that if the Big Four Aussie banks have to pay higher rates internationally, they're going to pass on those rates domestically. We'll see what happens to housing finance commitments then.

One guess is that the government will have to pony up more money in the residential mortgage backed securities market (RMBS). The government has pumped more than $8 billion into the market since 2008, according to Danny John in today's Age. This means the housing boom is being propped up by government borrowing to support lending.

There are more than few outrageous aspects to all of this. For one, it looks to use like many of the non-traditional lenders who are financed via the AOFM are loosely affiliated with Big banks anyway. It's a way for the Big Banks to practice high-risk lending and sell the loans to the AOFM, all in the name of making housing "affordable" to people whom the Big Banks won't lend to on their own balance sheet. That's pretty shady.

The issue for Australia is whether the back-door rigging of Aussie house prices by the AOFM will eventually endangers Australia's ability to pay its sovereign debts. Granted, $8 billion here or there hardly seems like the sort of thing to break the national bank these days. But it's the trend that concerns us.

That trend is that in markets where traditional financiers and lenders won't participate, the government is forced to come in and put the public balance sheet on the line. There are few markets more politically important than housing. You can see why the government is committed to supporting prices even if it means supporting friendly affiliated non-bank lenders with billions in the securitisation market when few others will.

But our question this week is what happens to that $500 billion in foreign debt with a maturity date of less than one year? What happens in another credit crunch if Australia's main borrowers - and let's be clear it's the big banks and financial companies we're speaking off - have to pay more to borrow (assuming they can get it?)

One obvious answer is that the federal government will have to step in. This could lead to transfer of private liabilities on to the public balance sheet here in Australia in just the same fashion it happened in the U.K. and the U.S. And for a nation already carrying a large foreign debt burden, it might not take much for such a crisis to put the federal finances on incredibly unsteady ground.

But maybe we're just grumpy because it's Monday.

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• A National Mortgage Bubble
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Australia to Borrow as Much as $300 billion
• Wage Pressure in China to Drive Up Cost of Goods in Australia

But on to financial markets. The not-so-big news from Wall Street is that the Fed will not be raising the price of money anytime soon. The kingpin of the banker's cartel told the market it would keep short-term interest rates "exceptionally low" for "an extended period of time."

Stocks gave a muted "woo hoo" and rallied about 40 points on the Dow. The rally was weak because low rates for most of this year mean several things, most of which are bad. For one, the Fed isn't sold on the recovery story. It thinks the economy needs cheaper credit to build more momentum.

Secondly, higher short-term U.S. rates would push up ten-year rates. That, in turn would push up mortgage rates. And that, in turn (coupled with falling home prices) would be a death blow to the millions of Americans hanging on to their homes by the skin of their teeth.

That's not what the Fed said, of course. It actually reiterated its intention to stop purchasing mortgage backed securities in March. So far, the Fed has pumped nearly $1.25 trillion into the market to keep lenders to lending to all those first home buyers taking advantage of the tax credit from Congress.

In any event, today's news was mostly a non-event. There was finally some dissent on the rate policy from Kansas City Fed President Thomas Hoenig. He reckons the Fed has been too lax already and the economy doesn't need low rates. But for the most part, the Fed is still intent on financing America's debt recovery program with more debt.

Should we talk housing for a moment? How can we not? In the U.S., new home sales fell 7.6% in December after falling 11.3% the month before. All that government tax tinkering is increasing volatility in home sales. But that's what happens when you alter incentives willy nilly.

The U.S. Commerce Department said 374,000 new homes were sold in December. That was the lowest monthly total since the Department began keeping figures in 1963. What's more, new home prices fell 3.6% to a miserly $221,300. Granted, that's more expensive than the median price for an existing home. But heck...it's starting to look affordable to buy a house in America again...if you can get a mortgage.

In Australia, we can't say the same thing. Prices are soaring in Australia's capital cities, according to data realised by the Australian Bureau of Statistics. Melbourne led the pack with an 18.5% increase in 2009. Hobart clocked in with a 14.4% increase, while Darwin was next at 13.5%, Sydney at 12.1%, Canberra at 10.6%, Perth at 8.7%, Brisbane at 7.7%, and Adelaide at 2.4%.

As a contrarian, Adelaide interests us the most. We were just down there over the weekend. There are some lovely old homes. Sure, it's a bit quiet. And the median price of $427,109 is not cheap. But it's not cheap anywhere in Australia at the moment. The national median price for the December quarter is $525,524 - up 12.1% for the year.

That's insane.

While Australians march down the path of a national house price obsession/mania, the world's bond traders are firing warning shots. Bloomberg reports that, "Credit default swap (CDS) protection buying against sovereign debt default has spiked to five times the level of similar protection bought for corporate bonds, as the potential for a wave of sovereign debt defaults intensifies."

A credit default swap is way of buying insurance against a default in your bonds. AIG, for example, got into big trouble (along with Tim Geithner) for selling insurance on sub-prime backed bonds purchased by Goldman Sachs and other investment banks. When the underlying collateral (U.S. homes) went bad, the bonds fell and the insurance kicked in, taking AIG (and nearly the U.S. financial sector) with it.

Bloomberg's story shows that credit default swaps have jumped for 54 sovereign governments since October by an average of 14.2%. In Europe its worth, with Portugal's CDS rates rising 23%, Spain's by 16%, and Greece's by 5%. But what does it mean?

