- Edward Gibbon

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

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

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

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

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

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

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

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

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

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

By European standards, America is cheap.

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

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

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

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

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

David Rosenberg:

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

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

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

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

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

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

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

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

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

So why are people buying bonds with such puny yields?

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

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

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

But what if they're all wrong?

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

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

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

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

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

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

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

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

Bill Bonner
for The Daily Reckoning Australia

• America’s Decline as a Great Empire
• Warren Buffett Says American Economy is a Shambles
• Mistakes Made By America Are the Same Mistakes That Empires Make
• Deleveraging Will Give Us a Bout of ’30s-Style Deflation
• Biggest Problem With US Economy is Too Much Debt

..how does it all work? We're doing some serious thinking this week. What is it that actually causes a depression? A stock market collapse? Or too much debt? How come government can appear to cure the problem sometimes - 2001-2007 - but not other times? How come the Japanese were not able to increase consumer prices? Even now...Japan's inflation rate is negative. And why is it, despite the most massive effort at monetary inflation ever undertaken, the US bond market still forecasts an inflation rate of less than 2%?

An interview with Richard Koo, author of The Balance Sheet Recession, and a new book by Ken Rogoff and Carmen Reinhart are helping us understand what it going on. More to come...

In the meantime, the Dow went down 42 points on Friday. Gold dropped $7. Still no sign of the Chinese coming to the rescue in the gold market.

"Global rally shows signs of running out of steam," says The Financial Times.

Reuters says the job data will "test the rally." The New York Times says the ratio between job seekers and jobs available has never been worse.

The Wall Street Journal, on the other hand, tells us that greater than expected profits will support the rally. So far, the increase in stock prices has not come from increased earnings. It's come from increased P/Es...based on the hope of higher earnings. In terms of forecast earnings, the Dow is selling at a P/E ratio of 27. But in terms of actual, reported earnings...the ratio if 180.

A friend made the mistake of asking us what to expect from the economy. We said it would go do down.

"You mean, you expect a W-shaped recovery," he said... "A double-dip recession?"

"No...we expect no recovery at all. It's a 'W' without the last stroke..."

Of course, we were exaggerating. But not much. We do not think that the economy of the Bubble Era can ever be revived. It will never recover...because it is dead.

But that's doesn't mean we will march backward forever. The economy may lose 10% of GDP...maybe 20%. But we do not expect to be slithering in the mud of the Middle Ages, with each man is planting his own wheat and brewing his own beer. No, not at all. It only means that the depression must continue until it comes to an end.

"But when will it come to an end?" you ask.

"When it is over."

A depression ends when it has done its work. It must correct mistakes. It must punish errors. It must destroy the bubble economy...and the mindset of the Bubble Era. Only then can new real, sustainable growth begin again.

So far, in 2009, 95 banks have gone broke. How many more need to go broke before the depression is over? We don't know. This is where is gets complicated. Because the feds are determined to keep us from finding out!

Here's how it works. The Fed lends the bankers money. Then, the bankers turn around and lend it back to the feds. The banks are happy; they're making money on a risk-free trade. The regulators are happy; what could be safer in a bank's vault than US Treasury bonds? Investors are happy; it looks like the financial sector is making money again. And the feds are happy; they're able to finance their deficits.

Who's not happy? So far, so good. But hold on...

"This is not a sustainable recovery," says fund manager Crispin Odey in The Financial Times.

What a spoilsport! You mean you can't build a lasting recovery on debt and shell-game finance?

Nope. Apparently not. Just look at what has happened to the auto industry. The feds borrowed money to help Americans pimp their rides. And this Thursday, when September sales figures come out, we find out how sustainable that boost was. Many Americans got new wheels. But now they don't need new wheels. And now the feds are out of the auto- incentive business. So now we get to see what happens next.

Stay tuned...

Bill Bonner
for The Daily Reckoning Australia

• Krugman Warns That the Run-up in Stocks Can’t Be Justified By the Fundamentals
• No Evidence of Recovery as Unemployment Getting Worse
• We Don’t Expect to See Australian Banks Suddenly Keen to Expand their Loan Books
• Where, Exactly, is this Economy Headed?
• Feds Can’t Cause a Genuine Recovery Simply by Throwing Money into Economy

The story goes, Achilles was dipped in the river Styx and made invulnerable. But his mother held him by his heel, leaving that part untouched by the magic waters. Naturally, that is where a poison arrow got him.

