No jobs...

No credit...

No sales...

But look at those stocks!

And oil! And gold! And even London property!

Real estate agents in London say they are sold out...as prices go to records. Well, asking prices...that is. As for sales prices, that is another story.

Still, London is driven by finance...and finance seems to have gotten out of rehab. It's party time again.

The Wall Street Journal is talking about a "full recovery" in luxury goods sales by 2011. And Wall Street itself is pricing stocks as if the record profit margins of '05 and '06 were just around the corner.

In other words...investors' expectations have not changed. They think things will return to the way they were in the Bubble Epoque.

How could that happen? A full recovery implies a number of things...

..that the 'Son of Bubble' will be as big as his dad...

..that all those people without money or jobs will somehow find the wherewithal to spend again...

..and that the baby boomers will stop saving for their retirements and begin to party like it was 2006 again...

Remember, Bubble Epoque spending, sales and profit figures were made possible by borrowing. People spent every penny they earned...and then "took out equity" from their houses in order to spend more.

What they really got was a house with a bigger mortgage - without moving!

At the height of the bubble period, if we recall correctly, Americans were taking out more than $500 billion per year. Now, they're putting back nearly $500 billion a year in savings.

We don't like to be party poopers here at The Daily Reckoning. But there is no way to get a rerun of the Bubble Epoque on those numbers.

What we see happening is a typical post-crisis bounce...powered by easy cash and credit from the feds. How long can it go on? How far can it go? No one knows. But if you want answers, we'll go way out on a limb:

It won't go on forever. And it won't go to the moon.

And most likely...it won't be long before the whole thing comes to a crashing end.

Here's noted analyst John Hussman:

"The stock market has never been this overbought."

Hussman says that the only time stocks were this overbought was on Nov. 28th, 1980. That was the last rebound in the great bear market that had begun in 1966. Afterwards, stocks fell another 30% before finally hitting bottom in August 1982.

That's why we have our Crash Alert flag flying over the headquarters of The Daily Reckoning. We put it up two weeks ago. No crash so far. But it can't be too far in the future.

And more thoughts...

While champagne and caviar is served out in the speculative economy of bankers and hedge fund managers, its bread and branch water for the poor folks stuck in the real economy.

First, we have some figures from the Center for Responsible Lending. Nearly 3 million houses are expected to be foreclosed in 2009. And there are 8 million still to go!

Yes, we've crossed the foothills of sub-prime already. But the Rockies of Alt-A, jumbos, and other salacious mortgage instruments are still ahead.

Bill Bonner
for The Daily Reckoning Australia

• Another Big Wave of Foreclosures
• The Only Thing Really Going Down Right Now is the U.S. Dollar
• La Bubble Epoque
• People Without Jobs Can’t Make Mortgage Payments
• The New Chinese Era

'The Singularity' is an idea from Ray Kurzweil. The gist of it is that computers will soon be smarter than humans; by the middle of this century they'll be smart enough to figure out how to get smarter and smarter, faster and faster.

No doubt, many of them will go into finance. And no doubt, many will make a fast buck. But will more smartness really make the world a better place? According to the singularists, increased brainpower will be able to solve all sorts of problems - from global climate change to market crises.

But the brain is a big disappointment. No mechanical engineer has ever improved the old-fashioned kiss. Nor has any brain ever straightened out the business cycle. Dumb as a slide rule, the brain does what it is told to do; it doesn't ask questions. Tell it to build a bridge and it is on the case. Put it to work packaging tranches of toxic assets or selling aluminum siding...it is just as happy with one task as with the next. And the more a man's brain bends to a challenge, the more it elbows out of the way his finer senses...and the dumber the man becomes. He turns his back on his own intuition as well as the accumulated wisdom from previous bust-ups and bruises. Like a man who has gone crazy, as G.K. Chesterton put it, all he has left is his sense of reason. Then, with nothing more to work with, he comes down on his work like a blacksmith's hammer on a fine Swiss watch.

During the bubble period, the big banks were the biggest employers of top graduates from the world's top schools. Oxford, Cambridge, Harvard, Yale...the financial sector drew them in like flies to an open latrine. The financial industry made so much money it had a hard time explaining it. The smart dudes did not toil in the fields, neither did they spin. Then, what did they do? They earned millions, bought BMWs and got dates with actresses. They claimed they were doing a fine job of allocating the world's wealth and making everyone better off.

But when the bubble blew up, it was apparent that the financial world they created was fragile and perverse. Not a single one of the largest Wall Street banks survived without government handouts. And a news report from this week tells us that Americans were so damaged by the Bubble Epoque that their discretionary spending has now been cut to levels not seen in 50 years. The geniuses wiped out a half-century of economic progress in the richest, most successful economy the world has ever seen.

Smart people were also to blame for the biggest single error of the last century: central planning. The central planners thought they could fix the supposed evils of the natural economy with logic and reason. The idea was so alluring half the world fell for it. If the Nobel Committee had been on the ball they would have given Karl Marx a prize.

If the bug had come from stupid people...smart people might have avoided it. They might have come through the period without permanent scaring. But the wheezy intellectuals behind it were too clever for their own good. They soon infected the top universities...and the government. They convinced almost everyone that central planning was the wave of the future and that anyone who stood against it was a bumpkin, a parasite or a fool. Then, in the name of human progress, they took control in two of the world's largest countries and turned them into prison camps.

But by the last decades of the 20th century it was obvious even to central planners themselves that it wouldn't work; in both Russia and China, the planners simply gave up.

Central planning didn't work because people had plans of their own. They resisted. Then, the planners brought down their hammers. "If you're going to make an omelet, you have to break some eggs," said chef Vladimir Lenin. The "Black Book of Communism" puts the death toll as high as 100 million.