Well it means traders think we're right. Well, that is, it means 2010 is the year the GFC becomes a sovereign debt crisis. National governments were able to backstop their respective financial systems by greatly expending debt-to-GDP levels. But in some cases, those levels are so high that bond traders rightly wonder if those governments can make good on their debts and still function.

The fact that CDS spread are rising means traders reckon government finances in some nations (especially those in Europe that have no independent fiscal policy, i.e. the means of printing money to pay the bills) are in for a tough year. But then, it's going to be a tough decade for the nation state.

The nation state itself is a relatively modern organisation. It's a way of allocating power (the monopoly on violence). And, when it's consensual, it's way for free people to guarantee that certain rights and liberties (that existed prior to government) are protected in an organised fashion.

But at some point - and we reckon it was the evolution in British finance in the 17th century - the funding model of the nation state turned a way of securing property and individual liberties into a way of making perpetual war. The nation state became the Warfare/Welfare state through the invention of perpetual debt financed by customs, excise, and income taxes.

And here we are in the globalised, iPadded world of today, where the funding model of the nation state is breaking down. It's not able to deliver prosperity. And in some cases it can't even deliver security. So what can it do? It can project power and coerce tribute from its citizens through taxation.

Of course some States are better than others. And we reckon that question - where is the most secure place for myself and my assets - is the most important investment question this year. Not whether house prices and interest rates are going to keep rising.

Dan Denning
for The Daily Reckoning Australia

• U.S. Bonds Better than Greek or Other Sovereign Bonds
• U.S. Home Sales Up Because of Congress Tax Credit
• It All Comes Down to Debt Again for NAB
• U.S. Government May Default On Its Debt
• Aussie Stocks on Tenterhooks and RBA to Decide on Interest Rates Increase

For starters it looks like we missed a $45 down move in gold. All up, gold is down over $100 in the last two weeks. Gold is still up nearly $300 in the last twelve months - or about 35%. But if you're a new gold investor - and many people are - a $100 move down gives you the willies.

The nice thing about being away from the news cycle for a week is that it gives you time to think. We did a lot of thinking last week. And a lot of listening. Our main observation for the week is that things are probably unfolding in just the way we're expecting, but not exactly at the pace we expected.

We'll get to what we mean by that. But we should have a look at the markets and see what's cooking. Behold the Santa Rally, says equities analyst Julia Lee of Bell Direct! Lee says that despite five daily declines last week, the index has risen in December twelve times in the last sixteen years.

"The Santa rally is not just a figment of the imagination," Lee says. "If history is any guide, expect another one this year to top off a year of strong gains."

Yes Julia, there is a Santa Claus! His name is Ben Bernanke and he drives the Fed Sled filled with money. But strong gains?

Well, it's true. The S&P ASX 200 is up over 1,000 points and 25% from where it began the year at 3,659. And from the lows the rebound is even more impressive. From the March sixth low of 3,111, the index is up 48%. Merry Christmas!

Not to be a Scrooge about things, but in that 16-year period, there WERE four years in which Aussie stocks did not rally in the month of December. Out of curiosity and for the sake of thoroughness, maybe those are worth investigating. Those years are 2000, 2002, 2007 and 2008.

You could say that in two of the last three years, the Santa Claus rally has failed to show, but that would not confirm the happy story. So what, if anything do those four years tells us? Are those four years recent evidence that the 16-year trend of happier Decembers is over?

Well you should know we don't really care about what happens in December. It's the longer trend that matters most. And by our reckoning, those four years DO matter a lot. They tell you a much different story about what to expect NEXT year.

Our version of this Christmas story is that a long-term bear market began in 2000. This was the fall-out from the dot.com boom and the end of an 18-year bull market in stocks that had begun in 1982. Left to its own devices, the market would have declined to more reasonable valuations and companies would have sorted out real ways to grow earnings.

But you know what happened next. Alan Greenspan cut interest rates over and over again. To be precise, the Greenspan Fed cut the discount rate 13 times from January 2001 to June 2003, lowering it from 6.5% to1% and leaving it there for a year. Cometh the rate cuts, cometh the boom.

However, to paraphrase an old saying, you can lead investors to liquidity, but you can't make them buy stocks. The rate cutting frenzy didn't save the stock market until 2003. But by then, low short-term rates had dragged longer-term rates down in sympathy. This lowered mortgage rates in the States, kicking off a mortgage bubble.

You know the rest of the story. Through CDOs and the magic of securitisation, America's mortgage boom was sold, via Wall Street, to the world. And in 2007 and 2008, that boom went bust, along with a lot of other leveraged asset bubbles made possible by historically low global interest rates.

Those four years, then, in which Aussie stocks did not finish up in December were all years in which the primary forces of deleveraging asserted themselves. In the first two of those four instances, rate cuts spurred rising asset prices again. But in 2007 and 2008, rates had already been cut as low as they could go. Which brings us to today - where stocks are again up and seeking further stimulus.

But today, interest rates are rising. It will be interesting to watch Wednesday's GDP figure. A weak figure (which economists are predicting) may slow down the Reserve Bank in its rate rise campaign. But that may not matter all that much anyway.

Our main observation - the one we gained from thinking and talking last week in South Africa with our mentor Bill Bonner - is that stocks are probably better sold than bought in the next decade. Not only are valuations high at these prices, but it's the trend that matters - in a world of excessive public debt and deleveraging, corporate earnings aren't going to grow at the go-go rates of the boom years.

