China is a country of hyperbole. There's scarcely anything you can say about it that doesn't end with 'est.' In some ways, it is the world's oldest society. In other ways, it is its newest. It is the world's richest - with more than $2 trillion in reserves. It is also the world's poorest, with some 200 million people who get by on less than $5 per day. It faces the world's biggest problems too.

Even in its calamities, China is second to none. People inside the Great Wall were about as rich as people outside it, man for man, until the 19th century. Then, China missed the industrial revolution. Nearby Japan missed it too, but quickly corrected its mistake. It kept the barbarians at arms length, but still managed to pick their pockets. The Chinese, on the other hand, played it cool. The barbarians had nothing to offer, they believed. They still think so. Said Xue Chen of the Shanghai Institute of International Studies, just last week: "The US has a lot to ask from China. On the other hand, the US has little to offer China."

In the early 19th century, traders from Britain and America bought porcelain (china), silk and tea. Trouble was, they could find nothing to sell in exchange. The trade balance with China went negative, with China building up substantial monetary reserves (in silver). In 1830, a Chinese merchant, Hao Gua, who enjoyed a near monopoly on trade with the gweilos [foreign devils], was said to be one of the richest men in the world. Then, the English found something the Chinese would buy - opium. The fruit of the poppy was popular in many countries but, as usual, the Chinese over-did it. First, it was a favorite of the leisure classes. Then, it trickled down to ordinary workmen. Soon the coolies were neglecting their labors and China was in crisis. When the authorities tried to stop the drug trade, the English opened fire, humiliating the government and almost bankrupting it. People lost confidence in Manchu rule. By mid-century, nearly half the country was in open revolt. A Christian revolutionary had set up the "Heavenly Kingdom" in Nanjing. He raised armies and challenged the Qing Dynasty to battle. For a time, it looked like he might win.

In the north, meanwhile, infanticide of female babies had become common in Nien territory - a reaction to famine and scarcity. By mid-century, one out of four young men in the region couldn't find a bride; "bare branches," they were called. By 1855, these bare branches were ready to break. They armed themselves and organized. They drove out government forces and controlled a large part of the country before they were finally put down. Between natural calamities and war, some experts put the 19-century death toll at an unimaginable 200 million. And then came the 20th century! The Middle Kingdom staggered forward, from error to accident to catastrophe! From the Taiping insurrection to Mao Tsetung. Then, 30 years ago, Deng Tsaoping announced the new line: "To get rich is glorious," he said. Suddenly, the Chinese began saving every penny. Building factories. Cutting prices. And beating the barbarians at their own game.

Again, they exaggerated. While Americans built too many shopping malls, the Chinese built too many factories. Then, in 2008-2009 came the "greatest collapse in world trade in history," says Nobel-winning economist Paul Krugman. Americans - their biggest customers - rediscovered thrift. You might think China would realize it had too much capacity and back off. Instead, it rolled more steel. It built more factories and offices...entire cities.

If stimulus spending is a measure of stupidity, the Chinese are three times as dumb as Americans. Both governments respond to correction by doing more wrong than they did before. Loans in China are rising by about 40% of GDP annually. The money supply is soaring at nearly 30% a year. "We estimate that [fixed capital formation] accounted for 70% of China's growth in 2008 and close to 90% of China's first half of 2009 growth," says a report from Pivot Capital.

It is just a matter of time until this capital spending bubble blows up. But China is full of bubbles. In another example of its central planning, it made the ancient practice of infanticide state policy. One couple/one child was the rule. Missing girls was the result. Then, when the boys grew up, they discovered that their brides were missing too. The working age population of China is collapsing. There were 7 workers to every old person in 1990. Now, there are barely 4. By 2035, there will be only 2. What happened to the workers? They are the missing children of the missing girls who then became missing mothers. And by 2040, 397 billion old people - more than the total populations of France, Germany, Italy, Japan and the UK combined - will be missing the support of those missing workers.

Where this leads, we don't pretend to know. But bare branches bend...and then they break.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• China and its Perplexing Investment Strategy
• China is a Key Driving Force in the Gold Market
• What a Summer
• US Economists Think China Should Raise the Value of Yuan
• The Codependent Relationship Between China and the United States

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

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

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

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

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

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

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

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

Click to enlarge

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
for The Daily Reckoning Australia

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

'The 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

This from the Financial Times:

"Perhaps more than any major economy, China is showing signs of improvement, writes Geoff Dyer. Indicators suggest that the economy began to recover in March with industrial production rising 8.3 per cent from 2.8 per cent in January-February.

"But could it all be a bit of false hope? Could we, in fact, be misinterpreting a temporary stimulus-induced economic pick-me-up as an actual sustainable recovery?"

China says it is growing. But if it were really growing it would be using more fuel and more electricity. Instead, industrial demand for gasoil, used by factories and commercial plants, fell 12.6% in the first quarter.

Our old friend Sean Corrigan, chief investment strategist over at Diapason Commodities, also points out that electricity generation has been going down too. The last seven months' power output has been 8.5% below that of a year ago.

Another old friend, Jim Rogers, believes China - along with commodities - is still the best place for your money. He may be right. But we don't speak Chinese...and we fear the Chinese market may be subject to more risks than is popularly understood.

One of the risks we think is especially understated for China is the risk of central planning. Investors tend to favor China - over, say, India - because they think the Chinese government - even in the hands of communists - is capable of guiding the economy to prosperity. That is, in China's case, they believe central planning is a plus and pay a premium for it. But central planning is always a mistake as near as we can tell. It is only not a problem when it is carried out so clumsily that it is ineffective.

"China's head honchos tout a rosier future for the 'Red Dragon' economy than seems possible," says The Richebächer Letter's Rob Parenteau. "Over 15,000 factories in the Chinese provinces of Shenzhen, Guangzhou, or Dongguan have already shut down... with many more slated to close over the months ahead.

"It's an epidemic that's happening all across Asia, though you might not be hearing about the full scale of their meltdown on the evening news.

'Half of China's toy factories have shut down. In fact, at least 67,000 factories overall closed in the last six months of 2008. With another 60,000 factories in the Wen Zhou Province alone about to shut down.

"As many as 27 million Chinese are already out of work - with 20 million of them streaming out of the cities and back to the abandoned farms of the Chinese countryside."

Remember the 1980s? Then, too, investors were willing to pay a premium for central planning. Then, it was Japan that was doing the planning. Investors sold U.S. stocks - on the theory that the United States couldn't get its act together - and bought Japanese stocks, because MITI, the Japanese bureaucracy in charge of economic planning, was supposed to be doing such a fine job of guiding the country to eternal success. It didn't seem to bother them that this same agency had advised Japanese carmakers to stay at home and not try to penetrate the U.S. auto market.

Of course, in 1989, the Japanese market...and its economy...cracked. Then, the Japanese turned their central planning skills to the task of avoiding the kind of creative destruction that capitalism had in store for them. In this they were more successful - preventing the necessary restructuring for the next 20 years. Brain dead banks were kept alive. Zombie companies remained in business. And an amount of money equal to more than an entire year's total output of all the Japanese people was spent in futile 'stimulus' efforts. Today, Japanese stocks are still selling for 75% less than they were in 1989. Japanese property, too, is only worth about a quarter of what it was worth at the top of the boom.

Bill Bonner
for The Daily Reckoning Australia

• End of the Road for Toyota and for Japanese Stocks?
• China, the Miracle Economy
• Chinese Economy Appears to be Transitioning Into a Sustainable Form of Adolescence
• Equity Premium Will Be Replaced With a Tangible Asset Premium
• China as a Nuclear Power Play