Then too, central planning didn't work for less obvious reasons. Planning requires information. The planners had plenty of it. But private individuals had far more - local, current, more accurate information from first-hand observation and experience. With better information, they could make better plans. Most important, individuals didn't limit themselves to only the fresh fruit of their rational brains. They put their hearts in it...and drew on instinct and tradition - the distilled spirits of previous generations - giving them a huge advantage over the apparatchiks.

But the brains kept at it. When the forensic experts sifted through the debris from the 2007-2008 financial blow-up they found fingerprints from a whole list of Nobel winners. It was they who had developed the formulae and the theories that deceived investors, and themselves. They believed they could tame risk...by calculation! They figured out the odds and worked out prices - to as many decimals as needed to put investors to sleep. And then along came a risk they had not foreseen - the risk that their own formulae were claptrap and that they were idiots.

Meanwhile, the brains were at work in the public sector too. There, they were still pushing central planning...albeit on a much less ambitious scale than in the last century. In Western countries, government economists fixed lending rates and credit policies in order to encourage over-consumption. In the East, they fixed exchange rates and recycled credit back to their customers in the West in order to encourage over-production. And what ho! Wouldn't you know it; now the world has too much debt and too much capacity.

And so the brains are back on the job. In China, the government boosts production. In America, the central planners are trying to boost consumption. In short, the fixers are still fixing. And soon, the world will be in an even worse fix than it is now.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Can Government Bureaucrats do a Better Job of Allocating Capital than Free Markets?
• The Bubble Deniers Deny that Their Own Stimulus Caused it
• Chinese Economy Seems to be Growing
• One of the Biggest Humbugs in Capitalism is Private Equity
• Zurich Minds Symposium

According to the popular version, Ben Bernanke, our flawed hero, has averted a Second Great Depression. When the crisis came in '07-'08, he calmly took out the text he had written himself: "Dummies' Guide to Avoiding a Japan-style Deflation"...or something like that.

Then, he followed his own theory...coolly...confidently...cutting Fed rates down to nearly zero, pushing Congress to pass a huge 'stimulus' bill, and even forcing Bank of America to take over Merrill Lynch. In this last event, he is accused of deliberately hiding Merrill's enormous losses and then threatening the BofA board with dismissal if they refused.

Because of Bernanke's swift and assertive action, the nation's banking system held together during those critical weeks of late 2008. And because of his monetary (and fiscal) policies, all the worlds' economies are now in some stage of recovery. Stocks are rising. House sales are increasing. All the indicators point to a better world.

In recognition of the fact that he saved the world, Ben Bernanke was given the nation's highest honor; Obama picked him to continue as head of America's central bank, the Federal Reserve...even though his predecessor, a Republican, appointed him.

Everyone needs a story. It's the way we understand things. Data is just data. Numbers are just numbers. Facts are just facts. Without the framework of a good tale to hold them together, they are worthless.

That's why, here at The Daily Reckoning, we are suspicious of facts, data and numbers. As for the numbers, they are wrong before they get to us...often intentionally. Then, when they are later straightened out, they sometimes tell a completely different story. Even the 'facts' often turn out to be not facts at all...but distorted data, information has been twisted to fit into a storyline.

The more precise the data, meanwhile, the more they lie. Give us a CPI rate of 6.24% and we will give you back two numbers that are total fictions...and another one that turns out to be wrong later. As for the GDP growth rate...don't even bother to give us a number at all. Whatever the digits say, it's a lie.

This week came news that the GDP is falling at a 1% rate. This number surprised economists. They thought it was falling at a 1.5% rate. This better-than-expected number encouraged investors to buy stocks; the Dow rose 37 points yesterday. Oil and gold remained more or less where they were.

Economists are frequently surprised. In a study of GDP forecasts, a researcher found that economists did nothing more than extrapolate current trends into the future. If the GDP was growing at 2%...they projected that it would grow at 2.3% the following year. Or maybe 1.9%. These projections were mostly correct. Generally, one year is a lot like the year before. But whenever the direction changed dramatically, economists missed it completely. In other words, they're not really capable of telling us what the economy will do - unless it does nothing different.

We've discussed the emptiness of the GDP figures many times. Just because the GDP is growing doesn't mean people are really any better off. In fact, GDP growth during the Bubble Epoque was really a measure of how fast people were ruining themselves. Seventy percent of the GDP was consumer spending; as consumer spending went up so did debt. The result was a paradox and a shame - at the end of one of the longest periods of uninterrupted GDP growth in history, the typical householder was poorer than he was than when it began.

That's why we are skeptical of numbers...especially precise numbers. They lie through their decimals.

What matters is the story...and our story now centers on the role of one man: Ben Bernanke. But the story that most people hear...and believe...is false. It is like GDP growth in the Bubble Era...it may sound right on the surface, but the real story is opposite to what is commonly believed.

Bernanke 'wrote the book' on avoiding deflation, 'tis true. But he doesn't really have a clue what he is doing. He didn't really avoid a Second Great Depression. There isn't really a genuine recovery underway. And the world is not becoming a better place as a result of Ben Bernanke's exertions.

Au contraire...he's making a natural mess into an unnatural one. He's turning a depression into a Great Depression. He's making a bad situation worse.

At least, that is OUR plotline. But we'll let the story tell itself...day by day...and see where it leads us. If we are wrong about the plot...we'll find out...

