'We didn't ask you to stock up all those dollars,' as Obama might have put it. 'It's not our fault if the dollar goes down and you lose money.'

Perhaps Mr. Obama should have quoted the immortal words of a former US Secretary of the Treasury, John Connolly. "It may be our dollar, but it's your problem."

Over at USA Today, the editors are more concerned about human rights. The paper must imagine itself back in the days of Woodrow Wilson or George W. Bush, when the US nobly embarked on a mission to raise all of mankind out of sin and error. In effect, Mr. Obama said that all people have 'universal rights,' including the right to a free press. China figured this was just the sort of opinion that its people didn't need to hear. So, it killed the story in its own press. The American president might as well have been talking to himself.

China is today's big story. Throughout the world's media there is much buzz and blather about the "romance"...the "historic relationship"...between the two titans. Some reporters see love. Some see jealousy. Some see rivalry.

Here at The Daily Reckoning we are suckers for romance. Give us some "a cigarette that bears a lipstick's traces...an airline ticket to romantic places..." and we are moonstruck. But we don't see much romance in the US and China hook up. What we see is the sort of things that delight psychologists and bore everyone else - perversion, co- dependency, and enabling.

On the surface, the two giants bicker over money like any other couple. The US accuses China of being a tightwad...holding its currency down and saving too much. China accuses the US of being a spendthrift, destroying its own purchasing power by wanton and reckless expenditures.

"US president's currency call breaks with script," says a headline in The Financial Times today. US economists think China should raise the value of the yuan. This would immediately lower the value, domestically, of the trillion(s?) worth of US-dollar assets China holds as reserves. It would also make Chinese products less competitive on the world market.

Mr. Obama wasn't supposed to say anything about it on his trip. It would be like bringing up your husband's drinking problem on your wedding anniversary; it would spoil the occasion.

Apparently, Obama couldn't help himself. Or maybe he just thought the folks back home would like to hear him give the Chinese a piece of his mind.

But how does the American president know what price to put on the yuan? A sinking dollar is good for the goose over in the US. Why isn't it okay for the gander in the Middle Kingdom?

A strong yuan would help the world economy "rebalance," say economists who think they know what they are talking about. In a nutshell, the Chinese produce too much; Americans consume too much. A higher yuan would come down on the high side of the scale - giving the Chinese more purchasing power (thus increasing consumption in the Peoples' Republic)...and making Chinese exports more expensive (thus decreasing consumption across the Pacific). With a stronger yuan, the Anglo-Saxon economies would be able to produce and sell more things to the Chinese...thus tilting the US economy more towards capital formation and production.

Chinese authorities are no dopes. They know they have a "floating" population of some 150,000 million people who are looking for work. They know that if they don't find some way to keep these people occupied they are likely to cause trouble. Trouble is the thing China's leaders most don't want.

"You think you've got trouble," Premier Hu Jintao might have replied to Mr. Obama. "Did you know that there are something like 200 million Chinese who still get by on as little as a dollar a day? Let's face facts. You're sitting there in Washington, comfortably talking about how much free health care and unemployment benefits to give the American people. We don't have the time...or the money for those kinds of things. Too many Chinese people. They don't earn enough to afford the kind of cradle-to-grave bribes you give your people. We have to keep them working; there's no other way.

"Besides, we don't quite see why we should pay for your mistakes. It wasn't our economy that blew up. It wasn't our financial industry that sold houses to people who couldn't afford them. It wasn't our consumers who spent more than they had and went too deeply into debt.

"It's the debtor who's supposed to pay, not the lender. We're the lender!"

Behind all the superficial arguing, accusing and kvetching, however, is a sick relationship. It has give and take. But the US is all take. China is all give. And now, on both sides, public authorities make the same mistake. In the US, they try desperately to prod Americans to take more...to continue doing what they were doing wrong. They offer incentives of every sort to lure consumers to consume even more. And their solution to the debt overhang is to hang on even more debt.

In China, meanwhile, the authorities desperately prod their people to give more...to produce more. Or, at least to build more plant and equipment with which to turn out more goods.

In the US, consumer spending is about 70% of the economy. In China, fixed capital formation is estimated to have made up 70% of China's growth in 2008 and as much as 90% in the first half of this year.

Is this a formula for a happy marriage? Over the last two years, this co-dependent relationship has broken down. Paul Krugman wrote in The New York Times that we've seen "the greatest collapse in world trade in history."

But neither side has learned a thing. The taker now proposes to take more. The giver now proposes to give more.

They don't need counseling. They need a divorce.

Bill Bonner
for The Daily Reckoning Australia

• Chinese Yuan Marches Towards World Domination
• Admonishment from China and the Decline of U.S. Credibility
• US Has Highest Unemployment Rate of All Major Economies
• Chinese Consumers Are Getting Shiny New Credit Cards
• Geithner Reassures China that America Takes Financial Obligations Seriously

"Okay."

"Why so serious? I mean, all you do every day is write about the worst-case scenario. It's depressing. Who died and made you the harbinger of financial doom? How about something positive for a change?"

"Is that code for, 'buy me another beer?'"

"No, seriously. It's not all bad all the time is it?"

We'll tell you how we answered our friend's question below. But first up, the markets. It was another red day in New York, with Dow stocks down over one percent. Tech stocks on the Nasdaq - the ones enjoying a bit of euphoria renaissance - were down 2.67%. September new home sales in the U.S. fell 3.6% from the month before. The Aussie dollar shed 1.44% against the greenback.

Is that all just noise? Or is there a melody building in the markets? The chorus chanted by Ken Henry, Wayne Swann, and most of the media is that the strong Aussie dollar, the strong market, and the strong(ish) economy are all factors of Australia's great policymaking and unique relationship to the China boom.

But the alternative tune - the one which we've been humming - is that most of the rally in stocks since March and most of the 30% rise in the Aussie dollar is a result of the carry trade. Yes, Aussie assets are relatively more attractive when the cost of capital in the U.S. is zero. But this can change in a flash when foreign speculators change their trading minds.