The moral of this story is that you have to go all the way. If you want your baby to be invulnerable, put him all the way under the water...even the heels. Or, maybe there's another point: that there's always some place where you're vulnerable.

For the purpose of today's tale, we'll take the second possibility. Try as you may, you can never escape all risks.

All over the world, consumer prices are falling. The world has too much capacity...too many factories...and too many workers. Too many, that is, for current demand. The 'world's mouth' - the USA - has gone on a diet. And if the United States reduces its intake, that means the rest of the world - especially China - must reduce its output. Otherwise, the whole thing will become unbalanced.

Yesterday's news tells us that despite press reports of a recovery, the key indicators of real economic growth are still falling. Almost one out of ten mortgages are now delinquent. And the rate of foreclosures is increasing faster than any time in the last 30 years. Housing prices, meanwhile, fell 16% in the 2nd quarter, from a year earlier, according to the National Association of Realtors.

Unemployment claims went up last week. The sharp eyes of The Financial Times see the link: "Mounting joblessness fuels US housing crisis," says its headline.

In the real economy, people are cutting back...with the inevitable results we discuss every day here in The Daily Reckoning. One major consequence of reduced demand is too much supply. The factories built in China to supply products to America during the bubble years now find they have no market.

Currently, overcapacity and oversupply are causing prices to fall. Falling prices mean rising currency values. Each unit of 'money' buys more stuff. But there are many competing currencies, and they don't all rise and fall together. Even in a world of deflation, some currencies will deflate more than others.

The dollar is, of course, the world's main money. In a sense, the whole world economy is under its heel. But it is a heel that has never been dipped in the river Styx. It is now a heel that waits for an arrow.

PIMCO is the biggest manager of bond funds in the world. It says the greenback is going to lose its status and lose its value.

"Investors should consider whether it makes sense to take advantage of any periods of US dollar strength to diversify their currency exposure," says its Emerging Markets Watch report. "The massive amounts of US dollar liquidity produced in response to the crisis" doom the currency.

Both China and Russia are calling for a new global currency to replace the dollar.

"While we have not yet reached the point where a new global reserve currency will arise, we are clearly seeing a loss of status for the US dollar as a store of value even in the absence of a single viable alternative," continues the PIMCO report.

Meanwhile, our old friend Jim Rogers says he is moving all his assets out of dollars and buying Chinese yuan. And Warren Buffett warned this week - writing in The New York Times - that "greenback emissions" threaten the whole world econo-system.

But what does it mean? What are the threats to you? What are the opportunities? If you pay your bills and keep score in dollars, what does it matter if the dollar loses value against the yuan? If prices are generally falling, the dollar is actually getting stronger, isn't it? So what if some other currencies are getting even stronger still?

Colleague Bill Jenkins, at Master FX Options Trader puts in his two cents:

"We lived through a financial earthquake in 2008. The effects of it are still being felt. Aftershocks may still be ahead. But predicting when they'll strike is just as hard as predicting natural earthquakes. We had a number of prognosticators for years telling us about what would happen last year; it's just that they didn't know when. And that is the hard part of the life of a prophet.

"And while it is equally difficult to tell when the next economic tremors will hit, we can look at the numbers and make some predictions as to their cataclysmic effect."

Bill goes on to say that he thinks the US is headed for another shockwave...which will include another round of dollar buying - even while the 'experts' are touting 'green shoots' and a return to normalization.

The trouble with the Achilles' heel is that it is connected to the Achilles' tendon...which is connected to the leg muscles...which is what keeps the whole thing moving forward. Cut the tendons and the feet go flippety, floppety and you get nowhere.

Yesterday came word that the US deficit for 2009 might come in lower than expected. Instead of borrowing $1.8 trillion as anticipated, the feds might only borrow $1.58 trillion. Well, that still leaves them about $680 billion short - even if every dollar of trade deficit and every dollar of domestic savings is applied to it. But definitely a step in the right direction! This gap must be closed by quantitative easing, or, in other words, by printing press money. So, holders of old dollars are bound to wonder how much their savings will be weakened by the addition of so many new ones.