Mind you stocks may be a better hedge against inflation than bonds. Bonds are probably the great "short" opportunity of the next ten years. But you have to be pretty selective with stocks. You have to pick industries or sectors that will do relatively better than declining paper money. Luckily for Aussie investors, we think that means precious metals and energy shares.

But who knows? Maybe that's just the jet lag talking. Still, when you step away from the computer screen, turn off your mobile phone, and stay away from the television, a funny thing happens these days. Time gets less compressed.

With the omnipresent news cycle, there's an urge to digest every piece of news as it comes in and instantly discount what it means to the economy and stock prices. But this is nonsense. In the aggregate, there IS some immediate pricing in of what people think "the news" means. But "the news" does not generally trump "the debt" or "the fundamentals."

The more we think about it, the more we think people are thinking less and reacting more. This leads to pricing mistakes; bubbles on one hand and oversold or ignored assets on the other hand. The problem with a liquidity boom is that it's hard to find anything that's really oversold. You have to settle for avoiding the obvious traps and picking your other targets carefully.

And finally, on a completely unrelated note, do a peacock's feathers contribute to its survival strategy? Whenever we see any kind of physical trait or behaviour in nature, we assume it exists because it promotes the survival of the animal or its species. We can understand how a peacock's feathers make it attractive to potential mates. But what about predators?

Of course in the garden at the hotel we were staying at in Johannesburg last week there were no predators. A solitary peacock was presenting himself/herself to some French airline pilots and Arab oil men. In exchange for the extravagant effort it was served up a few bread crumbs. It probably came out ahead in terms of calories received versus expended, putting on the show.

Incidentally, asking how a social behaviour is useful in evolutionary terms does not always work with human beings. Why? Surplus. Human beings - at least a fair portion of those living in 2009 - have more surplus time and calories than probably any other animal in the history of the planet.

This huge amount of surplus - partially a function of the misallocation of resources from the credit bubble - allows people to do indulge in incredibly stupid and wasteful behaviours, like karaoke and politics. Spend a few hours waiting in line in an airport and you'll quickly come to the conclusion that without so much surplus (and the division of labour) quite a few of today's homo sapiens wouldn't last long in a world of scarcity. They would be lion food.

Fortunately, 300 years of free trade has built up a lot of accumulated social and real capital in the world. Lions can be seen in zoos, circuses, on the television in high definition. They don't have to be dodged on your way to work (although that might make an excellent reality TV show). For most people, living standards have risen. But most of that was a function of cheap energy and cheap credit. And today...we reckon both of those economic inputs are getting more expensive or scarce. Uh oh.

Dan Denning
for The Daily Reckoning Australia

• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• The US Dollar Showing Signs of Life
• Investors Are Thinking: Inflation is Coming, But it Isn’t Here Yet
• Profiting From the Copper Indecision
• Are Aussie House Prices in a Bubble?

"Fed takes first step in exit strategy," is the headline in The Financial Times. A more accurate headline would have been...

"Fed dodges and weaves...fakes exit."

The only way to exit is by the door the Fed came in. It barged into the market buying up toxic assets and Treasury notes and bonds. In order to get back out the door, it has to get rid of all the debt it gobbled up. How? It has to sell them back to the people it bought them from - or to someone else.

Instead, the Fed has come up with a subterfuge: the reverse repo.

"In a reverse repo," The Financial Times explains, "the Fed sells assets, such as Treasury securities, to dealers for cash, with an agreement to buy them back later at a slightly higher price..."

No kidding. That's what it says. Now, let us put the question to you, dear reader. Having thus reverse repo-ed a boatload of debt, has the Fed:

a) unloaded its unwanted debt and drained liquidity from the system,
b) not unloaded any debt at all...but merely lent out the credits at negative interest rates
c) postponed the problem until later?

If you answered "all of the above" you are not paying attention to the choices we've given you. It's not on the list. Still, it's probably the right answer...

The Fed says it's going to try out this reverse repo trick and see how it works. We can tell them now. Save them some trouble. Either the Fed is the bagman of bad US debt, or it is not. It is either in or out. Long or short. Either Fannie Mae, AIG, GM are backed by the government or they're not. If they're not, the market will sort them out in its own good time. If they are the bagmen...well, then, the feds will squirm and dissemble...get themselves in deeper and deeper...until, finally, the bags drag them beneath the surface.

This reverse repo is just a scam to disguise the situation...so the Fed can pretend to exit without actually going out the door.

We talked about the origins of US government scofflaw-ism a couple of days ago and promised a follow up. What sparked the idea was the recent newspaper report that President Obama has called for an extension of George Bush's post-9/11 emergency measures - such as eavesdropping and the suspension of the Bill of Rights in terrorist cases. Today, we see that he has announced another troop surge in Afghanistan, with no declaration of war from the US Congress (whom would they declare war against?) We pin this lawlessness on Napoleon Bonaparte's nephew, Charles Joseph Bonaparte.

This story comes to us from one of our favorite raconteurs of Baltimore history - H.L. Mencken. It answers a question we posed ourselves for many years: what happened to them? The Bonapartes of Baltimore...that is.

Jerome Bonaparte, Napoleon's younger brother, came to Baltimore in the early 19th century. There, he met the beautiful Betsy Patterson, from a prosperous Scotch-Irish family that gave its name to a leafy park that later became a center for drug use and homicides. But back in the 19th century, Baltimore was still a civilized place. And when Napoleon's bro' came, he was apparently attracted both by the energy of the place as well as the seductive charm of Ms. Patterson.

