For proof of the first claim - that excessive leverage and too much debt cost Australian investors billion of dollars - read today's essay "Pigs at the Trough" by guest essayist Adam Schwab. Adam's got a new book out by the same name. And he makes a great point: Australia may not have learned much from the first round of the GFC.

But is there really going to be a round two? Well, if the first incorrect assumption was that Australia didn't have a bad debt problem, the second assumption is probably even more dangerous. It's more dangerous because it's the single most unexamined assumption behind much of Australia's economic prosperity. The assumption is that we'll always have China.

A growing number of professional investors are betting against China. It's true that all of these investors - short-seller Jim Chanos, our friend Dr. Marc Faber, Harvard Professor Ken Rogoff - are all talking their book to some extent. We all do that all the time. But that doesn't invalidate our arguments.

And the argument is simple: China's economy is the Greatest Bubble on Earth. James Rickards, the former General Counsel for the famously-failed hedge fund Long-Term Capital Management, told Bloomberg that China is in the midst of "the greatest bubble in history." He said the Chinese central bank's balance sheet, "resembles that of a hedge fund buying dollars and short-selling the yuan." "As I see it, it is the greatest bubble in history with the most massive misallocation of wealth," he told the Asset Allocation Summit Asia 2010.

Students of the Austrian School of Economics would identify with the comment. Credit bubbles - and the world has arguably been in one long once since the U.S. dollar could no longer be redeemed for gold internationally in 1971 - know that credit creates excess demand. It gives producers a false impression of the consumer appetite for goods and services. Real resources are poured into providing people with products they buy with debt-based money.

When the bubble bursts, the demand goes too. This is why Australia's government, slavishly obeying Keynesian dogma, has tried to "bring demand forward" or "support aggregate demand"
by giving away the nation's surplus. And once it was finished doing that, it borrowed (stole) from the future in order to support demand.

But this just perpetuates the misallocation of resources (in this case, stealing tomorrow's savings to support today's consumption.) In China's case, however, the misallocation of resources is even more impressive. There is massive over-capacity in commercial real estate with millions of square meters of vacancies. Whole cities lie empty.

These cities and office buildings were made with Australian iron ore and coking coal. If China's miracle economy (regularly achieving politically mandated 8% GDP growth to support employment) is really the world's largest collection of misallocated resources ever, then what do you think will happen to Australia's economy?

On the verge of another big increase in contract iron ore prices, it may seem like a strange time to ask the question. But it's probably the most important question Australian investors could ask themselves this year. "What can I do to protect myself against a crash in China?"

The possibility may seem remote. But remember, no one in the mainstream media or economics profession warned you of the GFC either, did they? Even if you think it's unlikely or absurd, it's probably something you should think about a bit. We've thought about it and we think the best answer is to retire now.

But what does that really mean? It means you should own a lot fewer stocks. But yes, that does contradict the rosy projections for Australia's super annuation system. Australia's super system is projected to have nearly $5 trillion in assets by 2025 according to an article in today's Australian.

Chris Bowen, the Minister of Financial Services, spoke by video to a conference in Brisbane. He didn't say where all the super money would go specifically. But he did say, "This might mean greater investment in infrastructure assets, provided a stable pipeline of opportunities was available."

Now you may want your money to go into infrastructure assets. And if you do, more power to you. After all, they are tangible assets. But you can't put a bridge in your refrigerator. Portable tangibility - wealth you can wear, store, or trade - is the name of the game as you reduce your allocation to deflating financial assets ahead of the hyperinflation. More on that Big Crash two-step in Friday's letter.

Dan Denning
for The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• The ASX Bubble, Fueled by China
• Building a National Economy Around the Housing Industry
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• The Price of Oil is in a Bubble

Stocks are surfing a sigh of relief that Dubai hasn't precipitated a global crisis. Plus, huge amounts of liquidity in the market are bound to take it higher for now. This makes valuing stocks a risky - dare we say futile - proposition. But we'll push on.

Someone has called us out on the message board and demanded we put an exact date on our prediction for an Aussie house price collapse. This is a moronic suggestion. The claim is that if you say anything often enough, sooner or later you're going to be right...only you're not really right...you're just repetitive...and lucky.