They're likely to wonder, too, how much those US Treasury notes will be worth after this monetary inflation catches up to them. At some point, they are likely to think twice about buying more of them...and possibly even want to sell the ones they have already. Either way, it could create a nasty financial whirlpool that sucks down the entire world economy. As private investors reject US dollar credits, the Fed would be forced to print up more money to buy them itself. As the Fed buys more, private investors become more fearful that this monetary inflation will lead to consumer price inflation; they may panic and dump all dollar-denominated assets.

But if investors drop the dollar, what do they take up in its place? Oil...maybe. Oil is selling for $72 a barrel, even while the world is in a major downturn. What makes it so expensive, if not the fear that the currency in which it is quoted is more slippery than the black goo itself?

And gold? Yesterday, gold lost $3. But is still trading in the mid- $900s - not far from its all-time high. And this at a time when consumer price inflation is going down! In the US non-oil export prices are falling at a 5% rate. If people are buying gold as a hedge against inflation, they must know something we don't. Consumer prices are falling...actual CPI rates are negative in many countries already. Take out the effect of speculation on oil and commodities, and deflation is probably a fact of life almost everywhere. Gold buyers are not hedging against an increase in the price of bread, in other words; they're hedging against a poison arrow directed at the dollar itself.

Though gold may not make you rich tomorrow, as a long-term investment, there's nothing better. Strike while the iron is hot...or, while gold is relatively cheap. It's sure to get much higher than it is now...perhaps as high as $2000 an ounce.

Bill Bonner
for The Daily Reckoning Australia

• A Dollar Crash Will Have Disastrous Implications for Global Financial Markets
• Will Synchronized Rate Cuts Solve International Financial System Problems?
• 4 Ways to Protect Against a Falling Dollar
• The More Money in a Financial System the Less Each Unit is Worth
• Prices of Gold in the Top 10 World Currencies

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
• Where, Exactly, is this Economy Headed?
• How the Stimulus Works

It was a rainy day in the Emerald Isle yesterday. The wind was blowing. Rain was coming down. By 7pm, it was time for a pub and a drink. The Irish know what to do in the evening...

"Welcome to Ireland," said the cab driver this morning. "Don't you love this summer weather?'

It would have passed for a bad winter in Maryland. Cool. Wet. Disagreeable.

"What happened to that global warming?" asked a colleague. "It was supposed to make Ireland hot and dry."

Meanwhile, back in the USA...people were wondering what happened to the stimulus program. It was supposed to stimulate.

Mr. Geithner says it is working. He says it's "too soon" to begin thinking about another stimulus program. But every time we pick up a paper someone is voicing the need for more stimuli. And the things that really matter in the economy are going in the wrong direction: Jobs are going down. House prices are going down. Consumer prices are going down too.

This from Robert Reich's blog:

"Recovery doesn't depend on investors. It depends on consumers who, after all, are 70 percent of the US economy. And this time consumers got really whacked. Until consumers start spending again, you can forget any recovery, V or U shaped.

"Problem is, consumers won't start spending until they have money in their pockets and feel reasonably secure. But they don't have the money, and it's hard to see where it will come from. They can't borrow. Their homes are worth a fraction of what they were before, so say goodbye to home equity loans and refinancings. One out of ten homeowners is under water -- owing more on their homes than their homes are worth. Unemployment continues to rise, and number of hours at work continues to drop. Those who can are saving. Those who can't are hunkering down, as they must.

"Eventually consumers will replace cars and appliances and other stuff that wears out, but a recovery can't be built on replacements. Don't expect businesses to invest much more without lots of consumers hankering after lots of new stuff. And don't rely on exports. The global economy is contracting.

"My prediction, then? Not a V, not a U. But an X. This economy can't get back on track because the track we were on for years -- featuring flat or declining median wages, mounting consumer debt, and widening insecurity, not to mention increasing carbon in the atmosphere -- simply cannot be sustained.

"The X marks a brand new track -- a new economy. What will it look like? Nobody knows. All we know is the current economy can't 'recover' because it can't go back to where it was before the crash. So instead of asking when the recovery will start, we should be asking when and how the new economy will begin..."