Jerome stayed in Baltimore long enough to leave his name on the founders' brass plaque in the Maryland Club, of which your editor is a member, and to leave Ms. Patterson with child. Later, under Napoleon's heavy thumb, he rejected his Baltimore connections in order to aim for something grander, leaving the aforementioned Ms. Patterson abandoned in Paris...later to return, enfant en main, to Baltimore. This issue - Jerome Bonaparte-Patterson -- had two sons of his own, one of whom, Charles Joseph, devoted himself to public service....which is to say, he became a dangerous and meddlesome hack. Somehow, he caught the eye of Theodore Roosevelt, who had just enough knowledge of history to be flattered at the thought of a Bonaparte under his command, so he put him in as his Secretary of the Navy.

"He was the worst Secretary of the Navy ever heard of," writes Mencken. He did not move to Washington, which was seen as a step in the wrong direction in those days. Instead, he kept his house in Baltimore and took the train down to the Navy Department in Washington. By the time he got down to work it was time for lunch. After dinning, he turned around and went home.

This proved that he had the talent for even greater responsibility in Washington, so Roosevelt elevated him to Attorney General. Normally, a semi-comatose Attorney General is the best kind. He is not chasing terrorists or Dadaists or climatologists. Bonaparte was one of the best. For three years, he did nothing. Then, something stirred him to action. Roosevelt had his eye on a group of Italian immigrants in Paterson, New Jersey. He was sure they were undermining the republic with seditious literature. They were anarchists, with a small circulation newspaper, written in Italian, who were no danger to anyone, except perhaps themselves. Nevertheless, Roosevelt thought he heard the walls crack. He was determined to stop them before the roof fell in. So he put his Attorney General on the case.

The trouble was that Mr. Bonaparte had sworn to uphold the law of the land. And the law of the land clearly gave the anarchists freedom of the press. It was then that the Roosevelt/Bonaparte team came up with a model for all the scalawags and scoundrels who have ever since smudged high office in the United States of America. They simply ignored the law and banned the Italians' rag from the US mail. Thus was established the hallowed principle of American jurisprudence -- it is perfectly all right to turn your back on the highest and most sacred laws of the land, as long as you can get away with.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Maryland Film Festival This Weekend
• How the U.S. Dollar Came to be the World’s Reserve Currency
• Naturally the Feds Want to Raise as Much Money as They Can
• Irving Fisher Remains Immensely Important in the History of Economic Thought
• AIG to Receive $85 Billion Loan from Fed

Then on Tuesday the market snapped up $25 billion in ten-year notes and yields fell. Sovereign debt? Big whoop! Whether it's the end of the year and investors feel safer in Treasuries, or some other reason, Tuesday's auction showed no signs of an impending "bond fire of the vanities." The bond bubble keeps getting bigger.

Today, though, the market gagged. In an effort to lock-in low rates for longer terms, the Treasury served up $16 billion in 30-year bonds. The market turned sour. Reuter's reports that demand for the 30-year was the weakest since May and that yields moved up as the weak auction triggered selling.

And then everyone seemed to lose their nerve. Stocks fell across the board. Gold set a new high at $1,123.40 in New York trading, before retreating. The weak 30-year auction has people thinking...what happens when Treasury supply overwhelms demand?

What will happen to bond prices then? To inflation? What should I do?

The rest of today's Daily Reckoning will be devoted to some constructive apocalysm. We may have left the impression yesterday that there was nothing but pain and heartache ahead for investors. But that doesn't have to be the case. But you have to start with the big picture. And that begins with the end of the bull market in bonds.

Check out the chart below from Ron Greiss at the www.thechartstore.com. Ron's chart shows long-term U.S. bond yields since 1941. Mostly this reflects the yield on 30-year bonds, although there were periods where 30-year issuance was discontinued. Either way, it shows a great cycle...which appears to be bottoming out.

What story does this chart tell? We reckon it shows you why the U.S. government (and so many banks and borrowers) are eager to sell as much debt now as possible. Rates are near historic lows. If and when they go up, it's going to make borrowing and servicing new debt even more expensive. Bond prices will fall and yields will rise again.

Now you could say that, according to the chart, there is room for another decade of low yields. The Fed, for example, could move to set rates further out on the yield-curve. It only sets rates right now for short-term debt. But the quantitative easing program has moved the Fed out to ten-year yields. It's done this to try and keep mortgage rates low, as mortgage-rates are keyed to U.S. ten-year yields.

But we reckon not even the Fed can keep yields low forever by supporting prices. It will have to wind down its programs eventually. For example, the U.S. government ran its largest October deficit ever last month, at $176 billion. Between demographics and existing debt, the Fed may not have the resources to support bond prices too.

Besides, you'd think markets would begin to tire of U.S. debt, given the lousy fiscal position of the American government. At least that's what we'd think. And if we were trading it, we'd look for put options on ETFs that track bond prices, or call options on ETFs that track bond yields. That would be the cheap trade.

The investment decision is to find assets that out run inflation as bond yields move up. Granted, this assumes there is going to be inflation, which is a whole other argument. But if you'll grant us the assumption, we'll continue with the strategy...of finding assets that beat inflation.