Bill Bonner
for The Daily Reckoning Australia

• Ben Bernanke is a Victim of the Trade
• Does Bernanke Really Not Understand His Fate?
• Recession is Over, Welcome Back to the Depression
• Congress Slams Ben Bernanke and Fed Reserve
• Ben Bernanke is No Hero

In this age of miracles, people seem ready to believe that anything is possible. Recklessly crossing the street at the end of the Late Bubble Epoque, the world economy got hit by a cross-town bus. Now, the feds propose to reverse and run over the poor fellow again. It will be as if they had reversed the film; the economy will be as good as new, they say.

But we are suspicious. And we begin today's rumination by examining the bus driver's motives.

In its naked form, government is not evil; it is merely a self- interested parasite, like a bank lobbyist. Its main value comes from its ability to elbow out other parasites. Of course, the typical citizen is no saint either. Instead, he is merely a parasite in the larval stage. If he is lucky enough or cunning enough, he could grow into a parasite himself. The citizen, generally, doesn't mind being lied to and robbed - just so long it is by someone he elected. Or at least by someone whom tradition or local connivance put in place. He does not usually resent his homegrown government, even though it routinely costs him a substantial part of his output. On the contrary, he grows so fond of it he even dons his helmet from time to time to protect it. Naturally, the feds return the favor.

The basic business model of government is to keep order, protect campaign contributors and lure supporters with the promise of other peoples' money. The game plan of the typical citizen is even simpler: to be on the receiving end, not the paying end. Over time, more and more of them get into position. And the whole society becomes more costly, and more corrupt.

In the United States, entire industries now operate as wards of the state. They may have too little capital. Or, their operations may be too costly. Or, their products may be simply out-of-date and unattractive. Still, government keeps them going - even at the cost of at the expense of competitors. And the money doesn't only go to business. Cities stay solvent only by the grace of federal government grants. Whole sections of the population depend on government - including 34 million who draw their rations directly from the federal food stamp program. The spectacle is breathtaking and alarming at the same time - like a Pakistani bus on a mountain road, freighted with passengers clinging to the roof. The old rust bucket could tip over at any time, but what politician would tell a voter to get off?

That preface on the state out of the way, we turn to the state of the economy. The key to understanding the great credit bubble of 1945-2007 is to capture the codependent relationship between China and the United States of America. It seemed to serve both parties well. Each enabled each other's excess. China added mightily to the world's supply - far more than was actually needed. America, meanwhile, did heroic work on the demand side. While the growth in the United States was led by consumer spending, the growth in China was led by capital investment; factories expanded, towns were built, and output was revved up. But there was a flaw. Americans ran out of money. After the '70s, they could only increase their buying by going into debt. This they did with insouciance bordering on insanity. Total debt rose 370% of GDP and then blew up in 2007, with major lenders forced into bankruptcy and mergers, while GDP sank at its fastest pace since the end of WWII.

Now, the old formula no longer works - neither for Americans nor for the Chinese. Despite the urging of their government, Americans cannot be expected to take on more debt in order to consume more stuff from China. As savings rates grow toward 10%, demand from the United States will collapse by an estimated $1 trillion per year. With the China trade now accounting for 83% of America's non-oil trade deficit, you'd think the Chinese would panic. They already have as much as two times the output capacity needed to meet real demand. They should trim their manufacturing sector, not expand it.

We draw out that relationship only to show how hopeless it would be to draw it out further. Borrowing to consume is merely tricking stuff from the future to enjoy in the present. By 2007, some $30 trillion worth of spending that would have occurred 'in the future' had already occurred in the past. Factories that would have produced consumer items for 2009 discovered that they had already produced more than enough of them in 2005 and 2006.

It would be better to invite the future in...let her collect her debts...and then get on with things. Yet government officials on both sides of the Pacific continue their numbskull efforts to revive the bubble economy. On the US side, the feds are trying to stimulate demand for more stuff. On the far side, Chinese stimulation is going into producing more stuff. As if the world didn't have too much stuff already.

But the role of government is neither prosperity nor plausibility...but protection of the pests and parasites. They will keep paying them off and carrying them along...until the bus runs off the road.

But it's not prosperity that government really cares about. The big bus keeps trundling along - picking up pests and parasites along the way. It will keep going until it runs off the road.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• China Was the Maker and the United States Was the Taker
• Roubini Says United States Will Climb Out of Recession Towards End of Year
• The United States Matters Less and Less to the Oil Market
• Is Inflation Necessary for Recovery and Growth in the United States?
• China Rises While United States Declines

What Jack sees - in his new book, The Great Prosperity of 2020, is a series of booms and busts that correspond to the way people think about themselves...what they want...and how they want to live.

This is what defines American capitalism, he believes. And then he connects these phases of American capitalism to development patterns and real estate trends. Since about the beginning of the 19th century, he sees three major forms of capitalism - the small-scale frontier capitalism which peaked out about the mid-1800s...followed by large- scale industrial development which reached its zenith, according to Jack, at the beginning of the 20th century...followed by the consumer society that we grew up with.

Each major trend rises and falls. Prices rise and fall with them. The first wave of development raised prices of frontier land, first in the Mississippi River basin...and then out on the prairies. In real terms, farmland in some part of the mid-west hit peaks in the speculative fever of the 1880s that have never been seen since. Then, the development of the next phase pushed up values in major industrial centers - particularly in Chicago - whose growth far surpassed the older cities such as New York and Philadelphia. There too, prices in inner city Rust Belt metropolises have never been higher. Then, came the Material Age...when the consumer was king. Every king wanted his own suburban castle...and his carriage, with horsepower provided by Chevrolet or Ford.