But we've done plenty of homework on the Aussie housing market. We're either right or we're wrong. Our forecast is not an option. There is no time decay. True, there may be people out there who are weighing up whether now is a good time to buy a house based on predictions about the direction of prices.

However this more or less proves our point. Buying a house is one of the most important financial decisions you make in your life. It should be based on whether you can afford it, leaving plenty of wiggle room for rising interest rates, the loss of income, and, of course valuations.

On the last subject, we couldn't be clearer about what we think of Aussie house valuations. They are outrageous. Even if demand is being fuelled by foreign buyers, this simply makes them more unaffordable to people just getting on the property ladder. Besides, getting into the property market now with a huge mortgage at a variable interest rate because you think you can sell to a foreigner for a capital gain is not an investment. It's a gamble.

Aussies have been gambling on houses for at least ten years now (credit to Steve Keen for that description). We don't know when it will end. But we know that it has to end eventually. It could end if something drove up unemployment or down existing wages.

But we think the more likely shock will be an external one. There are two big looming factors out there. The first is the rising cost of capital which makes importing funding more expensive for the big banks. The government is trying to soften this blow by supporting the housing market with the AOFM's purchase of residential mortgage backed securities.

The other big factor is China. And for the sake of argument, let's just put this out there: China's boom is entirely a function of the credit cycle. The expansion in Chinese fixed asset investment and productive capacity is fuelled by a trade surplus and a currency policy that are on borrowed time. China's economy is every bit a symptom of the credit bubble as the U.S. housing market.

Obviously a pop in the China bubble is a game-changer for Australia. Specifically, national income would go down (export volumes and prices probably plunging). Australia already has a mountain of debt to service. At higher rates with lower national income, that debt gets even more burdensome.

The only realistic argument is that the government will not let house prices fall. Too many people have too much to lose. The banks, the real estate industry, the builders, the spruikers, the tax man, and Australians with mortgages. In other words, Australia's housing market is too important to fail.

But even this argument fails. Just because the government wants it doesn't mean it will happen. As we are learning, national governments have limited resources too in a global credit crunch. Pouring them into the housing market to support prices is one part wasteful and two parts stupid.

Besides, a nation doesn't get wealthier buying and selling houses. The ability to purchase your own home and elevate your standard of living begins with rising incomes, and those come from productivity increases and innovation and trade.

For the Australian government to make housing the centrepiece of the national wealth strategy is every bit as disastrous as the Wall Street/Washington axis making finance the crown jewel of the American economy at the expense of manufacturing. It's a massive selling-out of Australia's long-term economic future for short-term political gain.

This Anglo obsession with getting rich off of houses is just that: an obsession. It's also lazy, and perhaps a sign of civilisastional decadence/fatigue. We wrote a report in 2004 called, in subtle fashion, "The Total Destruction of the U.S. Housing Market." Excuse the formatting there. It's the only on-line copy we could find.

You should have a look at it - but don't order yet, we're working with a friend to relaunch the product shortly. And if you think our advertising copy is hyperbolic, of course it is. We're operating at the margins of the financial publishing world, writing about the kinds of scenarios that terrify the mainstream media because they alienate advertisers. They laughed when we first made the claim, and those were just the people who weren't calling us "un-American" and a "fear monger."

Of course it turns out we were two years early on our call. Did that make us wrong? Well, if it was a trade, yes. Way wrong. But as a macroeconomic call about an unsustainable set of circumstances, it was right. And that's the call we're making here about Australia. If you want a date, check out the online personal ads.

Dan Denning
for The Daily Reckoning Australia

• Are Aussie House Prices in a Bubble?
• Housing Market is Becoming More Affordable but That’s Not Necessarily a Good Thing
• The Big Question: What is the Aussie Gold Price Doing?
• Aussie Housing Market Actually Leads the U.S. by Three Years
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar

If China's economy continues to grow at its current rate, it will pass the U.S. as the world's largest economy in 18 years. Of course, it won't grow at its current rate for 18 years - not continuously, anyway. It will grow somewhat slower in spots and sometimes faster. What growth rate comes out in the end is anybody's guess, but the 18-year guess will probably be off.