You don't have to look far. Gold...oil...iron ore...tangible assets are what you're after. Does this conflict a bit with our analysis yesterday that China's resource demand is more fragile than reported? Yes, it does. But it still pays to focus on those resources that will be in demand no matter how bad the global economy gets again. What do nation states really want to own? What can they not do without?

You know they can't do without oil. And you know more and more of them prefer to own at least some gold rather than rapidly devaluing foreign currencies. That leaves us where we began, buying oil and gold and selling U.S. sovereign debt. Production of the first two is hard to increase. Supply of the last one is growing.

"There is a strong case to be made that we are already at 'peak gold'," Barrick's Aaron Regent told London's The Daily Telegraph today. Regent was speaking at RBC's annual gold conference in London. "Production peaked around 2000 and it has been in decline ever since, and we forecast that decline to continue. It is increasingly difficult to find ore."

Gold exploration budgets are up. But with the exception of China, gold production from traditional stalwarts like South Africa and Australia has trended down. Alex Cowie at Diggers and Drillers recently wrote a report suggesting that the best Aussie gold stories are listed here in Australia but digging for gold in Africa, where they incur production costs in U.S. dollars and where there are more greenfield projects than recycled brownfield projects.

Frankly, we have no idea if gold production has peaked. Mine supply could grow this year for all we know. But finding and mining gold is not easy and it's not cheap. And even if the gold supply does grow, we'd take it to the bank that the global gold supply will not grow faster than global money supply.

And oil? Any scenario in which an economic collapse leads to falling GDP ought to mean lower demand for oil and lower oil prices. But the case for oil is not really about the demand side. You reckon that's bound to grow over time anyway, unless someone comes up with table top cold fusion. The real oil bull story is on the supply side.

Earlier this week the U.K.'s Guardian reported that, "The world is much closer to running out of oil than official estimates admit, according to a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying."

" 'The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year,' said the IEA source, who was unwilling to be identified for fear of reprisals inside the industry. 'The 120m figure always was nonsense but even today's number is much higher than can be justified and the IEA knows this.'"

We remember writing about the IEA figure a few years ago. And we remember pointing out that producing 120 million barrels of oil per day would be a 44% increase on producing 83 million barrels per day. And you'd have to find that oil first. You'd have to explore, drill, and produce it. And you'd have to maintain existing production levels at the world's big elephant fields like Cantarell and Ghawar.

In point of fact, production at Cantarell has fallen by 25% since 2004. Energy expert Matthew Simmons says Mexico's days as an oil exporter will end in 18 to 36 months. This makes Mexico's government-which derives 40% of its revenues from oil sales-the most likely candidate for "next failed state."

By the way, if you think illegal immigration is problem in America now (and it is), imagine what would happen if the finances of the Mexican state imploded with a production catastrophe at Cantarell. The Obama administration would face another crisis, but this one right on its massive southern border.

Not everyone believes in Peak Oil. But it's not really a matter of faith. Either oil production is declining or it is not. It does not mean there isn't any oil left. In fact, technology has lengthened the life of productive fields. And technology has also made it possible to find and produce oil in increasingly hostile environments (deep water drilling, the Arctic, etc.)

Even rank and file petroleum geologists are mostly in agreement (and sometimes in disagreement with their corporate overlords) that Peak Oil is real and it's here now. But we make this point not to say that all is lost. It isn't. It's just the great changes in the world are afoot.

You have a secular bond bull that's long in the tooth. The post-war monetary system that supported the expansion of the fiscal welfare state through perpetual debt is failing. Energy, which has been getting cheaper and cheaper for years as we found more and more of it, may start becoming more expensive and harder to find.

That's going to make the world a slightly less friendly place. But for investors, there are heaps of opportunities. For example, right now Alex is looking at what the fallout from next month's Copenhagen summit is. It has opened the door to a great entry point for energy investments, but not necessarily oil. Fear not! Or fear a little. But prepare.

Dan Denning
for The Daily Reckoning Australia

• Attack of the Bond Yields
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• U.S. Bond Prices Rose and Yields Fell
• Higher Oil Prices, the New Normal
• Consumer Price Inflation has Spooked Investors Everywhere

But along came two very important bits of information.

First, we got word that the crisis was officially over. GDP grew last quarter. Thanks to all the Cash for Clunkers, Cash for Bankers, Cash for Houses, Cash for Trash, and cash for every other blessed thing under heaven, the number crunchers were able to report positive economic growth for the third quarter.

Let's not get too excited. Stocks bounce. Bonds bounce. An economy bounces. Even dead economists bounce. And if we're following the Japanese experience, with a long, slow on-again/off-again period of depression, we can expect some quarters of growth, followed by quarters of non-growth. It's going to be a painful adjustment to the 'new normal,' whatever that is.

The other important bit of news was that the Fed - faced with undeniable evidence of growth and prosperity - decided to err on the side of caution. It will keep monetary policy loose from here until kingdom come, if necessary, in order to avoid a Japan-style slump.

But so far, a Japan-style slump is just what we seem to have...and our public officials are fighting it, Japan-style.

Unemployment is headed up. The U6 figure - a more accurate picture of how many people are out of work - is up to 17%. There are 1.5 million homeless children in the US now, including 300,000 in the state of California alone. One out of 10 Americans will not bite the hand of government - for it is the hand that gives him his food stamps.

Foreign direct investment has dropped 30%. International trade is down 10%.