These comments sound sensible enough to us. In fact, colleague Rob Parenteau has been saying something quite similar in these pages. "Over the last three decades," he says, "we've taken one of the greatest industrial nations in history... and traded it off piece by piece. In its place, we became the world's #1 shopping nation.

"Even now, we're facing an economy in which 70% of our economic output depends on consumer buying. No buyers, no recovery.

"And yet, unlike other recent minor busts and even major corrections, the lesson hundreds of millions of strapped Americans are learning all over again is that same lesson our forebearers learned after 1929.

"Namely, that the law of personal and financial responsibility is as irreversible as the law of gravity. And it's the egg that no bureaucrat - no matter how popular - and no multi-billion dollar bailout - no matter how large - can unscramble.

"In short, the hearts and minds of the American consumer have been thrown into reverse. And it's this total psychological 'snap' that will make a back-to-baseline conventional recovery impossible any time soon."

Bill Bonner
for The Daily Reckoning Australia

• Wage Pressure in China to Drive Up Cost of Goods in Australia
• If the US Economy is Really Following Japan Things Will Get a Lot Worse
• What Evil Sends Investors Running to the Protection of Gold?
• When People Fear Inflation or a Falling Dollar They Find Refuge in Gold
• Fannie and Freddie Say Goodbye to Veto

So where's the surprise for us? What'll it be? Japan or Zimbabwe? We've already said we're expecting both Japan and Zimbabwe. What else could it be? And we're ready for them both.

Well, needless to say, we'll be surprised like everyone else. And needless to say, we don't know what will surprise us. But we have an idea. Almost everyone we know is expecting a fairly quick up-move in inflation. Our guess is that that up-move might be a long way off.

"It's a very funny and troublesome situation," said a fund manager in Boston last night. "The world's central bankers are committed to a policy of monetary inflation...which they call 'Quantitative Easing.' And they believe that inflation targeting is the way they can tell if their policy is working. That is, they believe they will know when to stop inflating the currency by looking at consumer prices. When consumer prices begin to rise, they'll be ready to stop adding to the money supply. In fact, they say they'll then turn the machine to reverse to take out the extra cash they've added.

"So, they'll keep at it until the CPI goes up. But by the time they see consumer prices rise, it will be too late. By then, people will be eager to spend...to get rid of dollars. And once they begin to spend again, the velocity of money will go up. And with it, inflation rates will go up higher...and then dollar holders will want to get out of bonds quickly...because they'll see the next move too - a drop in bond prices.

"Well, how could the Fed combat this rising inflation? And prices could be rising very, very fast. It would have to go back into the market and sell those bonds that it bought from the Treasury. Selling the bonds would have the opposite effect as buying them. Instead of creating money with which to buy bonds, it would re-absorb money when it sold them. People would pay money for the bonds...and the cash would be sequestered by the Fed.

"So, you'd have the Fed trying to sell bonds just when everyone else was selling them. At that point, with the biggest bond buyer in the world turning into a seller, the Treasury market would collapse. This would paralyze the Fed. It might want to sell Treasuries. But, under the circumstances...with yields soaring and prices crashing...it wouldn't be able. So all the inflation that it put in the system would have to stay there...and inflation would have to run its course.

"It's very hard to know what to do as an investor. I guess in theory you should stay long treasuries...buy them as long as the Fed is buying. And then you should go short...sell them, just before the inflation numbers turn positive...and just before the Fed tries to sell. But that is going to be very, very difficult timing.

"I began buying gold for the first time ever last week."

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Central Banks’ New Money is Piling Up
• Things That Matter in the Economy are Going in the Wrong Direction
• Irish Govt Pledges Bailout, Who’s Next?
• In Gono We Trust
• Zero Percent Interest Rate Didn’t Work for the Japanese

That’s the kind of lead that should be good for the local market. And then there is that speech Glenn Stevens gave yesterday in Sydney.

Stevens said that higher interest rates look like they’ve slowed down demand in the Australian economy. As a result, "It looks more likely now than it did a couple of months ago that this more moderate track for demand will continue," and that it would "in due course begin to exert downward" pressure on inflation.

The papers loved it. “RBA boss hints at rate cute,” reports the Age. “Australia winning battle against inflation,” reports the Herald Sun. “Reserve may cut rates despite 'high' inflation,” says the Canberra Times. We are told that even a big CPI number on July 23rd won’t worry the RBA too much, now that the fight against inflation appears to be won.