The bigger picture was that energy was cheap and US manufacturing was leading the world in the post-WWII era. Cheap energy seemed to make suburban life a sensible, affordable alternative to the city. In the suburbs you had the advantages of being close to a major city - with access to jobs, entertainment and education. You also had the advantages of country living - backyard swimming pools, gardens, lawns, fresh air, and space.

Movement to suburbia began in the '20s. By then, the first suburbs were being built north of Baltimore...connected to the downtown area by tramways and paved roads. The richest families began by buying summer places on the high ground of Guilford and Mount Washington. Then, as transportation improved...and the cities became more and more crowded with immigrants and factory workers...the rich lived year-round in their leafy refuges.

As the trend developed, the suburbs spread...and the middle classes joined the exodus. By the '80s, practically all that was left in the central cities were drug addicts and welfare recipients.

Meanwhile, in the early phase of the consumer trend, wages for ordinary working stiffs were going up rapidly. A guy could graduate from high school, get a decent job, and expect to earn more and more money. This gave him the wherewithal to buy more and more stuff. So buying stuff became a national pastime. "He who dies with the most stuff wins," was the basic rule of the game.

The first challenges to stuff culture came early, says Jack. The hippies and counter-culture movements of the '60s were basically a reaction to the excesses of consumerism and suburbanism. Then, prodded by the oil crisis, there was a counter-trend movement towards self- sufficiency and independence in the '70s. Those early attacks were beaten back by credit and bubble markets. It seemed crazy not to enjoy the benefits of stuff culture when it was at its apogee in the late 20th century.

But now the consumer economy has played itself out, says Jack. It is spent, wornout and passé. Here at The Daily Reckoning we described the Bubble Epoque - the final, blowout phase of the trend - day by day, during the 2001-2007 period. Now, we are describing the bust-up. The consumers are broke. The suburbs are démodé. The lust for stuff has given way to a lust for security, stability, and simplicity.

The shift from one major trend to another one is typically marked by depressions. The transition period requires retooling, re-pricing and often, relocating. The suburbs are unlikely to be a growth area in the next socio-economic trend. Instead, it is likely that suburban property hit its all-time high in 2005-2006. We will never see those prices again - ever. People will move. They will move to new areas.

The "season of depression," to use Jack's term, usually lasts 20-30 years. We are in one now. He puts the end of the depression - and the beginning of a new period of prosperity - at 2020.

Bill Bonner
for The Daily Reckoning Australia

• Republican Candidate’s 17-Year-Old Daughter is Pregnant
• New York Will No Longer be Among World’s Five Largest Cities
• The World’s Largest Cities
• Maybe the “Cartoon” House Period is Over
• Investors Fear Rising Inflation

Except for the jobs, of course.

And except for the retail sales.

And except for the foreclosures...and house prices. And incomes. And consumer prices. And business profits.

It's like a female impersonator...just like a real woman in every way, except for the essential ones.

At least stocks are doing well. The Dow rose another 36 points yesterday. In terms of time, it's already beat the bounce of '30...it's in its sixth month. In terms of stock prices, it's still a laggard, however. US stocks are up about 45% from their low of 6,547 on the Dow. By that measure, the current reading of 9,398 falls a little short of the 50% increase registered five months after the '29 low.

Yesterday's news was a big disappointment for mainstream economists. It's 'back to the drawing board,' says The Wall Street Journal.

The dumbbells were already celebrating the end of the recession. Just yesterday, we reported on a survey of 53 of them. They figured the stimulus was working and the recession was coming to an end.

Even the Fed seemed to think so. The Washington Post headline: "Fed views recession as near end."

But here at The Daily Reckoning summer headquarters we were doing some more painting yesterday...

..which means, we were doing more reckoning...

We don't know when the recession will end...but we're dead sure that those 53 economists interviewed by Bloomberg...and those at the Fed too...don't know either. Few of them seem to have any idea what is really going on.

And now comes news that the economy is not recovering as planned.

"Even with Cash for Clunkers retail sales fall," reports The New York Times. Retail sales were expected to go up in July. Instead, they went down.

Bummer.

Economists also expected unemployment numbers to go down. Instead, they went up in July...and last week, 558,000 people filed for unemployment benefits - up from the week before. That brings the total to 6.7 million jobs lost since the downturn began in December '07.

Oh...and what's this? Foreclosures hit another record high in July...making the third new record in the last five months.

This is a "recovery that only a statistician could love," says another Washington Post headline.

You can prove anything if you torture the numbers enough. But if you need a job...or need to sell your house...or refinance your mortgage - good luck to you!

And here...in the spirit of summer...of warmth and camaraderie...we would like to offer the above-mentioned economists a little help: Pssst....it ain't a recession; it's a depression.

Since 1945, the US economy - and much of the rest of the world economy - has been carried on the backs of American consumers. First, they spent money they earned during the war years. Then, they spent money they earned in the big boom of the '50s and '60s. And then they spent money they hadn't earned at all. They borrowed from future earnings...increasing total US debt from just 120% of GDP in the '70s...to 370% of GDP in 2007.

In the last 15 years of that period, especially, each time the consumer showed a reluctance to continue spending, the feds rushed to give him more credit. And during the final five years - the Bubble Epoque - debt doubled.

Now, the consumer has dug in his heels. He's not going a step further until he unloads his excess baggage of debt.

Once again, the feds are trying to stimulate him. The Fed's key interest rate is practically at zero. The feds are pumping money into the economy as fast as they can. And they'll give a fellow up to $4,500 if he'll agree to kill his old car. The Cash for Clunkers programs seem cruel to us auto enthusiasts, but they have been popular, all over the world (more below.) But what good do they do?