Then again, the guess also assumes the U.S. stays where it is. And that is also unlikely. The U.S. economy shrank last year and looks to shrink again in 2009. Meanwhile, China is one of the few big economies still growing, though at a slower pace. The result is that China will actually make up ground faster in 2009. As Ting Lu, a Merrill Lynch economist based in Hong Kong, notes: "In 2007, the gap between the growth rates of China and other big countries was huge. Actually, in 2009, the gap between will be even bigger."

As the Great Depression II continues to lay siege to the world's economies, China remains a coiled spring of growth. Even though China is now the world's second- or third-largest economy, it still is a relatively poor country. And its resources are barely tapped.

The vast potential of China is hard to grapple with. Already, China has built the world's largest building (Beijing's airport terminal) and its longest transoceanic bridge. It has the world's fastest train and the biggest dam. As John Pomfret, former bureau chief for The Washington Post in Beijing, observes: "It is a nation of builders, of grand schemes, of gigantism." He calls China's engineers "some of the world's biggest risk-takers. Geeks with guts."

The Qinghai-Tibet railway was another engineering feat. Chinese engineers, already considered the best railway builders in the world, built a railway on the complex and shifting permafrost linking Llasa with Golmud in China's western hinterlands. The railway stretches hundreds of miles across a treacherous plateau.

Author Abrahm Lustgarten in China's Great Train describes the area as one of "intermittently frozen marshes, lakes and soggy permafrost that heave and shift more actively than almost any other geologic environment on Earth." In places, the quicksand is deep enough to swallow a tank. It is also higher than any other railway on Earth - at its peak, more than 16,600 feet above sea level. The cars of the train are pressurized as in an airplane, with oxygen pumped in.

After this stretch of the Qinghai-Tibet railway opened in 2006, the riches of Tibet started to come to light. The Ministry of Land and Resources disclosed huge resource finds - big veins of copper, zinc, lead, iron, gold, silver and other minerals.

"The new reserves make Tibet one of the richest regions in China's territory," Lustgarten writes, "and could shift the country's reliance on imports of copper and iron altogether." Tibet could hold 40 million pounds of copper - one-third of China's total. There is more than a billion tons of high-grade iron ore.

Again, Lustgarten: "Among the discoveries in Tibet was China's first substantial rich-iron supply, a seam called Nyixung, which alone is expected to contain as much as 500 million tons - enough to put an expected 20% of Chinese iron importers out of business."

More than just minerals, there is also an abundance of oil. Sinopec estimates some 65 billion barrels of oil will become accessible in Tibet. "A find, that if proven," Lustgarten writes, "would make the region one of the next great petroleum envies in the world."

What makes these projects economic now is the Qinghai-Tibet railway. Many Canadian and Australian companies already have joint ventures in place to mine the plateau.

The economy boomed in Llasa, too, thanks to the railway. The number of restaurants and bars in Llasa increased over 20% within a year of the railroad's completion. More than a million tourists took the train west to Llasa. Where it was once hard to find a hotel room in Llasa, over 660 hotels sprouted up after the railway. One, the Brahmaputra Grand, is a luxurious hotel with crystal chandeliers the size of Volkswagens and 50-foot tall plastic palm trees. A night here set you back $1,100.

Tibet industry up to that time was mostly in trading yak tails, fur and salt. And now, it looks as if Tibet will play the role of China's great western frontier, much like America west of the Mississippi in the 19th century.

There will be and is an ugly side to all of this that I've not talked about - the suppression of ethnic Tibetans and the weakening of a very old culture. China, though, continues to build and build. As Lustgarten notes: "The western outposts are linked by an expanding transportation infrastructure - roads, power transmission lines, pipelines and railways - built at a rate that makes Dwight Eisenhower look lazy."

But as with the rest of world, the pace has cooled. The fingers of depression wander all over the globe. No one can say how long it will take to work out of this mess.

However, some hopeful signs emerged recently. The China Electricity Council reports that electricity consumption rose nearly 7% in December, year over year. If no one has doctored up those numbers, that would be the first such increase since July. And there is some anecdotal evidence that housing prices in China are on the rise again.