That's just what happened last year. Only then, it was both a dollar and yen carry trade that led to a rise in Aussie assets. Once the credit crisis set in, the yen carry got dropped and investors fled risk assets and piled right back into the greenback and U.S. Treasuries. Stocks fell, commodities fell, and the Aussie dollar plummeted to nearly 60 cents against the USD.

It doesn't have to happen that way now just because it happened that way then. But since our main job here is to question conventional wisdom and offer you an alternative explanation, that's the one we're offering you. Beware carry trades promising false permanent prosperity!

But what about today's earnings? ANZ followed up yesterday's bad debts bonanza from NAB with one of its own. ANZ reported an 11% fall in net profits (to $2.94 billion) and a 46% rise in bad debts to $3 billion. But both banks hinted that the end of the "bad debt cycle" is over and that things can only get better.

Let's take the other side of that trade. Again we'll focus on two risks: access to foreign funding and asset values on the balance sheet. ANZ sourced more of its funding from domestic savers and less from short-term whole sale funding, according to its report. Aussie savers funded 55% of ANZ new loans for the year (up from 50%) while the company reduced its reliance on short-term whole sale funding by 17% (now just 17% of all funding).

What does that mean? It means the company is making plenty of new loans (you'd want to, especially to the housing market, to prop up the value of your real estate portfolio). But it means the company is relying a lot less on short-term borrowed money from overseas in order to boost lending to Aussie homes and businesses.

Whether it is doing this by necessity or by choice is big question. But all we want to point out is that if your economy relies on imported capital to finance investment (or consumer spending, or new mortgage lending) you're vulnerable if that capital is not forthcoming. It's great when the dollar is high and capital is flowing. But if those capital flows reverse, the banks may find themselves in a jam that even a government guarantee makes it hard to escape.

It's not just us saying this, by the way. "We need to figure out how we can become less dependent on wholesale funding to finance our economic growth," said Commonwealth Bank of Australia chairman John Schubert in last Friday's Australian Financial Review. "It is not assured that we will get the funding into the future."

No foreign funding, no continued housing boom. In fact, we'd be willing to say that a cut off from short-term wholesale foreign funding is just the sort of thing that could lead to a major correction in Aussie house values. Naturally, the government here would step into the mortgage finance market in a big way, and not just for non-bank lenders, as it's done with the Australian Office of Financial Management buying securitised residential mortgage backed securities.

The U.S. government has done everything it can to keep the mortgage credit flowing and household net worth from imploding. Australia would do the same if it had to. But like in the U.S., this means more government borrowing to prop up the property market. More debt, higher interest payments, less capital available for lending to the rest of the economy.

But let's assume for now the public sector does not enlarge again to Depression-era levels of debt. Let's assume that Aussie banks have access to overseas credit. There is still the issue of asset values. ANZ says it is leveraged about 17 to 1. With $476 billion assets, that leaves it with about $28 billion in equity (according to how it calculates both assets and equity). And like yesterday, it's fair to say that a few billion in loan losses and bad debts are hardly the sort of thing to wipe out that much equity.

That's not where the real risk is, though. The real risk is to the asset portfolio. Twenty eight billion in equity capital is just under 6% of total assets. Or, put another way, a 6% loss in assets wipes out the equity.

A six percent loss in assets? Is that possible? The IMF and APRA have stress tested Aussie banks for scenarios in which large chunks of homeowners can't pay their mortgages. They chuck in large corporate bond default rates just to make things more stressful. And after all that, they've concluded that most of the banks' assets are solid and safe and unlikely to incur mammoth losses that would jeopardise the equity capital (solvency).

And maybe they are right. But we're just saying...in a world dominated by massive credit write downs...where we have just seen six months of re-leveraging...and where house values here in Australia have managed (thus far) to escape massive deflation...is a six percent loss on assets totally unimaginable?

We can imagine it, although we don't relish it. Either way, we wouldn't buy the banks just now.

But if you're looking for the most over-valued asset class in the world - the one worth a punt for going short - it has to be U.S. government bonds. Paolo Pelligrini, the man who helped John Paulson make a mint shorting the U.S. housing market, told Bloomberg that shorting long-term U.S. debt is the "only attractive bet" going at the moment.

"I always like to think about assets that are likely to experience a breakdown; the only thing I'm pretty comfortable with right now is U.S. Treasury securities and U.S. agency mortgage-backed securities...I think that those are overpriced so they are attractive shorts."

If you're not going to short the U.S. long-term bond market any time soon, the take away from this is to look for assets that go up when U.S. bond prices fall. If U.S. bond prices fall it means U.S. interest rates go up. That might, for a bit anyway, lead to a stronger USD and a weaker AUD.

For a trader - other than cash and gold - we'd look to see which of those Aussie stocks hammered by the stronger Aussie dollar have been beaten down the most. They might be due for a quick rebound - although they will be fighting the general trend in the market. We'll ask Murray what he thinks and get back to you.

So what did we tell our drunk friend when he asked us why were so critical, sceptical, negative, and gloomy all the time?

"Relax dude. It's my job to plan for the worst case scenario. It makes me happy to have a purpose in life. If you want the best case, turn the TV on and turn your brain off. And I object to your overly negative characterisation of my work."

"Huh?"

"My work isn't negative. It only seems that way because we live in a period of wealth destruction. I wish it were a world of wealth creation. But in a world of wealth destruction, you have to focus on preserving your wealth and maybe, when you can, growing it if you've got the big picture sorted out correctly."

"But you make it sound like the end of the world every day."

"It is the end of the world every day. But it starts all over the next day. And it is just the end of the financial world as we know it. Not the end of the world world...Besides, it's a lot less scary when you face up to what is really going on and make a plan for it. Uncertainty is scarier than risk because with uncertainty, you have no idea what to expect. Risk you can at least manage."

"But how can you be so sure you're right about the big picture? Everyone else I talk to says there's no way the dollar is going down as a reserve currency and that only kooks believe that. Are you a kook?"