Even with the stimulus spending...and the stimulating low interest rates...he's still not willing to add debt. Of course, this is just what happened in Japan. The public sector spent; the private sector saved. Net result: an on-again, off-again recession that has lasted almost 20 years.

That's a depression. It's a point where the model no longer works. Look, how could the US economy recover? It's a consumer-led economy, so the consumer would have to spend more money. But he's not earning more money. He has no prospects of earning more - not with 10% unemployment and a punky economy. So, the only way he can spend more is by borrowing. Ergo, the only way the consumer economy can grow is by adding more consumer debt. Is that possible? Could the ratio of debt- to-GDP go to 400%...500%...to the moon?

Well, we've weren't born yesterday. We've been around long enough to know that almost anything is possible.

This morning's news tells us that the federal deficit through July comes to $1.27 trillion. We didn't think that was possible. And despite this inferno of new debt...the 10-year Treasury bond yields barely 3.6%. We never thought that was possible either.

So, anything could happen. But generally, government stimulus only works when it is not needed. That is, it only works when it goes in the same direction as the underlying trend...not against it. Just like you can make a sailboat go faster by unfurling the sails, you can speed up an expansion by offering more and easier credit.

But now, the underlying trend has reversed. It's no longer a credit expansion; it's a credit contraction. The consumer has had his fill of debt. He's cutting back on his spending and paying off debt. That's what the July figures show. That's been the history of entire downturn. That's why it's a depression, not a recession. It's a major change of direction that will take years to accomplish. Now, stimulus is not only useless - since it is against the major trend - its counterproductive. It delays and contradicts the adjustments that need to be made.

But wait. We know what you're thinking - that the Cash for Clunkers program is a success, because it encourages consumers to buy. See. Sometimes central planning really works, right? Yes, and if you look no further than the auto sales figures for proof, who can argue? Alas, a centrally planned economy is a perverse thing...where every positive statistic has the crumpled up bodies of tortured numbers buried beneath it. Take away the 'free money' from the feds and there's nothing left. No real increase in demand...just a temporary demand based on a temporary and unsustainable stimulus.

Encouraging people to buy too much was what caused the problem in the first place. Encouraging them to buy more now is not a solution; it's just a continuation of the same flawed policy of stimulating consumer demand...a policy that has been in place for decades.

But now the wind is blowing in the other direction. The government may not like it, but they can't stop it.

Bill Bonner
for The Daily Reckoning Australia

• Take Away Stimulus Spending and You’ve Got an Economy Entering Depression
• Why Weren’t Economists On Top of This Thing?
• China, the Miracle Economy
• Recession is Over, Welcome Back to the Depression
• Where, Exactly, is this Economy Headed?

It's too early in England too. Financial Advisor Peter Hargreaves says that talk of 'green shoots' gives rise to illusions. People think they see the light of dawn when the sun is still going down. And forget about a V-shaped recovery. There won't be any simple bounce-back. Nor even a W-shaped double decline. "There could be a quadruple dip in my opinion," he said.

And what about California? This week's Economist magazine gives us a new measure for California' budget deficit -- $26 billion, up from the $24 billion last reported in this space. A widely published photo shows Arnold Schwarzenegger smoking a cigar... apparently confident that the state's problems will work themselves out somehow.

Of course they will. They always do. But not necessarily the way people hope.

California is the world's 8th largest economy. It can print IOUs when it runs out of money. But there's no law that says banks have to take them. They stopped taking them last week...which leaves the Golden State in a jam.

What is ailing California is ailing the entire United States of America - and much of the rest of the world, especially that part of the world that speaks English. Politicians have promised too much...without being willing to raise the money to pay for it all. Solution: spend less. Or tax more. Or a little of both.

Hey, Arnold should have asked us. It's so simple.

But wait. California is a democracy. And the democracy is a flim-flam. As we've explained in these reckonings: there are two parts to it. One part is like professional wrestling - full of bullying, humbug and hollow gestures. One group wants to stop its neighbors from smoking. Another wants a flag with yellow trim. Still another wants revenge on a neighbor because it feels disrespected. There is no accounting...or predicting...what direction the mob will take.

The other part of democracy is more rational. The citizen wants to know not what he can do for his government, but what he can get out of it.

This second part is a time bomb. Once citizens realize that they have the power to vote themselves the contents of someone else's pocket, the system is doomed. They don't let up until they've bankrupted it.

A man may vote for a candidate who promises a yellow flag. No harm done. But when he votes for the candidate who promises more "benefits" at someone else's expense, he is on the road to Hell.

"Democrats in the House propose setting a 1% extra tax on couples earning more than $350,000," reports the Financial Times this morning. The money is to be used to pay for other peoples' health benefits.

If you earn less than $350,000, you feel that you are getting something for nothing. But that money - had it not been confiscated - wouldn't have disappeared. It would have been put to work in one way or another - added to the nation's capital formation, lent to the government, used to buy a new car or take a vacation. Instead, it is to be sucked out of the benefits of the willing economy and used to give people something they couldn't afford or didn't want to pay for themselves.

In order to get elected, politicians have to promise more and more of these 'benefits.' There is no backing up...no turning around. Even when the government is clearly headed to bankruptcy. If a politician hesitates, some other clown will just take his place. He may even be overcome - in a weak moment - with a desire to level with the voters. He may imagine himself going on TV and putting it to them straight:

"Look, we'd like to continue these programs; but we don't have the money."

Then, he comes to his senses: 'I might as well say I've fallen in love with a woman from Argentina...or a man in a public bathroom; either way, I'm dead, politically.'

Now, Dear Reader, you may object. 'The American political system draws forth the best and the brightest from the entire nation of 300 million," you may say. "Surely these people are capable of doing the right thing for the good of future generations."