Hang on.

We are going to ask an obvious question. Sometimes the obvious is so obvious that everyone ignores it. But we feel compelled to be obvious this morning and are not afraid of looking stupid for challenging a basic assumption. It wouldn’t be the first time.

Does the Reserve Bank (and the bulk of the Australian financial press) believe that consumer demand causes inflation? If so, it is either a deliberate deception or monumental monetary stupidity. Let’s unpack that, as Dr. Phil might say.

If you think that rising demand causes inflation, the sensible thing to do is reduce demand. You do that by raising interest rates. The higher cost of money causes people to cut back borrowing and be more prudent. Aggregate demand in the economy falls, and, presumably, so do prices.

But that is all catastrophically backwards. It is a text book cause of putting the cart before the horse. In simple terms, it is a faulty definition of inflation. Inflation is not “rising prices.” More on this crucial point in just a moment.

While we’re on the subject of inflation, both consumer and producer prices in the U.S. blew out this week. Big time. Uh oh.

Wholesale (producer) prices in the U.S. grew by 9.2% over the last twelve months, according to data published yesterday by the Commerce Department. It was the fastest 12-month growth rate in 27 years. And today, we learn that consumer prices are rising, too.

Consumer prices for food, fuel and other things people actually buy rose by 1.1% in June. But over the last twelve months, the rate is more like 5% (and probably much higher than the official figures suggest). It’s a shame if you’re living on fixed income in America these days. The Fed is plundering the value of your savings to bail its buddies in the risk-mismanagement business. Too bad.

However, the bad news for savers kicked of a perverse rally in the U.S. dollar. P-day will have to wait. Ignoring the actions and words of the Fed, some traders apparently believe the higher inflation figures mean the Fed is more likely to raise rates this year, making the greenback a bit more attractive than it currently is (how much uglier can it get?)

The merest possibility of a rate hike, plus the good news from Wells Fargo, sent the Dow up 276 points. The money centre banks (Wells Fargo, J.P. Morgan, Citigroup, Bank of America) were all up, with the industry index itself climbing by 16%.

Here’s some more obvious free advice: Don’t be fooled by the fake-out rallies. The big money centre banks are unlikely to fail. Why?

Well, take a look at who’s on the Board of Directors of the New York Fed and you’ll see why. The big American banks won’t be allowed to fail because they ARE the Fed. The smaller banks that have GSE debt on the balance sheet (but don’t have friends in high places) aren’t going to fare as well.

Even though we expect the money centre banks to look out for each other (via the Fed), there are signs of dissension in the ranks among the Wall Street elite. It’s kind of fun to watch. We read yesterday that Lehman’s CEO Richard Fuld is rumoured to have confronted Goldman Sachs CEO Lloyd Blankfein over even more rumours that Goldman traders were disseminating bogus information on Bear Stearns and Lehman to make a profit.

Now that could ever happen, could it? It would be illegal to profit by knowingly circulating false or misleading information. We can’t imagine anyone in the investment banking business doing it.

Yes, internal quarrelling is a sure sign that Wall Street is really worried about its model. It’s like watching a bunch of high school cheerleaders gossip about who’s cheating on who’s boyfriend. Normally these institutions are united in their Olympian disdain for the individual investor. They are now divided over their mistrust of one another.

To modify an ancient phrase, “Those whom the gods wish to destroy they first make envious.”

Now, about this inflation issue.

If you navigate your way to the Glossary of Terms and Definitions at the Reserve Bank’s website, here is how you’ll find the word inflation defined:

A measure of the change (increase) in the general level of prices.

That is simply wrong. But rather than acting like a school teacher about it, we’ll give you an example of why this definition mistakes an effect for the cause.

Let’s say you’re in a bar having a quiet drink. Next to you is a man drooling on his chicken parma. He later rouses himself and turns to make conversation with you, only his tongue is so thick you can’t understand anything he’s said. Much later, he strips naked and dances up and down the length of the bar, shouting that the Dow is going to 20,000. After the police come and arrest Jim Cramer, they ask you a few questions.

“Did you know the suspect was drunk because he couldn’t hold his head up?”

“No.”

“Did you know the suspect was drunk because he danced a jig in your mashed potatoes?”