Do you call this a recovery? We don't.

As David Rosenberg puts it, the man on the street is perhaps "less enthused by the fact that a lower rate of inventory de-stocking is arithmetically underpinning GDP growth at this time."

In other words, it's 'growth' that only an economist could love...and then, only an economist who was an idiot. Rosenberg:

"Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go - and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

"Only 29% of those polled believe the economy has hit bottom - imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally - not the onset of a new bull market) has not swayed their view (or ours for that matter). There is going to be some very tough slogging ahead as far as the economy is concerned."

Growth is largely illusional. It is the result of delusional policy- making at the Fed.

So, we'll just keep our Crash Alert flag flying.

Bill Bonner
for The Daily Reckoning Australia

• Markets Rise While the Economy Sinks
• Bear Market Bounce a Sure Thing
• Take Away Stimulus Spending and You’ve Got an Economy Entering Depression
• Come And Get It!
• AIG to Receive $85 Billion Loan from Fed

- Edward Gibbon

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

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

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

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

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

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

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

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

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

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

By European standards, America is cheap.

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

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

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

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

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

David Rosenberg:

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

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

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

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

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

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

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

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

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

So why are people buying bonds with such puny yields?

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

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

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

But what if they're all wrong?

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

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

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

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

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

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

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

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

Bill Bonner
for The Daily Reckoning Australia

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

But first, what the stock market and the economy are doing...

In the past two days, the price of gold has shot up more than $40. It's now near $1,000 an ounce.

Why? We don't know. Rumors, talk, noise...there's plenty of that. But as for why investors are suddenly putting so much money into gold, we'll have to wait to find out.

But should you buy gold now? The answer is simple: yes and no.

The Trade of the Decade is still buy gold/sell stocks. And the decade isn't over. If you have US stocks, this is a good time to sell. The Dow went up 63 points yesterday - a weak bounce after several days of losses.

This is no time to hold stocks - for the reasons we outlined yesterday.

But gold? Should you buy gold and hope to get rich when gold shoots up to $3,000 an ounce? A bad idea, in our opinion. You should buy gold to protect your assets. The risk is in the paper money...because they can create as much of it as they please. And they're under pressure now to create a lot. You buy gold as insurance against inflation, a dollar bust, a bear market in stocks and bonds, or a financial crisis. Gold is nature's money. It is better than manmade money. Because, with gold, what you have it what you've got. They can't artificially depreciate it or easily increase the quantity of it. That's why the feds don't like it. It won't support their cause du jour - whether it is a war, a bailout, stimulus, health care, or whatever. Gold doesn't cooperate with the financial engineers. That's why it's a good thing to hold when you think the financial engineers are making a mistake.

But our view at The Daily Reckoning headquarters is that while the engineers are making a mistake, they not very good at it even when they're making a mistake they're good at. Typically, they're pretty good at causing inflation. But now the credit bubble is deflating, not inflating. It will take them a few years before they become reckless enough to move prices up again. And then, they'll probably overshoot their objectives considerably.

In the meantime, there's no inflation to speak of...no dollar crisis...no bond bust. So we wouldn't expect the price of gold to soar...not just yet. That's the big surprise - that this period of deflation will last longer than expected. Then, when it begins to seem permanent, inflation will suddenly come roaring back.

By then, most investors will have given up on gold...especially those who were speculating on it going to $3,000. It will go to $3,000, but only after speculators have dropped their positions.

So far, everything is happening just as we expected. After more than half a century of boom, we are now in a bust. People need to downsize...cut back...and live a little less large than they had in the boom years. That means...well...just what you'd expect.

Wasn't it just yesterday that we reported that Florida was losing population? People just aren't retiring like used to. Here's comes the evidence:

From The New York Times comes this headline: "Older US Workers Put Retirement on Hold."

The Times tells us that older people are continuing to work because they don't have a choice. They can't afford to retire. So they hold onto jobs, which is another reason it's so hard for the unemployed to find a job. Those who have them aren't giving them up. A Bloomberg report today, for example, tells us that more people are applying for job benefits than expected. Another tells us that millions of people are running out of benefits before they find a job.

Just what you'd expect, in other words. Here are some of the other things we expected:

1. Unemployment is still rising.

"Investors discouraged by US jobs report," says a headline at the International Herald Tribune. To make a long story short, August was a disappointment. More jobs were lost than expected.

We don't know how many jobs we should expect to lose. But we're in the downhill part of the credit cycle; we're bound to lose a lot of them.

2. Sales are falling.

That's another thing we would expect. People have to cut back. So...they do cut back. Sales go down. That means fewer sales and fewer jobs. No point in making things, shipping them and retailing them if no one is buying them, right?

3. What else would you expect? Lower house prices? Check. Higher savings rates? Check. More bankruptcies? Check. Falling prices? Check.

Isn't it nice when things work out "as they should?' Check.

Bill Bonner
for The Daily Reckoning Australia

• Should You Buy Stocks Now to Take Advantage of Bull Market?
• Economy Has to Grow at 1% to Stay Even With Population Growth
• The Bailout is Approve So Now It’s Time to Buy Gold
• You Buy Gold When the Government is Making a Mess of the Monetary Situation
• You Can Lead Investors to Liquidity but You Can’t Make Them Buy Stocks

"You can forget about getting anything done in the month of August," said colleague Simone Wapler. "The French are busy with serious things...real things...like painting shutters and picking green beans...fixing curtains and making strawberry jam. They don't want to hear about economics or markets..."