They are surely capable of making rational decisions. But what is rational for them - ducking serious issues...nourishing the illusion that voters can get something for nothing -- is fatal to the republic.

Of course, the same thing could be said for a business...as well as a country. Why did GM go broke? It was the largest company in the world. It could pick and choose the very best managers ...the smartest businessmen...the greatest investors...the most far-sighted engineers... the most wonderful of the wonderful. Surely, these fellows could add and subtract, right? Surely one of them noticed:

"Hey...if we keep adding costs, we're not going to be competitive any more. And if we're not competitive, we're not going to be able to sell cars at a profit. And then, we're going to lose money and go broke.'

How come the best talent money could buy couldn't change course at GM? How come all those smart people in the California legislature can't balance the budget? Well, that's just the way it is. An institution matures...and the parasites take it over.

Retirees, executives with their golden parachutes, the halt, the lame, employees, managers, hangers on, lawyers, accountants, businessmen... everyone has an interest in keeping the hustle going. The executive wants his bonus...the retiree wants his pension...the lawyer wants his retainer... All can see that the old place ain't what it used to be. They all know that the gravy train won't go on forever...but that just makes them more eager to get it while the getting's good. So they jiggle the numbers so each quarter doesn't look so bad...jive the news so it sounds almost as if the institution had a future...and they juke up the whole system so that no one even mentions that they're going broke.

GM "sets out on a fresh start," says the Financial Times. "From this point on," says its top man, "our efforts are dedicated to customers, cars..." and repaying the feds.

What were they dedicated to before they had to turn to the feds for money? Answer: to looking out for number one.

What are they dedicated to now: refer to the question above.

This from our old friend, Adrian Day:

"I've been called a cynic-and worse-but, as Winston Churchill told us, if you don't know the future, look to the past. So if we want an idea how long the government might be subsidizing GM and Chrysler, let's look to the experience with railroads. In 1970, Penn Central, America's largest rail company, filed for bankruptcy, and Congress created Amtrak. The government passenger rail monopoly was confidently expected to be paying its own way by 1974. Well, 38 years and $33 billion later, it has still to turn a profit. So this year, congress has voted another $14 billion for the next five years."

From our perspective - because we hate taxes and we like trains - it would have been better if the railroads had gone broke...and been bought up by whomever could make a go of them.

And from our perspective - because we hate taxes and we like cars - it would be better if GM had been allowed a death with dignity. Then, other automakers could have salvaged the wreck for spare parts.

Of course, this formula applies to all the crippled banks, bankrupt households, reckless insurance companies, greedy Wall Street...and all the rest of the flotsam and jetsam of the Bubble Epoque.

As Yu Faz, who anticipated the 'laissez-faire' economists by 500 years, said: "A man lives under the roof of his own making. If it falls on his head, so be it..."

The Financial Times interviewed our friend Hugh Hendry, of Eclectica Asset Management. Excerpts:

"I've never known a moment where a trade has become so crowded. And that trade would be this absolute certainty that the future is going to result in inflation. And not just any old inflation. People are using quite severe language. And there are notable contrarians and commentators who are comparing America's monetary policy with Zimbabwe. And they're not just saying inflation, they're saying hyperinflation.

"Prices today...are falling, in America and in the British economy, and indeed across Europe. That never happened in the 1960s, 1970s, 1980s. 1990s. That's a new phenomena. It's almost as if we have this flood and yet people are buying fire insurance, and that's quite - you couldn't make this stuff up.

"When Japan hit the turbulence which we're experiencing now - when they hit it twenty years ago, their public finances were very similar to the public finances we had in the UK going back a year or so, and the US, where gross public debt was no more than 40% of GDP. Now over the last 20 years, the Japanese have fought crisis after crisis by expanding the public sector debt. They've issued trillions, literally trillions of yen, and debt is now approaching two hundred percent of GDP. What's happened to government bond yields? They've gone down.

"Here we are with the most profound collapse in industrial production, world trade, since the 1930s. That is not an exaggeration, that is reality. Okay? And yet today ...they only proposed to grow the money supply at the rate at which it's expanding just now - it's expanding at like nine percent just now...history will determine that their steps were modest, and they were massively overwhelmed by this hysteria, which raised interest rates."

We can't find the passage...but one thing in what Hugh said stuck in our brain. He said the inflation narrative was "too easy to articulate" and too persuasive.

That's what's been bothering us too. It's too obvious. The feds print money. Prices go up. People who own gold get rich.

Well, the fed is printing money, but as Hugh points out...probably not enough to offset the economic collapse. Are prices going up? No, they're going down.

Should you be long or short bonds? The dollar?

We suspect Hugh is right. In the short run, you should probably be long both. The correction has been underestimated. It will be worse than most people realize. Since a correction is fundamentally deflationary, the dollar should rise.

But here at the Daily Reckoning, we're not smart enough to invest in the short- run. We never know how short short is. And we fear having our short positions when the long run finally arrives. So, we'd prefer to take the long-run position from the get-go. In the long run, we have faith in the feds. They may not be very good at causing inflation. They may have underestimated the downward tug of the correction. But give them time. They'll keep emitting their I.O.Us...and keep propping up their dead institutions with make-believe money...and keep handing out their bonuses and benefits...

...until the country goes broke.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• California Has Run Out of Money
• Consumer Confidence is at its Lowest Point Since 1980
• The Business Bankruptcies and the Personal Bankruptcies
• If the US Economy is Really Following Japan Things Will Get a Lot Worse
• Inflation or Deflation?

This is the shift we've been talking about for months. The great credit expansion of 1945-2007 is over. Now cometh the great credit contraction.