"Certified. But that doesn't mean I'm wrong. You can't keep adding debt forever to fund your way of life. Debts have to be repaid. And interest has to be paid on the money you've borrowed. The politicians in America keep making new promises they aim to keep with borrowed money. This borrowed money is massively interest rate sensitive. And it's in addition to a huge amount of money they've already borrowed. It's the end-game for the whole financial/fiscal/political model."

"But so what? Isn't everyone else doing the same thing?"

"Well yeah. All fiat money is a scam. It's a way for the government to run perpetual debts and steal savings through inflation. It's an immoral living arrangement in that respect. But more importantly, from a financial perspective, it's a way of funding a political arrangement. And that way of funding it - borrowing more and raising taxes on a small productive class to pay for a larger public sector - is every bit as dead as the funding model for investment banks."

"But the government bailed out the investment banks. Who is going to bail out the government?"

"No one. Nothing. It will try inflation. But that doesn't work. Printing more money to pay off your debts just destroys wealth. That's where we're headed. That's what you should plan for. Sooner, not later."

"I would like to begin my plan with another beer, if it's all the same to you."

"No worries."

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• IMF Report Concludes Aussie Banks are “Very Sound”…
• A National Mortgage Bubble
• Fed Now the Middle Man in Interbank Lending Market
• Corporate Debt is Just One Aspect of the National Debt Problem

Know what that means? It means the "Age of Thrift" is here...and that consumers really are cutting back - just like we said they would.

And it means that the consumer economy is not going to return to robust growth anytime soon. And it means, too, that people will find it hard to find jobs for a very long time.

Another thing it means is that housing prices are not likely to recover - not in our lifetimes. That was a once-a-century bubble and it has blown up.

Mortgage lenders say they expect the peak in foreclosures to come about a year from now. As for the bottom of price declines, you can expect that in 2013 or beyond. A housing bubble typically takes prices down for six years, says a study by professors Reinhart and Rogoff. But this was not a typical bubble; it was an extraordinary bubble. Seems logical that the correction will be extraordinarily deep and long too.

And it also means that this stock market rally is very vulnerable. The stock market and the economy seem to be reading different newspapers!

The Dow fell 14 points yesterday. It could begin a major drop any day. That's why our 'Crash Alert' flag is flying from our London headquarters.

Yesterday, we reported the curious fact that consumer spending as a percentage of the GDP had increased. But it only increased because the other parts of the GDP - notably business spending and investment - fell off even faster.

With output falling...sales falling...and investment (in new plant and equipment) falling even faster...who's going to hire new workers? Not many companies. And which companies are going to invest in young workers...who will have to be trained - sometimes over a period of many years - before they are really productive? Not many.

It's the "Lost Generation," says BusinessWeek. Unemployment nationwide is officially 9.8%. But for young people the rate is nearly twice that level - at 18%.

Their elders aren't doing so well either.

"Baby boomers working longer hours, for less," says a Financial Times headline. What do you expect? Their currency is going down in value. Their customers are disappearing. Their retirement savings disappeared with housing prices. They can't even borrow money anymore.

David Rosenberg:

"Now that lenders have started to respond to their record-high delinquency rates by rationing credit, a mad scramble for cash is occurring to replace the loans - food stamp usage is up 22% year-over- year, pawn shop business is up nearly 40%, and there is a tidal wave of applications for Social Security disability benefits that are not explained alone by workplace mishaps."

Boomers have no choice. They need money. So they work harder, and longer. And they get paid less. Why? Because prices are falling. Even the price of labor. It's a deflationary world.

Meanwhile, The New York Times reports, "China consolidates its lead in global trade."

This headline is a little like the announcement that consumer spending is a bigger part of the economy. It might lead you to think that global trade is growing - or, at least that the Chinese part of global trade is growing. Not at all! Global trade is still shrinking. Chinese exports too. It's just that China's part of the global marketplace is increasing...because America and Europe are losing market share. China is gaining market share because it competes on price. And price competition is what is driving this market.

No discount? No sale!

Power and wealth are shifting east. No doubt about it. The Chinese took over the Hummer this week. And they are even building a 'big plane' - the C919 - to compete against Boeing and Airbus.

Is there any business they can't compete in? We don't know...but we're counting on them to stay out of financial publishing at least until we retire!

Bill Bonner
for The Daily Reckoning Australia

• If Americans Do Not Return to Work, There Is No Recovery
• Bear Markets Do Not End With Stocks Still Trading at Nearly 20 Times Earnings
• Stock Prices Down Signals Bears to Hold onto Cash, Treasuries and Gold
• Economy Has to Grow at 1% to Stay Even With Population Growth
• We Expect No Recovery from the Economy

October is almost half over. Will we get through the month without a major sell-off?

Dear reader, if you think we know the answer to that you've got us mixed up with someone else. Someone who is crazy.

No one with his wits about him thinks he knows what the stock market is going to do.

Still, here at The Daily Reckoning, we have our hunches. We think it's time for a major pull back. Frankly, we'll be disappointed if we don't get one soon. Because, once again stocks are too expensive.

Too expensive for what? Too expensive for the circumstances.

The Dow rose another 20 points yesterday to a new bounce record. Oil rose to over $73. Gold didn't budge.

Of course, everyone now knows that the recession is over. NABE interviewed 44 economic forecasters. Four-fifths of them said the recession was over.

But we don't care what they said. These are the same seers who missed the biggest single event in financial history. There are many banking crises, recessions, panics and defaults in the record books. But none were as great as the one that hit September a year ago. Most economists didn't see it coming; why should we trust them to tell us when it is going?

Besides they've got the whole thing wrong. It isn't a recession; it's a depression. There is no recovery from a depression; instead, the economy has to re-invent itself in another form. Things aren't going 'back to normal,' in other words. Because the period leading up to the crisis was not 'normal;' it was a bubble. After a bubble explodes, you have a lot of debris to clean up. The bigger the bubble, the more damage it does when it blows up.