France begins its summer vacation today. We've come to join them...

But we will keep an eye on the money anyways...because it's just getting interesting...

Two interesting things are happening. First, the feds are facing a showdown with the vigilantes...you know, the people with money - $2 trillion worth of reserves, $1.5 trillion of it in U.S. Treasury paper. They've got to convince them that they'll protect their investment. If they fail, the vigilantes sell their bonds...cause the dollar to collapse...and force up U.S. interest rates - which will come down like Round-Up on those green shoots of recovery.

Meanwhile, stocks are not only anticipating a recovery, they're counting on it. And for that, they depend on stimulus from the feds. But what Bernanke gives in stimulus, the vigilantes are likely to take away...

More on that in a minute...

The other big thing that is going on is the rally in the worlds' stock markets. On Wall Street, for example, the Dow rose 96 points yesterday. How far will this rally go? Should you try to take advantage of it?

As a rough rule of thumb, a bounce can be expected to recover half of the losses from the crash. The Dow went down 7600 points below its pre- crash high. So, we can expect a rebound of about 3800 points - which would put the index back around 10,300. By that measure, this rally could still have a lot of life in it - enough to convince practically everyone that the depression will soon be over. Don't believe it. This depression is going to last at least a few years...and the bear market isn't over. The Dow will eventually close below 5,000. At least...that's our story and we're sticking with it.

But let's go back to poor Ben Bernanke. And poor Tim Geithner. The poor fellows don't seem to know what they are doing. But why should they? Ben Bernanke spent his career as a professor of economics. Modern economics is fundamentally an intelligence-destroying trade. The longer you spend in economics, the less you know about how the economic world functions. Many years ago, the profession got the wrong idea of what it was up to. Ever since, it's been barking up the wrong tree. (More below...)

As for Geithner, he is a smart young man...destined for hackdom almost from the day he was born. Ivy league university...consulting firms...government - a protégée of Robert "Nobody Saw the Crisis Coming" Rubin - you can't blame Geithner either; he hasn't had time to think about how an economy really works.

But at least their mission is clear: to convince the world of two things at the same time...both impossible and mutually exclusive! The Chinese vigilantes must believe that the feds won't undermine the dollar...and the rest of the world must believe that they will! Inflation is necessary for recovery and growth in the United States...or so everyone believes.

It was French economist Jacques Rueff who revealed the scam more than half a century ago. The whole idea of Keynesian stimulus, he explained, was to cause inflation...which would reduce the real price of labor. In a modern democracy, politics prevents wages from falling. But in a correction, if wages don't fall people don't get jobs. Keynes' didn't mention it, but the only reason his stimulus works is because it pulls the wool over the eyes of the working classes - reducing their wages by inflation so employers can afford to hire them again. Ergo, no inflation...no recovery in the job market. No recovery in the job market...no recovery in the economy.

But inflation will cost the Chinese plenty. And they've let it be known they won't sit still for it. Keep reading...

"China seeks assurances that US will cut its deficit," says a New York Times report:

"China sought and received assurances from the Obama administration that the United States would reduce its budget deficit once an economic recovery was under way, a senior Chinese official said Tuesday at the end of two days of high-level talks between the countries.

"Attention should be given to the fiscal deficit," said Xie Xuren, the Chinese finance minister. He said Treasury Secretary Timothy F. Geithner had assured the Chinese that once the economy rebounded, the deficit would gradually come down from its current record levels.

"Mr. Geithner confirmed that, saying, 'As we put in place conditions for a durable recovery led by private demand, we will bring our fiscal position down to a more sustainable level over time.'"

Did you notice, dear reader? Geithner promised a "durable recovery led by private demand." In other words, it won't be government spending that pulls the United States out of its slump, he told the Chinese.

He must have had his fingers crossed behind his back. At this stage, what other kind of demand is there? Are factories being built? Are they hiring? Are consumers borrowing and spending more? As we pointed out yesterday, private demand has collapsed ...and it's likely to collapse even more.

But let's stick with our vigilantes for a while. Inflation would cause them to lose money. More importantly, it would cause them to lose face. American officials have told them not to worry; the Chinese seem satisfied. But woe to the debtor who lies to his creditor; he gets cut off.

Meanwhile, a report from the IMF names Britain and the United States as the world's two biggest spendthrifts...and sees no end coming soon.

A global recovery is "not yet under way" and likely to occur at different times around the world, so pulling back public spending and investment may be "premature," the IMF staff said.

Additional discretionary spending may be needed in 2010, the report said.

The staff report also said inflation expectations are picking up, posing a risk to a rebound in economic growth.

"Preserving investor confidence in government solvency is key to avoiding an increase in interest rates, thereby not only preventing snowballing debt dynamics, but also ensuring that the fiscal stimulus is effective," the report said.

The IMF noticed the fix U.S. officials are in.

"On the one hand, a too hasty withdrawal of fiscal stimulus would risk nipping a recovery in the bud," the report said. "On the other hand, with a delayed withdrawal investor concerns about sustainability may increase, leading to higher interest rates on government paper, undermining the recovery and increasing risks of a snowballing of debt."

The IMF staff urged countries to develop medium-term strategies to rein in rising debt levels. Some countries already have begun to do so, the report said.