During the bubble years, more and more credit produced less and less real prosperity. It was as if you were borrowing more and more, to invest in your business or merely to increase your standard of living, but your income didn't rise fast enough to keep up with the interest payments.

In 2005, Americans saved nothing. Not even aluminum foil or string. Now, the savings rate is approaching 5% of disposable income - a big turnaround.

We know from logic and experience that saving money - not spending it - is the key to getting wealthier. Saving money gives you capital. And it's capital accumulation - in the form of factories, roads, ships, buildings, machines...and raw savings - that gives people the ability to produce more. It may take a man with a shovel a whole day to dig a decent grave. Give him capital - in the form of a backhoe - and he can bury everyone in town. That's why capitalism works. It rewards the fellow who saves his money.

Yet every yahoo economist in the year of our Lord 2009 takes news of rising savings rates like the death of Michael Jackson. If households don't consume, they reason, how can a consumer economy grow?

The problem is that you can't really grow an economy by borrowing and spending.

Recent history proves it. Despite the biggest splurge of borrowing and spending in history, the US consumer economy barely grew at all.

"In the five years to December 2007," reports Grant's Interest Rate Observer, "America's credit market debt climbed by nearly 57%, to $18 trillion. However, in the same half-decade, nominal GDP was up by only $3.3 trillion."

For every five dollars people borrowed, they only increased their incomes by $1. Imagine that the borrowing had an average effective interest rate of 10% (credit card debt can be much more expensive). At that rate half of the additional income earned between 2002 and 2007 had to be used just to pay the interest.

This was not the kind of growth that was likely to last. In fact, it didn't. The whole thing came crashing down in '07 and '08. And now, the consumer has had a cup of coffee. He's looked at himself in the mirror. He's sorted through his pile of bills. And he's made up his mind: that's enough of that!

"The ratio of cash held by households as compared with assets has been rising sharply," says James Saft in The New York Times.

"Companies, households and banks all want to pay down debt and...prefer to hold cash rather than assets, partly because the outlook for those assets is poor and partly because after a decade of excess, everyone now looks a bit over-extended.

"This is exactly what happened in Japan during its lost decade, when a balance sheet recession, one characterized by the paying down of debt and liquidations of assets, was self-reinforcing and very difficult to stem."

And now this from David Rosenberg:

"The ultimate question is where all this cash is going to be deployed, and we believe it will ultimately be diverted toward debt repayment."

Let's see. We can figure this out from the numbers above. American consumers must have added about $7 trillion in extra debt during the Bubble Epoque, 2002-2007. Now, instead of buying things, they use their money to pay it down. The average household has about $43,000 worth of income. Let's keep the math simple by saying there are 100 million households in the United States...and that they save 5% of their income. And let's say they use every penny of savings to pay down debt. Hey...it will only take about 30 years to pay it off! Get ready for a long, long slump.

Bill Bonner
for The Daily Reckoning Australia

• Consumer Spending Rises
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar
• Future Fund ‘Borrowing’ Program Amounts to Theft
• Why I Would Have Raised the Interest Rates
• Bill Bonner Back in the USA

The shop is tended by Chinese merchants...apparently dodging France's employment laws by only hiring family members. The merchandise, too, dodges high rents by squatting the sidewalk, under improvised blue awnings.

How come such cheap duds in such a dear city? The latest figures show negative consumer price inflation in 14 countries. In Ireland prices are collapsing at a 4.7% rate. In the United States, they are falling at 1.3% annually - their biggest drop in 59 years. In Britain, consumer price inflation is still positive...but falling. But clothing on the Boulevard de la Villette seems to have been thrown out of an airplane. It is not in deflation; it is in hyper-deflation.

What could cause it? A guess: excess capacity, inspired by excesses of credit, consumption and claptrap during the Bubble Epoque. Spurred by what seemed like insatiable demand from the United States and Britain, Asians built superfluous factories...Greeks bought superfluous ships...and Americans built superfluous malls. Now, the feet are in the other shoes - the cheap ones. The action of the bubble years produces an equal and opposite reaction: excess supply bedevils the market. Unable to sell superfluous brand name clothing, the rag trade strips off the alligators and polo sticks and dumps clothes on discount racks.

Last week, we warned about the extremely destabilizing effects of hyperinflation. One day middle class men are saving money for their daughters' dowries. The next, they are putting knives between their teeth and swimming across the Rhine.

Today, we deny hyperinflation thrice before the cock crows...and then deny we denied it. First, Professor Alan Blinder in The New York Times: "the clear and present danger, both now and for the next year or two, is not inflation but deflation."

Second, BusinessWeek elaborates:

"...the inflationary effects of the new money are being fully offset, or more than offset, by the far-reaching and long-lasting impact of household debt repayments. Whether it's voluntary frugality or under the coercion of creditors, Americans have abruptly switched from living beyond their means to saving more and working down the debts they incurred during the bubble years."

Third, as Ambrose Evans Pritchard puts it in the Telegraph: "the Fed's efforts to boost the money supply are barely keeping pace with the deflation shock. Stimulus is not gaining traction. The credit system is broken."

Professor Blinder explains why:

"In normal times, banks don't want excess reserves, which yield them no profit. So they quickly lend out any idle funds they receive. Under such conditions, Fed expansions of bank reserves lead to expansions of credit and the money supply and, if there is too much of that, to higher inflation. In abnormal times like these, however, providing frightened banks with the reserves they demand will fuel neither money nor credit growth - and is therefore not inflationary."