"The force of a correction is equal and opposite to the deception that preceded it."

You've heard our dictum before. In fact, you've heard our explanations for all these points before.

We just lived through the biggest bubble in history. Get ready for the biggest bust. Not just two years of falling stock prices and news- making bailouts. Not just 10% unemployment. Not just 100 bank failures and 30% off housing prices.

Noooo... We're talking about a worthy correction...a real correction...a noble and distinguished correction...a correction that can hold its head up in public.

This is a correction that will take many years...one that will knock housing prices down for at least five years...and stock prices down to the point where people no longer want to buy them. It's a correction that goes deep enough and continues long enough to do its work - wiping out the bad investments and mistakes of the Bubble Era, while allowing the survivors to pay down their debts and build up their savings.

Now, here's a confusing little item. Yesterday's news tells us that consumer spending as a percentage of the entire economy has edged up to 71%. Now wait just one cotton-pickin' minute. How could consumer spending be going up?

Hold on, cupcake. It's not going up. It's going down. It's just that the other components of the economy are going down even more.

In the second quarter consumers spent $195 billion less than they did the year before - a 1.9% drop. In the 20 years before that, consumer spending increased at an average rate of 3.3%. So, you do the math... that's an about-face of more than 5% of GDP - a loss to the economy of about $700 billion!

Consumer credit is going down (we reported the figures earlier in the week)...unemployment is going up...consumer spending is going down...

..those are not the circumstances in which stocks sell for 27 times earnings...and move higher. Those are the circumstances in which stocks crash.

David Rosenberg:

"By some measures, the S&P 500 is already trading at valuation levels that would ordinarily be consistent with an economic expansion that is five-years old as opposed to a recovery that, at best, is in its infancy stages.

"On an operating ('scrubbed') basis, the trailing P/E multiple on the S&P 500 has expanded a massive 10 points from the March lows, to stand at 27.6x. Historically, when the economy is taking the turn away from contraction towards expansion, which indeed was the case in Q3, the trailing P/E multiple is 15x or half what it is... While we will not belabor the point, when all the write-downs are included, the trailing P/E on 'reported' earnings just widened to its highest levels in recorded history of nearly 140x, which is three times the levels prevailing during the height of the tech bubble."

So, here goes...yes...today, we are officially running our "Crash Alert" flag up the pole here at the London headquarters of The Daily Reckoning. Cross Blackfriars Bridge and you might see if flapping in the wind, between the two huge gold balls on the roof.

Our Crash Alert flag is out because stocks have become too expensive...and because this bounce should be reaching its apogee by now. Already, central banks are talking about cutting back on their efforts to sustain the bounce with easy credit. Australia led the way last week with a rate hike.

It is also becoming clearer and clearer that the feds' efforts aren't really working. They can give money to their friends in the banking industry. They can give money to speculators who then make bets on the stock market, among other things. They can bailout major companies. But they can't really get much money into the real economy.

Au contraire; they take money OUT of the real economy. The feds will absorb $700 billion of private savings this year alone...to finance their deficit. They expect $1 trillion deficits at least for another 10 years. That won't leave much money for the private sector.

Naturally, Washington, DC, is doing well. While unemployment is near 10% in the rest of the nation, it's only about 6% in the Washington area.

But let's face it... What's good for Washington is bad for the rest of the nation. The feds have used this correction to increase their power...and add to their wealth. The average federal employee now earns twice as much as his counterpart in the private sector - if the fellow in the private sector has a job at all.

A news item tells us that TARP recipients spent $114 million lobbying for their bailout money - most of it going into Washington, of course.

And the feds now own major stakes in what used to be the private sector - insurance, automobiles, and banking industries.

This has been a great period for government. Money, power...it is all floating down the Potomac like raw sewage...and coming to rest in the capitol city.

Our advice to the feds: enjoy it while you can. When stocks fall again...and people figure out what a mess you've made of the economy...you'll be lucky if you aren't tarred, feathered and run out of town on a rail.

Bill Bonner
for The Daily Reckoning Australia

• Economists Agreed the Stimulus Was Working and the Recession Was Coming to an End
• Household Debt Represents Spending Taken From the Future
• Feds’ Plan is to Reflate the Economy
• Debt Built Up to Levels Even Obama Says Are “Unsustainable”
• A Battle Between a Natural Market correction and an Artificial Attempt to Avoid it

The US money supply growth was fairly constant for the last 45 years. Then, under pressure from the stimulus/bailout programs, it exploded. Art Laffer says it is meaningless to compare it to anything in our history; nothing like this has ever happened before. He argues that inflation this time could be much worse than the inflation of the '70s, when the prime rate hit 21.5%. This is a new era!

"More Americans see sunny skies ahead," says a headline in USA Today. Elsewhere, Bloomberg reports that consumer spending is rising.

The Wall Street Journal, however, reports that savings rates are going up.

How can consumers increase spending and saving at the same time? We don't know. But the statistics are so jiggled and jived we have little faith in them.

The Richebächer Letter's Rob Parenteau is scratching his head at this contradiction in trends. "Oddly," he writes to his subscribers, "along with flat consumer spending, the gross personal saving rate has surged to nearly 7%, yet the unemployment rate has kept climbing. How is that combination possible? Specifically, where is the household sector getting the income growth to both increase saving and stabilize spending levels when job cuts remain alarmingly high?"

"If households try to hike their gross saving rate and the business sector does not increase its investment, then simple junior high algebra tells us that nominal incomes, especially profit incomes, will decline," continues Rob.

"The only way to avoid this outcome is for the trade deficit to improve or fiscal deficit spending to increase. The trade deficit has come a long way, but it is starting to stall again as consumer spending stabilizes and the pace of inventory reduction slows. The existing fiscal stimulus will have to do the trick until the household saving rate stabilizes and residential and nonresidential investment gets some traction."