“No.”

“Did you know he was drunk because he claimed the Dow was going to 20,000?”

“No.”

“Then how did you know he was drunk?”

“Because I saw him drink eight beers, three shots of vodka, and a purple hooter.”

“You mean you knew he was drunk because he’d consumed too much alcohol?”

“Yes.”

Inflation is caused by an increase in money supply. Rising prices are merely the effect of the increased money supply. You wouldn’t blame rising prices on excess demand any more than you’d attribute a man’s drunkenness to his behaviour. The effects cannot be the cause.

-You don’t cool inflation by cooling demand. You cool inflation by making sure the growth in the money supply does not exceed the growth in the economy. When money supply growth exceeds real growth in goods and services, prices are going to rise. It all begins with the artificially adjusted supply of money.

Simple price rises are not inflationary. For example, with low unemployment in Australia, wages are going to rise. This is a simple case of supply and demand, and doesn’t have as much to do with the supply of money. But rising prices don’t always indicate inflation. You get inflation when the money supply expands, plain and simple.

For years in Australia, money and credit growth has exceeded GDP growth. This is what causes inflation. The RBA knows this. It published the graph below. What do you think it means?

The RBA says that, “Broad money is defined as currency (that is, notes and coins held by the private non-bank sector) and highly liquid assets held at financial institutions by the private sector, including deposits, cash management trusts (CMTs) and certificates of deposit (CDs).”

You can’t make this stuff up. It is what it is. The Bank erroneously believes that inflation is a rise in prices. But a rise in the general level of prices can only occur if there is first a rise in the money supply. And as you can see, the Bank knows full well that broad money has been growing at double digit rates for years, most recently at 17%. It should not come as a surprise then, that prices are rising. But you can’t blame it on consumer demand. Inflation begins and ends with money supply growth.

Just exactly why governments pursue systematic inflationary policies is another question. And it’s not just an economic question either. It’s partly moral and partly philosophical and somewhat diabolical. More on that tomorrow. And by all means, if you believe we’ve made a mistake in our interpretation or mischaracterised the RBA’s definition of inflation, let us know at dr@dailyreckoning.com.au.

Dan Denning
for The Daily Reckoning Australia

• The Drunk at the Dentist Office
• RBA Declares ‘Victory’ Over Inflation in Australia
• Reader Mail: Inflation Debate Rages
• Everyone We Know Expects a Fairly Quick Up-move in Inflation
• The Confusing Big Picture in the Oil Market

Peak this...peak that...

This just in from a Dear Reader, throwing our own words back in our face:

“‘Now, it appears that the gains from mechanization, bioengineering, chemistry and land clearing may have reached their limits. We may soon reach Peak Food’

“Now, let me ask: Has the DR morphed into a Marxist newsletter or something?”

Another reader was more flattering...

“Your writing reminds me of H.L. Mencken, after he had his stroke. But seriously, the one thing that marks human history...above all else...is the constant rise in population and the constantly improving technology to support it. I don’t see any reason why that basic theme should change. Peak Food? Don’t trouble yourself about it...”

Don’t worry about us, dear readers...we have not lost a wink of sleep to the peaks...neither Peak Oil nor Peak Food bothers us. No, it is not the peaks that disturb our sleep...it’s the valleys.

As our Dear Reader points out, we’ve faced peaks before. Many of them. Somehow we’ve made it over them – and then scooted down the other side. That’s how history works – like topography. Peaks, valleys, and broad, fertile plains. What more could you ask for?

We’ll return to the Peaks in a moment...but first let us look around...and get the lay of the land.

Oil sold off last week...and ended at $127. Gold rallied on Friday, but still ended the week considerably down.

Last week, we thought we saw an important break in the terrain. Speculators were betting that the Fed would reverse course and begin raising interest rates. This boosted the dollar, whacked gold, and sent the bond market tumbling. Lower bond prices come with higher yields; soon, the economy begins to sulk as if it had been punished.

“US mortgage rates leap ahead as investors bet on move from Fed,” is the headline in the Financial Times this morning. Thirty-year fixed-rate mortgages rose above 6% for the first time in nearly three months; jumbo mortgage money cost 7.21%. Ten-year notes, meanwhile, fell to yield more than 4%.