Nonetheless, over the long term, China has lots of room and resources to grow. We got a glimpse of the implications of that growth in the last several years - the huge pull on resources such as oil, for instance. At the moment, economic depression has set in most everywhere. But longer term, it seems foolish to bet against the great dragon in the East.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. I mentioned above that China's electricity usage was up. There is opportunity in that. A slowing economy has not stopped China from investing in energy projects. China's power demand is still growing. And China overall increased spending on power grids by 18% last year...

• Australian Iron Ore Shares on China’s Menu
• China’s Economy is the Greatest Bubble on Earth
• Jules Begins His Last Year of School in Boston
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike

We just weren't made for soccer. Our lack of movement was legendary. Apparently (according to Dad's favourite story), the ball itself could roll all the way over to us and make contact with our foot without drawing a response. We'd look down at it briefly. It just wasn't that interesting.

But the standout feature of those soccer games was the lack of structure. There were no positions. The ball would move from Point A to Point B. Inevitably, a jostling, violent clump of 11 year-olds would follow it.

All players on both teams went to the same place. At the same time. For the same reason. It was the ultimate example of mob behaviour. And now we're seeing more of the same in financial markets.

The ASX chases the Dow wherever it goes. Last night Captain America's stock market lost 242 points. Leading the charge toward oblivion were US financials. Banker Lehmann Brothers (NYSE:LEH) and insurer AIG (NYSE:AIG) took a whacking.

And what ho...this morning BHP (ASX:BHP) and Rio Tinto (ASX:RIO) are down 1.5% apiece.

Australia is a two-sector market: financials and resources. But in a bear market, they cease to be two different sectors. They become the same thing. 'Stocks'.

The same was true for the US market in the early 1920s. More so. There was no index for the overall market. One each for the two different sectors: railroads and industrials. You could have chocolate or vanilla. No strawberry.

Industrials pulled the whole market up during WWI. Analysts were worried pre-war that Europe would sell US dollars for gold to help finance their war efforts. The opposite happened. Liquidity flowed in. To murder each other more efficiently, European nations needed to tap into the new, American industrial machine. They bought everything America could make.

At the turn of the century, US industrial stocks were worth about 25% of the market. By the end of the war that was closer to 80%. During that time, the railroad-dominated transport index had been up and down. Then the bear of 1919-1921 struck.

Prior to the bear, industrials were industrials. Railroads were railroads. They went up and down for their own reasons. In 1919, they all became 'stocks'.

There was no more discrepancy. The chocolate tasted awful. Vanilla tasted just as bad. Investors spat them both out. Each lost over 40% before the market settled in 1921.

The last year has eclipsed that performance. Pretty much anything with a price tag has tumbled in value at some point, on a global scale. It all went up, bar a couple of dogs like the US dollar. Now it's all coming down.

The common denominators? Stupidity, ignorance and speculation. Credit booms breed these things. Credit busts help eradicate them.

What we want to know is how the financial mountain-range will look after the snow of speculation has fully melted. Our guess is that the real Everest of the boom (Asian industrialisation) will stand a lot taller than the other, false peaks (banking, real estate, derivatives, stupidity).

On that point, Rio has raised an interesting possibility this week. It reports annual results later today. Expect double-digit profit growth and shameless spruiking of its businesses.

But the big miner gave us an appetiser this morning.

Your Most Honourable Chief Reckoner Dan Denning mentioned the possibility of a post-Olympics slump in China's economy recently. Something similar to Sydney. A slow-down in the economy as all the tourists and competitors head home, taking their spending money with them.

Best of luck to any athletes travelling Qantas. The swimmers should be fine.

Beijing isn't Sydney, though. It's the centre of the world's third grand industrialisation. And while the country was on show, everything had to look ship-shape. That meant a bit of spit here. A bit of polish there. Shutting down factories that otherwise would've spewed pollution into the path of Kenyan marathon runners.

"The Olympics have accentuated the usual summer slowdown in commodities demand," Rio's Chief Economist Vivek Tulpule told reporters yesterday. "When activity is allowed to start around - Beijing, there will be a post-Olympics jump."