In any case, be wary of statistics - they are furnished by government. And government has its own axes to grind and its own heads to cut off. For example, inflation numbers tend to be held down - in order to avoid costly adjustments to social security benefits. Unemployment statistics, too, tend to be understated. If joblessness was reported in the same way it was during the '30s, the figures would be much higher. More on this in an upcoming Daily Reckoning.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• The Percentage of the U.S. Economy Devoted to Consumer Spending Went Up and Up
• Saving Money, Not Spending it, is the Key to Getting Wealthier
• Suspicion the Service Sector Consumer Spending Series is Overstated
• Why I Would Have Raised the Interest Rates
• Replace Private Spending with Public Spending

"I think the American consumer recognizes they've got to hunker down, spend less, and they're doing it. Saks and Neiman Marcus have the worst sales on the planet, and the dollar stores and Wal-Mart are doing terrific because they offer value. That's a huge change in the mind-set of Americans. It's going to be with us forever. Living standards, of course, can never be the same. You can't put [the US] in this kind of financial condition. In our [federal] budget, we have 4% of the budget for debt service. That's going to go to 8. Now, when you do that, what happens to living standards?"

- Retail expert Howard Davidowitz on a May 14 Bloomberg Radio interview.

The day of reckoning has arrived for California's state government. It will not be pretty. Spending cuts and tax hikes are unavoidable; unlike the federal government, the state cannot monetize its debt with its own fiat currency. On June 10, California Controller John Chiang said in an official statement: "Without immediate solutions from the governor and legislature, we are less than 50 days away from a meltdown of state government."

The golden goose that funded irresponsible growth in state spending is dead. Chiang issued a report detailing a 39% year-over-year drop in personal income tax receipts, a 52% drop in corporate tax receipts, and an 8% drop in sales tax receipts.

Both consumer spending and capital investment will keep dropping in the state of California, because during the credit bubble, which paralleled growth in government spending, so much economic activity that would have taken place in the future was instead pulled into the present. Entrepreneurs suspect that state taxes on businesses will go up and will incorporate this into their plans.

"Sustainability" isn't just a word for environmentalists. In fact, it has a lot to do with the various stages of our financial crisis. In short, unsustainable economic activity fueled by easy credit will fade away quickly under tight credit. As economist Herb Stein said: "If something cannot go on forever, it will stop."

Like California's government, the consumer discretionary sector - which includes specialty retailers, restaurant chains, auto manufacturers, and more - has not been acting in a sustainable manner.

California's budget crisis provides a good example of what happens to institutions that wait until the last possible moment to correct mistakes and gets their fiscal houses in order. Like state governments, many businesses in the consumer discretionary sector must correct mistakes made during the bubble and write off uneconomic investments.

So while Wall Street's shortsighted focus is on the growth rate of the so-called "green shoots" of economic recovery, at Strategic Short Report, we're going to swoop in and seize not one, but two opportunities.

But first, you may ask why the consumer discretionary sector made so many uneconomic investment decisions. In hindsight, it was easy to see that we had, for example, too much auto production capacity. But in the heat of the credit bubble, it simply was easy to be fooled by artificially boosted trends in consumer demand. Think about it this way: Consumer borrowing and government budget deficits both pull what would have been future economic activity into the present, while pushing the associated costs into the future.

When this unsustainable behavior reaches its point of exhaustion, and people finally realize the folly of it all, employment falls, reckless investments are liquidated, and bad debts default. This is why it's healthier (yet politically unpopular) to have small, frequent recessions to keep supply and demand in balance, rather than have massive debt bubbles followed by nightmarish depressions and currency debasement. Such are the perils of government-promoted, debt-driven economic bubbles. It's like trying to live on a diet of candy and energy drinks, rather than wholesome food.

The 21st century gilded age for US consumers ended with the popping of the credit bubble. And this bubble was so big that it may take a decade for specialty retailers and restaurants to shrink store footprint, operations, and product lines to match a more sober customer. US consumers will save much more and spend only on things that provide clear value, and this will crimp demand for things like three-martini lunches.

Meanwhile, the stock market seems to have forgotten that we are facing a long-term adjustment in consumer behavior; it's distracted by noise surrounding the latest taxpayer-funded bailout. Market participants are also mesmerized at the spectacle of the Federal Reserve transforming its balance sheet into a toxic waste dump. It's like a bad reality television show that must up the ante to keep the audience interested.

Consumer discretionary stocks enjoyed full participation in the post-
March 6 stock market rally. However, this sector must endure years of disappointing profits - thanks to the capital investments made during the bubble to meet a level of demand that turned out to be phony. As US consumer demand approaches a more sustainable level, the excess capacity in specialty consumer companies will come to light. In the coming years, bankruptcies, price wars, and shrinking competitive barriers will prompt the market to start treating these former darlings as "commodity companies."

Take another look at the lead quote from Howard Davidowitz, a widely recognized expert on the retail sector. He has lived through booms and busts, seen the rise and fall of winners and losers, and is not sugarcoating the return to sustainability in retail. The message is clear: Extravagance is out and frugality is in.

Davidowitz may not be an economist, but his point about the federal deficit is one that all rational economic actors understand. He emphasizes that you cannot overspend without eventually suffering consequences. There's no getting around the fact that as with California's budget, profit margins in the financial and consumer discretionary sectors must shrink. Sustainability matters. Even the federal government will recognize this as the market charges high interest rates to fund its deficits.

Dan Amoss
for The Daily Reckoning Australia

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Since productivity growth is used to estimate unit labor cost growth, costs also must be understated for the service sector as well, which further implies service sector profits are overstated. This should all come out in the wash in future revisions, but for the meantime, it is very likely that the GDP, consumer spending and profit realities are worse than currently reported.

Transfer payments have reached a higher share of personal income than interest and dividend income. Together, that means over 30% of the U.S. personal income flows are now being earned for no increase in work devoted to production of goods and services (although we do recognize loans earning interest may, in fact, finance increased production, rather than financial market speculation). The more people get paid without directly producing goods and services, the higher the inflationary bias likely to arise in an economy. Purchasing power without production is another, perhaps more accurate, way of depicting the old saw about "too much money chasing too few goods."