Reserves are what nobody wanted in the bubble years; now we live in a world of squirrels. Bankers add to their reserves; so do individuals and businesses. Americans saved an average of 7% of disposable income since the '30s. In the 2002-2007 bubble, that rate fell to zero. Now, it's back to nearly 5% and rising. Thrift is making a comeback. People are changing their own automobile oil. They are cutting their own hair and planting their own gardens.

When consumers cease consuming, producers cease producing. And shippers have nothing to ship. World trade has collapsed by more than it did at this stage of the Great Depression. And at 65% of capacity, there are more idle factories in America than at any time since they stopped making tanks and airplanes after WWII. Business earnings are falling, with no pricing power in sight. In this respect, this downturn is much more deflationary than Japan's recession of the '90s. When Japan went into a slump, the rest of the world continued to grow. Japan could continue to manufacture and export products - at a profit. Still, with so much excess capacity, producer prices in Japan fell in nine of 10 years in the '90s.

And now the denial: These commentators are right; deflation is the immediate problem. Our guess is that it will be deeper and more vexing than even they believe. The feds' money machine is broken. They can add reserves. But they can't turn the reserves into price inflation at the consumer level. Result: deflation...maybe hyper-deflation. But far from eliminating the danger of hyperinflation, falling prices practically guarantees it. In other words, it's not inflation we worry about; it's the lack of it. Unable to stimulate inflation in the usual way, the feds are forced to resort to extraordinary measures.

Only central banks with their backs against the wall - like Germany in the '20s...Argentina in the '80s...and Zimbabwe in the '00s...would dare to risk hyperinflation. But if its efforts to produce mild inflation don't work, the United States will eventually be in the same desperate position.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Inflation or Deflation?
• World Economy Faces Hyperinflation or Deflation?
• Until This Debt is Reduced, Americans Will Be Reluctant to Borrow or Spend
• The Feds Are Trying to Avoid Deflation
• Deflation is on the March

Remember back in November, we waited for the Obama Bounce? It was the one of the most reliable phenomena in the world of investing, we said. Then, we began to wonder. Month after month...no bounce.

It took a long time coming...then, finally, in March prices headed up. Since the 9th of March world stock markets are up 37% - about average for a post-crash bounce.

Now, it looks as though the bear market rally might have run its course. And yesterday, the Dow was down 184 points. We don't know if that marks the end of it or not. But count us out. At this point, it is far too dangerous to be heavily invested in stocks.

Why? Because the Bubble Epoque is over. The bubble in the financial sector blew up last year. That marked the end of a half-century of building up debt. Most likely, now debt is going to be thrown off, shucked, dumped, paid down, worked out and defaulted on.

Without the financial sector puffing up assets, prices will tend to go down, not up. And without the financial sector adding debt...and giving American consumers the wherewithal to dig themselves deeper holes...the whole world economy needs to be restructured. Manufacturers in China can't depend on the consumers of first and last resort in America anymore. People in the US are no longer buying what they don't need with money they don't have. Because no one will lend them money. And so, global commerce slumps. Ships wait at loading docks; where are the containers? Factories wait for orders and stores wait for customers; but where are the customers? The customers aren't going to show up. Because if there is one thing Americans have learned from this crisis it's that they must stop spending so much money. They're facing what the Washington Post calls the "Baby Boomers' Retirement Bummer." They have no choice; they have to pay off debt, not add more of it.

We're hearing that China is recovering. We don't believe it. Who's buying?

They say the US economy is close to a bottom, too. We don't believe that either.

Wait...let's ask Alan Greenspan. Here's the Bloomberg report:

Former Federal Reserve Chairman Alan Greenspan said on Tuesday that "the seeds of a bottoming" in plunging U.S. home markets were becoming visible.

Speaking to a National Association of Realtors summit, Greenspan said there were reasons to believe that bulging inventories of unsold homes were dwindling and that should bring some stability to prices.

"It looks to me, judging from the balancing of household formation on one hand, conversions, mergers, demolitions...that we're at the edge of a major liquidation in that excess of inventories which I suspect and I hope will be of such a pace that it will stabilize prices," the former Fed chief said.

"So as I look at the housing market...we are finally beginning to see the seeds of a bottoming," he added.

We can imagine seeds of a recovery. We can imagine signs of a bottoming. But we don't know what the hell "seeds of a bottoming" is supposed to mean.

Do the seeds grow downward? And turn into a bottom? Then what happens?

But that confirms it for us. If the former Fed chief thinks he sees the "seeds of a bottoming," a bottom must be nowhere in sight. And how could it be? You can't hope to erase the errors of a 50-year debt build up in a single year.

Just look at the auto industry. How long will it take to turn GM around...or to break it up...sell off the assets...and put the good pieces back to work? Many years. How long will it take to work off the housing inventory? Years. How long will it take China to retool her economy for domestic consumption? Years.

And how long will it take the American consumer to pay down his debt to a level where he is comfortable again? Well...forever... Just do the math. The savings rate has gone up to 5% of GDP. That's $700 billion per year. Yet, the excess debt alone is estimated (by us) to be between $20 and $30 TRILLION. At that rate, it could take 40 years, or more, to pay it down.

But wait again...while consumers are paying down debt, the feds are borrowing more than ever. While consumers may pay off $700 billion of debt, the US government is borrowing $1.84 trillion - at this rate, Americans will never get out of the hole.

Bill Bonner
for The Daily Reckoning Australia

• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• Krugman Warns That the Run-up in Stocks Can’t Be Justified By the Fundamentals
• A Letter from ‘Alan Greenspan’ About the Deterioration of the U.S. Economy
• Gold Standard Doubles as the Greenspan Fed Makes Real Interest Rates Negative
• Markets Rise While the Economy Sinks