The economists at the IMF see this as a problem of "balancing risks." Here at The Daily Reckoning, we see it differently. To us, it is lies colliding with each other. Stimulus will not produce genuine prosperity. You can't cure a credit-caused crisis by offering more credit; it just won't work. But rather than let the system correct itself, the feds are determined to 'do something!' What can they do? They can only destroy the dollar - or try to - thereby destroying the value of China's $1.5 trillion treasure.

Now, more on why private demand is going to weaken, not increase.

As the boom of the post-war period continued, consumer spending played a larger and larger role in the economy. It averaged 64% of the GDP during most of the period, but increased to 70% in 2007. Likewise, debt service as a percentage of disposable personal income rose too - from less than 5% in the '50s and '60s to over 14% now.

If, as we suspect, the trend towards more and more consumer debt has finally peaked out; consumption should have peaked out too. We should now see the percentage of the economy devoted to consumption go down...year after year...until it reaches the 'normal' level. Private debt too should go down, until it is at a more 'normal' level.

We calculated that during the last 7 years of the Bubble Epoque consumers added $1.4 trillion in debt per year. That was the spending that made the old mare go. But now what? They are now adding no debt - zero. In fact, they are paying off debt. This alone removed $1.4 trillion in private demand from the economy.

The savings rate is up dramatically too - from zero to 7%. This is another way of measuring the same phenomenon: the decline in consumer spending.

The only thing that would cause consumer spending to go would be a substantial increase in real wages. This would allow Americans to buy more - while simultaneously paying down debt. But with 16% unemployment (Rosenberg's estimate) it will be a long time before real wages increase at all...let alone substantially.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Investors Are Betting On Recovery
• Roubini Says United States Will Climb Out of Recession Towards End of Year
• Optimists Expect Mild Inflation in a Decent Recovery
• Boomers Made a Mess of the United States of America
• Why Weren’t Economists On Top of This Thing?

It is my contention that we will get neither hyperinflation nor deflation.

What is more likely is that over the coming months, we will get another deflationary scare. Any sell-off in the markets later this year will be met by an even larger stimulus from the policymakers and this will ultimately result in high inflation.

So, I maintain my view that due to the unprecedented policy responses around the globe, the world's economy will face high inflation over the medium to long-term. And the general price level will double over the
coming decade.

In the near-term however, we will probably get another period when the market will (once again) become concerned about the prospects of a lengthy economic contraction. It is conceivable that the 'green shoots' hype currently doing the rounds will soon be replaced by more economic worries as a second wave of foreclosures hits America later this year. So, it is possible that before year-end, we will witness large corrections in stocks and commodities. Conversely, we are likely to see big rallies in U.S.
government bonds, U.S. Dollar and Japanese Yen.

This near-term vulnerability in the markets is the reason why I have recently liquidated my 'long' positions in resources and emerging markets and gained a heavy exposure to long dated U.S. Treasuries. In my view, a
defensive investment stance is prudent at this juncture, as it will protect our capital and allow profit from the expected contraction. Once the pullback in the markets is complete, I will liquidate my positions in U.S. Treasuries and re-invest our capital in our preferred holdings in energy, materials, mining
and emerging Asia.

Look. In the business of investing, the tape never lies and it is worth remembering that Wall Street is littered with the graves of those who got married to one particular outcome and then held on to their ill-conceived
notions. At this point, when private-sector debt contraction in America is locking horns with central bank inflation, I prefer to have an open mind. Therefore, I am maintaining a defensive near-term investment position. If the market corrects over the following weeks, I will be in a position to profit from such a decline. On the other hand, if the major indices simply consolidate here and break above the recovery highs recorded last month, then I will have no hesitation in changing my defensive investment position. Put simply, I am currently watching and waiting patiently for the market to reveal its hand.

Coming back to the subject of this essay, the reason that I don't foresee immediate hyperinflation is because the velocity of money is currently weak. In other words, at least for the moment, the private sector in America isn't participating in Mr. Bernanke's inflation agenda. Despite the fact that Mr. Bernanke has injected a massive amount of reserves in the banking sector, this money is currently sitting as excess reserves within the American banking system. The fact that this money isn't being lent out rules out immediate hyperinflation. However, once the American economy stabilizes and the velocity of money picks up, these excess reserves will trigger a massive inflationary wave.

As far as deflation is concerned, I am of the view that the policy responses and our fiat-money system will ensure that the purchasing power of cash will continue to diminish over the medium to long-term. In fact, I am willing to bet that cash will probably be the worst performing 'asset' over the coming decade. Remember, in today's monetary system, central banks and governments the world over are free to create money out of thin air and this will prevent outright deflation in the global economy.

It is worth noting that in the past six months alone, China's commercial bank credit has expanded by a whopping US$1 trillion! Figure 1 highlights the surge in Chinese bank lending. Furthermore, credit is also expanding frantically in other Asian nations. So, contrary to the West, monetary policy is still alive and well in the developing nations and this factor also rules out outright deflation in the global economy.

In my opinion, rather than hyperinflation or outright deflation, we will witness elevated inflation after the American economy has stabilized. In the interim however, investors should be prepared for another deflationary scare and the associated market panic.

Regards,

Puru Saxena

for The Daily Reckoning Australia

• Inflation or Deflation?
• Inflation or Deflation?
• Hyperinflation and the Dollar’s Monetary Destiny
• Why Inflation Or Hyperinflation Lies in Wait for the U.S.
• Inflation is Our Future