Money doesn't chase anything. People spending money who did not produce anything to get the money - now, that's a recipe for inflation (or less disinflation/less deflation, than otherwise would be the case from favorable cost and supply conditions, to put the point more generally). In this regard, the major rise in transfer payments from 1966-76 may have played a role in the original onset of the stagflationary '70s, while the surge in interest income from 1978-82 may have contributed to the second wave of stagflation. Higher money incomes without increased production tends to lead to higher prices, unless, of course, saving rates among money income recipients rise sufficiently. Treasury Inflation-Protected Securities have been one way to hedge for an eventual inflation result, although they are no longer as cheap - but then again, neither are most inflation hedges, which have, for the most, part been bid up year to date.

We have been investigating which sectors have been accumulating Treasuries lately, as we believe placing new Treasury bond issuance may become more challenging not just because of the huge supply forthcoming, but because the quantitative easing measures adopted by the Fed and other central banks are designed in part to force investors out of the risk spectrum and away from cash and default-free Treasury holdings. Results from the Fed show broker-dealers, foreign investors and money market mutual funds have been the largest buyers of Treasuries of late. We are especially concerned the large buildup of long Treasury positions at primary dealers is unlikely to be sustained and there may be a rout in the Treasury market reminiscent of 1994, when Goldman Sachs had to borrow from the Japanese in order to stay afloat after getting caught the wrong way round in yield curve carry trades.

With 10-year Treasuries hitting 3.36% and passing through their 200-day moving average this week, our concern is looking less and less theoretical. We asked seasoned bond veteran Lou Crandall at Wrightson Associates about the unusual buildup in dealer position in Treasuries, and this was his assessment, which we have corroborated elsewhere:

"The large structural short positions that dealers developed in the middle part of this decade were a function of their market-making and hedging strategies. As a general matter, dealers would hold inventories of less-liquid spread products such as mortgages, ABSs and corporates on the long side, and then hedge them by shorting Treasuries of comparable duration.

"Once the liquidity crisis hit in the summer of 2007, a couple of things happened. First, the basis risk on those trades exploded, because spreads became highly volatile. Treasuries were no longer as efficient a hedge for private instruments as they had been. After Bear Stearns, you also started to see a rapid contraction in dealer balance sheets - even if Treasuries had still been an effective hedge for private-sector instruments, dealers were trying to lighten their inventories of those private obligations.

"In 2009, a couple of additional factors have come into play. Dealers wanted to front-run the Fed's purchases of Treasuries, which probably led to a modest amount of speculative long positions in Treasuries. More importantly, the Treasury market in May has adopted new delivery protocols that impose a 300-basis point penalty on anyone who fails to delivery a Treasury on time. The prospect of that fee created a lot of uncertainty in the market in April, and led some dealers to conclude that it would be safer to conduct their market-making activity from the long side, rather than the short side, of the market in the near term. (Just about everyone came to that conclusion about the bill sector, but some applied the same logic to coupons.)

"The increase in outright long dealer positions in Treasuries is close to having run its course. We could continue to see increases for a few more weeks as dealers complete the transition. However, we are seeing a restructuring of dealers' market-making business model, rather than an increase in outright long-term holdings in Treasuries driven by an investment view on the part of the dealers."

Essentially, dealers covered their spread trades by purchasing Treasuries and selling agency mortgage-backed securities and corporate bond positions. Some of them reconfigured themselves as banks, where procedures for the risk weighting of capital favors holding Treasuries. These, along with some procedural changes, are essentially one-off transitions. We, therefore, do not believe broker-dealers are likely to be big buyers in future Treasury auctions. Unless U.S. macro data start to get more alarming soon - and auto production cuts could dampen the Institute for Supply Managements' numbers, while the minor consumer bounce in Q1 was really mostly over in January and could cool further in Q2 - Treasury yields are likely to surge higher. So far, the backup in Treasury yields has not taken 30-year fixed mortgage rates higher, but this is the type of challenging set-up in the Treasury market that could squash attempts to stabilize the U.S. housing market. If you were planning on refinancing your mortgage this year, you may wish to consider acting sooner rather than later.

Best regards,

Rob Parenteau
for The Daily Reckoning Australia

• “Deflation” Remains the Watchword for 2009
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We were on an airplane when Edward, 15, noticed an odor that seemed out of place.

"Dad...you should have at least cleaned your boots!"

The manure began accumulating when we rode up to the high pasture on Tuesday. More about that below...

In the meantime, the Dow rallied a bit yesterday - up 127 points...barely half of what it lost on Monday.

Is the bounce still bouncing? We don't know. But we don't trust it. They say the stock market 'looks ahead.' So, it is possible for it to see things we can't see. On the other hand, what was it looking at two years ago? Didn't it see the economy going over a cliff? Apparently not.

But investors tend to believe what they want to believe. And what they want to believe is that the stock market has had its vision corrected and now sees a recovery.

Our guess is that they are wrong on both scores. The stock market is just as blind now as it was in early 2007...and there is no recovery coming any time soon. As to the first point, we have no further evidence to present...but as to the second; at least we have a theory.

By our reckoning, this is not a recession...this is a depression. In a recession, the bull market formula still works. It just needs a little time to rest...catch its breath...work off inventories...and rebuild cash accounts. But in a depression, the formula stops working.

The basic formula that drove the U.S. economy for the last 60 years has been the expansion of consumer spending. At first, that spending was healthy spending. People had built up savings during the war. In the Eisenhower years, they were ready to get back to work in the consumer economy, get married, have children, and spend money. America was the world's leading lender...leading exporter...leading manufacturer...and leading everything. Gradually though, having so many advantages caught up to the United States of America. By the '70s, the Nixon administration thought it could do away with the gold backing for the currency. By the '80s, the United States slipped from being a net creditor to being a net debtor to the rest of the world. By the '90s, American consumers were spending more than they made...and by the '00s they had given up saving all together - depending on the savings of poor people in China and elsewhere in order to continue living beyond their means.