Ain’t markets wonderful, dear reader? All that hard work that the feds have been doing – all designed to keep rates low so that people would borrow more money; it can all be undone by a day’s trading!

“The surge in mortgage rates will make it more expensive to buy homes and less likely that existing homeowners will be able to refinance mortgages. That in turn, is likely to dampen hopes of an early recovery in the US housing market,” explained the FT .

What went wrong?

Ah...remember the “crude oil vigilantes?”

When the Fed began cutting rates last September, the price of oil shot up. High oil prices are now oozing into the entire economy...greasing up prices for everything from cucumbers to diapers. And the trends that held consumer prices down for so long are shoving them in the other direction. Labor costs were forced down, for example, as hundreds of millions of Asians entered the worldwide job market. But now those laborers are cooking with gas...and driving automobiles...and eating regular meals – competing with Americans for food and energy, and driving up prices even as the U.S. economy goes into a slump.

Here is the latest from the Associated Press :

“Indonesians are staging protests against shrinking gasoline subsidies in a nation where nearly half the population of 235 million lives on less than $2 a day. And there are now 887 million vehicles in the world, up from 553 million vehicles just 15 years ago, and on track to nearly double to a billion by 2012, according to London-based consultancy Global Insight.

“So as oil prices have soared, average U.S. [gasoline] prices have gone up 144 percent in the past five years – from $1.67 in May 2003 to $4.02 a gallon this month, according to the U.S. Energy Information Administration. Over the same period, gas prices in France went up 117 percent to $9.66 a gallon.

“Proposals by U.S. presidential candidates John McCain and Hillary Clinton to suspend federal gas taxes this summer would lower the price tag – but have little effect on the underlying oil price. French President Nicholas Sarkozy has urged the EU to cut value-added tax on fuel.

“French fishermen and farmers, who need fuel for their trawlers and tractors, say their livelihoods are threatened by soaring prices and have blocked oil terminals around France and shipping traffic on the English Channel to demand government help. Italian, Portuguese and Spanish fisherman joined them and went on strike Friday. British and Bulgarian truckers are staging fuel protests, too.

“Turkey faces similar problems – and even higher prices – $11.29 a gallon, which for a full tank in a midsize car can reach nearly $200, enough for a domestic plane ticket.”

This is just the tip of the iceberg...

How do people deal with higher gas prices? Of course, they economize. In the Philadelphia area, for example, Triple A reports that they buy less gasoline...and then run out. AAA is getting twice as many calls from stranded motorists with empty tanks.

Consumer confidence is out of gas too – at its lowest reading in 28 years. And no wonder; house prices are still falling...while consumer prices are going up much more quickly than CPI numbers suggest.

On the housing front, the Boston Globe reports that some nearby cities have seen property prices fall by as much as 33% in the last year. And the New York Times adds that the housing problem is “trickling up” to the upper middle class. It may have begun with marginal subprime borrowers, says the paper, but now even expensive houses in good neighborhoods are getting marketed down...and taking much longer to sell. God forbid that you need to sell in a hurry; sellers have little bargaining power.

And thank God for those rebate checks. They’ll buy nearly 300 gallons of gasoline for every man, woman, and child in the country. That ought to keep the nation rolling for a bit longer...

*** Back to our theme. What was it? Oh yes, Peak Food. Well, we won’t actually have anything to say on the subject until later in the week. For today, we merely observe that people are ready to believe practically anything. In the early ’70s, they seemed to believe that we would all “starve...in the dark” as the world ran out of vital supplies. Then, in the ’90s (and still today) most people came to believe that there is nothing to worry about...that new supplies will always come forward just when they are needed.

Bill Bonner
The Daily Reckoning Australia

• Americans Are Hoarding Food
• Oil Has Hit a New Record High
• A Consumer Economy Doesn’t Work
• Investors Fear Rising Inflation
• Stock Markets All Over the World are Getting Whacked

It's in the mail, dumbo.

The U.S. feds have been hard at work pushing out $110 billion of 'rebates,' designed to help Americans do what they already do best - spend money that they never earned.

The resulting spending spree comes after 7 rates cuts sent the Fed's lending rate down to only half the rate of consumer price inflation.