There's the possibility China might have brought the slump forward. That's food for thought. Sydney didn't have smokestacks it could turn off prior to the 2000 Olympics. All it had was tourism spending.

But China has more internal demand that it can now bring into play. And it continues to prove that point. The greatest source of its wealth is its own people. Their spending and labour is self- contained. They have little to do with America's shambles.

China has 1.2 billion people living on incomes of around US$5,000 per year. The average person in a developed country makes over six times that. Catch up, China.

There will be bumps, of course. You can't grow a country at double- digits smoothly. And there's always the risk the whole thing could come crashing down in a heap. There's only so much oil in the ground, after all.

Until that happens we like a couple of metals plays. You'll find them in the recent pages of Diggers and Drillers.

The first is nickel. We'll hold off on dropping the full story here. Suffice to say, a lot of the world's biggest nickel mines are getting a mite expensive. That's putting a new floor under the nickel price. Want a closer look at the nickel market right now for free? Pop on over to Money Morning. Gabriel Andre has a few words for you.

But we don't mind telling you about the other play in full. We're out of time today. You can read the full report sometime in the next 48 hours. Keep an eye on your email inbox. And tomorrow we'll find out exactly what Rio has been up to there past six months.

Al Robinson
for The Daily Reckoning Australia

• CRB Index Correction Likely to Go Further
• Dividend Drop-Off: When Cushions Turn To Rocks
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• Australia Will be Affected By China’s Export Shrinkage
• Bailout Deal Will Expand China’s Influence in U.S. Economy

"China is unbelievable," was his judgment by evening.

Every detail is a superlative... bigger, faster, higher, more... more... more. Things are happening so fast that in just 10 years, China will be the world's biggest economy. We don't have to tell you what that means, dear reader. Give a guy some money and it's not long before he thinks he can tell other people what to do and how to live. The United States became the world's largest economy around 1900. By 1918, Woodrow Wilson was headed to France with his "14 Points."

"God himself only needed 10," said Clemenceau.

But America had lent a lot of money to the French and English; they had to listen politely, even if they thought Wilson was a fool.

Now, China has the money - the biggest pile of dollars in the world. And soon it will have the most powerful economy. It won't be too much longer before Chinese leaders will want to throw their weight around. And they'll have plenty of pounds to toss wherever they want. There are only 5 girls for every 6 boys. By the time China has the world's largest economy, it will also have 30 million young men who cannot hope to find a wife. What will they become? Soldiers! Then, China will have the world's biggest and most modern military... and a keen desire to show the rest of the world how things should be done.

How do you say, "We surrender" in Mandarin? We don't know, but the Pentagon may want to look it up, just in case.

But don't worry, that's still a long way away... with many a slip betwixt the cup and the lip. Oh yes, China is headed for trouble too... you can't have that kind of growth without trouble. In some ways, China is the biggest bubble the world has ever seen - bigger than dotcoms... bigger than U.S. housing... bigger than credit, finance and derivatives. Not only is it expanding rapidly - it MUST expand or it will blow up. Like a credit bubble, it can't rest... it can't stand still. If it stops expanding... bad things happen. In a credit bubble, people need more and more credit to service the bad loans and bad investments they've made. If they don't get more money, the credits go bad. Businesses go belly up. People miss their payments. Loans get marked down. Pretty soon, you have a recession... or worse. China's bubble is far more dangerous... because it has hundreds of millions of people who have come to depend on high rates of growth. They can't stay where they are... they're not peasants anymore. They've moved to the cities to join the international proletariat; they need work! They need progress! They need to build giant roads and aqueducts... airports and factories. They need to produce more things. They need to contribute to the global economy. They need jobs. And if they don't get them, China could blow up. What's more, China's economy is run - at the very top - by officials who are even more blockheaded than our own. If trouble fails to find them; they'll find it.

What caught our eye was a chart of China's oil use. Ten years ago, China imported 165 million barrels of oil per year. Today, the total is more than 1 billion. What does it do with all that energy? It grows... it develops... it chugs... it thumps... it soars.