Each time this system was faced with a recessionary correction, at least in the last 25 years, the feds tried to stimulate consumer spending with easier credit. And each time, consumers took the bait and got hooked on more debt. That's why the financial industry expanded so much...it sold more and more debt in more and more grotesque and amazing ways.

This time is different. This time the feds have responded with zero interest rates...and $13 trillion worth of bailouts and boondoggles. But the old magic doesn't seem to work anymore. This time, the formula no longer works. Consumers already have too much stuff - and no way to pay for it all. They have no choice; they have to cut back. This is not a pause in the long cycle of increasing consumption, debt and speculation. It is a reversal of the cycle - with less consumption and less debt (more savings). This is a depression.

If left alone, this cycle will see falling asset prices, falling bond prices and rising savings for many years. Stocks should sell down to levels where they are attractive again - at average P/Es below 8...7...or even 6. And with dividend yields above 5%.

Of course, when that happens people will have lost interest in stocks. The financial magazines will have pronounced the stock market "dead" and Jim Cramer will have been booted off the air.

By that time, the economy will have been restructured too. There will be less retail space. Many malls will have gone broke. Living standards in America and Britain will have gone down. And many of the people in the financial industry will be doing what they ought to have been doing all along - taking lunch counter orders.

Bill Bonner
for The Daily Reckoning Australia

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To be sure, the larger theme we believe will dominate the consumer sector is the need to reduce leverage, which will require a higher gross saving rate than households previously achieved. In a recent issue, we introduced a base case estimate that $1.2 trillion of household debt would need to be paid down over the next three years to return the household debt-to-income ratio to the pre-housing bubble trend. French banking group Societe Generale, however, estimated that a return to the trend of the past five decades would require nearly twice that level of pay down we expected. The key point here is that the consumer contribution to any future recovery is likely to be muted by these debt head winds, regardless of the degree of fiscal and monetary stimulus applied. Equity investors using the regular playbook and running into consumer discretionary stocks should make sure their long- run earning growth expectations reflect this likelihood.

For example, this is shaping up much more as a U-shaped housing recession than the typical V-shaped one, as the inventory overhang this time around has proven difficult to manage. The National Association of Home Builders reports slightly improved home traffic, reflecting mortgage rates' drop below 5% again as the Fed has ploughed deeper into Treasuries. Nonresidential construction, however, is just turning into a head wind for U.S. GDP growth, with commercial construction leading the way down. This is typically a late-cycle development, and nonresidential construction tends to remain a head wind well in to the next recovery.

One-third of manufacturing capacity utilization has been idled in this recession - something the U.S. economy has never seen in the post-World War II period. Capital equipment production is particularly hard hit, although the most recent monthly figures show the first sign of a turn in the momentum for both this sector and consumer goods production. Consistent with that is the pickup over the past two months of the percent of production sectors showing gains, as the one-month diffusion index has turned up and the three-month is beginning to make the turn.

Small business is arguably the most entrepreneurial segment of the economy, and there is as yet no sign of any stabilization to be found here. Plans to net hire are the lowest ever recorded, and capital spending plans are as punk as they were in the deep recession of 1973- 5. We suspect the credit crunch is hitting this sector especially hard, as banks tend to ration credit to their largest customers during such periods. While we believe the policy emphasis on renewing lending to the private sector is misplaced - private sector debt loads, especially household debt, need to be paid down - if there is a sector where this policy thrust is relevant, it is the small business sector.

"Deflation" remains the watchword for 2009, with headline inflation having dipped into deflation for the first time since the 1950s and the PPI crude material series still deep in deflation, though beginning to stabilize on a six-month rate of change basis, even ex energy. As the Fed trashes cash and drags down mortgage-backed securities and U.S. Treasury yields by expanding its balance sheet, it is at the same time pushing professional investors into riskier asset classes and inflation hedges. The more we think about it, the more we wonder whether the Fed has painted itself into a corner with its quantitative easing initiative.

Despite the current deflation, the ballooning of the central bank's balance sheet is encouraging many professional investors to increase exposures in tangible assets like precious metals, industrial metals, energy products and agricultural land. That means the cost of inputs to production will rise before the prices of final products rise. In addition, higher energy and food prices are likely to reduce the discretionary income of households already facing wealth destruction, credit constraints and job losses. We are perplexed. How does the Fed expect these impacts of higher prices for inflation hedges on either supply or demand to be supportive of economic growth? Put plainly, quantitative easing may have a built-in contradiction: The inflation expectations it is most likely to generate are in commodities that are either inputs to production or in consumer necessities. How either of these effects increases profit expectations, and hence induces a revival in production in output and employment, still escapes us.

The complexion of the U.S. macro results, while still severely recessionary, is generally better than what is coming out of Asia and Europe. Still, there are a few straws in the wind, like Japanese machine tool orders, which are showing several months of stabilization, along with Japanese consumer sentiment. These are surprising green shoots in what otherwise looks like scorched earth. We've proceeded on the assumption that the darker the macro news flow gets, the larger and more dramatic the policy push will be. A fiscal package on the order of 2-3% of GDP is under discussion in Japan, which will contain the damage, but we expect yen depreciation will need to be pursued, along with an escalating quantitative easing program to stabilize the Japanese income.

We've expected some retrenchment in equities, given technically overbought conditions and our view that the second derivative trade would give way under the Q1 earnings deluge. That concern is looking premature, although we are not yet in the thick of the earnings releases. Corporate bond spreads have not moved in synch with the equity rally, which is an anomaly we felt confirmed our decision not to chase the rally. So if we are wrong and the equity rally continues or is only briefly interrupted (say, because institutional investors that did not get on the bus early decide they need to get on quick or face career risk), the better way to hedge our view may be through a long position in corporate bonds. Alternatively, there are segments of the financial sector that have large long positions in corporates, like nonlife insurers, that could be played as well.