At the end of last week, the Fed also announced that it would allow lenders to launder their dirty car loans, student loans and credit card debt; they can henceforth use it as collateral for loans from the Fed. And this week, Ben Bernanke, guardian of the nation's money, urged Congress to take action to avoid more foreclosures.

And then, there's the promise of a "tax holiday" on gasoline for the summer.

All these measures are designed to do the same thing - make people feel richer than they really are. Thanks to the Fed's emergency low interest rates, they can borrow more money and pay less for it. Thanks to the 'rebate' checks, they can spend more money too. If the feds intervene to block foreclosures, as they have already stepped in to bail out Wall Street, people who should have gone broke can still hold their heads up...and live in houses they can't really afford.

And now, dear reader, we find that all these marvelous deceits are having an effect; they're bamboozling almost everyone into thinking things are getting better.

There's also a hidden flimflam...an even more important one. Since '95, reports Martin Hutchinson, the U.S. money supply, as measured by 'money of zero maturity,' has gone up at about 8.8% per year. The average fellow, seeing that he has 8.8% more cash - and with no knowledge of the volume theory of money - might reasonably conclude that he is richer. But when money increases faster than the goods and services it's destined to pay for, the result is rising prices. At 8.8%, U.S. money supply was increasing about 50% faster than the GDP. You'd expect prices to rise and the dollar to fall - which is exactly what has happened.

But recently, the feds have put their fabulous money machine into high gear. MZM has been going up at a 28% annual rate over the last three months.

Here at The Daily Reckoning, our theory is that the feds' inflation will goose up prices of commodities, gold, U.S. money supply and oil - but not the real economy. So far, that seems to be what is happening. The CRB commodities index is up 24% since last September. Oil has gone up 25% this year. Natural gas has risen 49%. Gold, meanwhile, has only gone up 4.8% in 2008...but this is after a correction; remember, it was over $1,000 just a few weeks ago.

As for consumer prices...the latest numbers show consumer prices rising at an 11% rate in March. This number would have been a shocker - if it had ever seen the light of day. Instead, the boys down in the basement of the Labor Department went to work on it with hammers and baseball bats; when they were finished, the number had been 'seasonally adjusted' down to only 3.6%.

But consumer price inflation is definitely in the pipes. It will start coming out of the faucets and backing up in the drains soon. Yesterday, oil - the sine qua non of modern economies - rose to a new record high of $122 a barrel. People are killing each other over rice and wheat. Farmers are sleeping in their fields to prevent thieving neighbours from helping themselves. And crooks are peeling the lead roofing off of churches in England...pilfering copper gutter pipes in Baltimore...and stealing the manhole covers in Detroit. This huge run up in prices of primarily materials has to make its way into prices for finished products - sooner or later.

And how about the economy? The latest report showed the economy growing at a 0.6% annual rate. Since the population is growing at 1%, this represents a real decline in output per person. We're getting poorer, in other words - just as forecast.

Still, all of this new cash and credit is creating its own happy disaster. People who didn't completely ruin themselves in the bubble phase are getting another chance. People who should be saving for their retirements, for example, are being encouraged to continue borrowing and spending as if nothing had changed. People who should move to a house they can afford are being encouraged to hold on to digs that that are beyond their means. Companies that should be liquidated are being refinanced and restructured on the Fed's EZ Credit. And to many people, all this looks almost too wonderful.

Yesterday, we mentioned Warren Buffett's comments - the credit crunch is over, he said.

Today, the Wall Street Journal tells us that the "housing crisis is over," too.

In a way, they're probably both right. With lower rates coming in...and fiscal stimulus checks going out...the money is flowing again. The 'crisis' stage is probably over - at least for now. But your teeth don't get better by putting off a visit to the dentist. And when the pain returns - probably in a few months - it will be worse than before.

That's why we continue to advise our dear readers to protect your wealth and assets now...because the initial crisis may be coming to an end - but the aftershocks will be felt throughout our economy for months (or years) to come.

It's always best to be prepared...learn how you can make the best of this topsy-turvy market environment here.

Bill Bonner
The Daily Reckoning Australia

• Baby Boomers Face Early Retirement With No Money Saved
• The Rich are Still Getting Richer
• In Europe, Banks Borrow Money and Lend it Back to the Government
• We are Confident the Bull Market in Gold is Not Over
• Willem Buiter Attacks Fed Policy