Looking at the photos (we haven't been to China for more than 15 years), the replace reminds of a teenager - sassy, obnoxious, and outgrowing his pants. It is an adolescent nation, growing so fast it must eat all the time. In addition to the oil, China has opened 229 new coal-fired power plants since 1990.

Wonder why the price of oil hit a new high last week - above $126 a barrel? Well, China is a big part of the answer.

And rice is now selling for twice as much as did last year. Could that too be blamed on China? Well, partly. When the Chinese lived on the land, they fed themselves with what they produced. But once in town, they become more customers for the globalized market... competing for their daily bread with people in Des Moines and Dubrovnik.

You've heard the expression about land - 'they're not making any more of it.' Well, in China, they're actually losing it. Since 1949, says National Geographic, China has lost one-fifth of its farmland to dust-storms, desertification, pollution and urbanization. Each year, the country loses more ground - an area approximately as large as the state of Rhode Island.

Let's see, more and more people moving to the cities - hundreds of millions of them. Building factories... building houses... buying cars... washing machines... computers... More and more people competing for the world's resources... less and less farmland...

Oh, we'll do the math later.

*** In China, people are working their way up - from the rice paddies to the packing plant... from the country hovel to the urban tenement. Soon, they will be moving to the suburbs and buying SUVs. Wait... they're already moving to the suburbs. The National Geographic has a photo of a new suburban development near Shenyang. There are houses that look like they might be in a suburb of London or New London - with white picket fences, lawn chairs and satellite dishes. And what's this... there are so many rich people eating at fancy restaurants in Beijing that a chef in the city already makes about as much as a chef in Manhattan!

In America, meanwhile, people are working their way down. We're not kidding. Wages are stagnant. Prices are rising. At the end of the day, they have less spending power; they are poorer. Besides, it said so in the New York Times. People lose their houses... move back in with their parents... and put their stuff in a storage unit. Then, they either can't make the storage payments... or they realize that the move wasn't just temporary and they give up. Pretty soon, the auctioneers are selling the stuff.

Of course, they didn't really need all that stuff in the first place. But getting more stuff is what life is all about... isn't it? So they got it, and now they have to get rid of it. If only they could hold a yard sale in China!

Bill Bonner
The Daily Reckoning Australia

• Invest in China’s Geeks and Guts
• Investors Think Things Will Return to the Way They Were in the Bubble Epoque
• The World’s Largest Cities
• Gold Not a Perfect Way of Measuring Wealth, Just the Best Way
• New York Will No Longer be Among World’s Five Largest Cities

"A friend who works at United Stationers - one of the larger office supply companies - tells us that there's a noticeable slowdown. People are being given days off with no pay, etc."

*** And here is our new friend David Fuller of Fullermoney with an insight:

"Despite China's dependence on the ailing US, its economy continues to charge ahead. Recently, it was announced that China's real GDP grew by a fantastic 11.2% in 2007. There is no doubt that China's economy is booming and in 2007, its trade-surplus doubled when compared to a year earlier. Moreover, retail sales in China have been growing at 14% per annum for many years and in the past 12 months, total sales reached almost US$1 trillion. Interestingly, the number of US Dollar billionaires in China jumped almost 10-fold in the past year from 14 to 106 individuals. All of the above leads me to conclude that the Chinese consumer will be an extremely influential factor in the years ahead.

"Elsewhere in the region, India's economy is also growing rapidly with real GDP growth clocking in at roughly 9%. Its industrial production has slowed down somewhat in the recent past but production of capital goods continues to soar.

"As far as the Asian region's dependence on the US market is concerned, Singapore, Hong Kong and Malaysia are the most exposed to the American consumer. Their exports to the US are equal to roughly 20% of their GDPs, compared with only 8% in China and a miniscule 2% in India.

"Due to the slowdown in the West, exports to the US from Singapore and Malaysia have declined by roughly 15% from their peaks. Yet, it is worth noting that both these nations' total exports have still managed to grow by 6% due to surging exports to Europe and the other emerging nations. This data suggests to me that we are slowly but surely moving away from a US-centric world."

Bill Bonner
The Daily Reckoning Australia

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