Best regards,

Rob Parenteau
for The Daily Reckoning Australia

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This just in:

We have it from our usually unreliable source in Washington that Gideon Gono, now head of the Zimbabwean central bank, has been called in to aid the Obama Administration. In secret talks, Gono has agreed to replace the out-going Ben Bernanke, who is said to be going to work as a helicopter pilot. Gono will take over the Fed. And a new bill has already been designed - our source was able to sneak out a copy of the new note - for 1 million U.S. dollars. That's Gideon Gono's picture on it.

According to reports, Gono insisted on getting his face on the bill as part of the deal. "Dead presidents are a dime a dozen," he is said to have remarked. "And this is just the beginning; we can add zeros later."

Gono was in the news yesterday for other reasons too. Zimbabwe has taken a couple of bold steps recently. First, it announced that henceforth citizens would be allowed to use currency other than the stuff produced by its own central bank. This came as a great relief to the people of the nation - who were already using U.S. dollars to replace the Zimbabwean brand. With 230 million percent inflation, the Zimbabwe dollar has not been so much a store of value but an incinerator of it. Second, Gono announced that he was taking 12 zeros off the Zimbabwean currency. Twelve seems like a lot. And it seems like only yesterday that Gono introduced the first note with 12 zeros on it - the 1 trillion Zim dollar note.

But that's the problem with zeros. They've got holes in them. You add nothin' to nothin' and you still got nothin'. Easy come. Easy go. You can as easily add zeros as take them off. At the end of the day, the extra zero gets you zilch.

Still, dear reader....

In Gono We Trust. Our economy is in a terrible mess. We need inflation; only Gono seems to know how to get it.

Yesterday, the report card on the economy came in. It showed growth in the last quarter of last year at MINUS 3.8%. "Could have been worse," say economists. It WILL be worse, we reply. This Depression is just getting started.

The Dow fell 40 points yesterday. We're in February already. Investors look back and see that stocks have lost more than 8% so far this year - the worst on record. In 87% of cases, what goes down in January goes down all year long. Last year, we had the worst stock market performance on record. But what the heck...records are made to be broken. This year will probably be worse still.

Macy's said it laid off 7,000 people. California says it is kiting checks. And Republicans say they are digging in their heels about Obama's Bailout Boondogglization program. They favor boondoggles of their own.

Consumer spending fell last month - for the 6th month in a row. Consumers are exhibiting the quality that economists fear... "the propensity to save." Until last year, of course, they had a propensity to spend. Now, all the news tells us that what ought to happen is happening now; consumers are closing their pocketbooks.

According to mainstream economists, this "propensity to save" thing is as welcome as halitosis. It's a conversation stopper, for sure. One man's expiration is another's inspiration. One's spending is another's income, in other words. So when he stops spending, the whole system of consumer spending comes to a halt. Sales plummet. Incomes fall. Jobs are lost.

Hey...welcome to the Depression of 2008-? And get ready to welcome Gideon Gono to the Fed. We need him.

*** Yesterday, we promised to take up a theme...hmmmm....what was it...? Oh yes, the critical issue...when.

When? When what?

Oh yes...when will deflation turn into inflation?

You want a date, don't you dear reader? You want to know exactly when you should switch out of Treasury bonds and into stocks, gold and freeze-dried food. Alas, that we can't give you. Not even an approximate date.

This past weekend, we sat down in the Dr. Richebacher chair that we keep next to the fireplace. It's the chair where Kurt Richebacher used to do his heavy thinking. We inherited it from the family after he died.

We sat and we tried to channel Kurt. What would he think...we wondered.

"Imagine you are in a small town," we thought we heard him say. "Imagine that the banker printed up the town's money in his basement. One day, he went a little crazy and started making huge loans, even to unqualified borrowers, at very low rates of interest. You would soon have a boom on your hands, with everyone paying for everything with IOUs, all derived from the bank's easy credit policy. But, eventually, when it was discovered that people couldn't repay their loans, there would be a terrible bust.

"That is where you are now. (I say 'you,' because I am no longer among the living...but I have to say, heaven is not a bad place to be... There is almost a total absence of economists, lawyers...and not a politician anywhere.) It is a period of price discovery in the credit market...because no one knows who can pay his bills and who can't. The IOUs are being marked down. Unemployment is rising, too, as the local economy slows down. Consumer demand has been greatly reduced as every has gotten poorer.

"Now, the banker sees what a mess the place has become. Naturally, he wants to do what he can. He tries to lend more money, but people have been down that road; they are reluctant to borrow. Then, he undertakes to build a new ballpark...you know, for playing baseball. And he decides to upgrade the town hall too...printing up the money to pay for it, as necessary, and to pay for a variety of projects to keep his friends and relatives employed.

"But while he is trying to get the boom going again, the bust is still going on. For every dollar he puts back into the town economy, $2 or $3 is taken out. Instead, of spending money like they used to...citizens stuff it in mattresses and bank accounts (much of it comes back to the bank where it started!)

"This process can go on for much longer than you think. Because the banker is, in effect, standing in the way of what needs to happen. He is blocking the process of price discovery...by lending money to deadbeat debtors and propping up businesses that are no longer profitable. The baker, for example, had built a fancy oven to produce 200 pastries every day. When the boom was in full swing, he sold every one of them. But now that people are cutting back, he sells only half as many. His investment in the new oven is now a losing proposition. But it takes the market a long time to find out; because the banker gives him enough money to carry on...when he should have declared bankruptcy months ago. And so with the tailor and the hat-maker and all the rest.

"Eventually, the banker realizes that his efforts to restart the boom have failed. Instead of spending money, people use it to pay down their debts. They cut their expenses; they reduce their output; and they'll continue to use their cash surpluses to pay their debts until they are back down to where they usually are, he reasons. Even then, people are likely to save because they've gotten in the habit of saving; this could go on for a long time, he figures.

"And then, he realizes that the only way to prevent people from falling into the 'propensity to save' trap is to make them realize that the currency is not worth saving...that it is losing value. That is when he will turn to Gonoism. He will go down into the basement; print up stacks of $100 bills...and begin passing them out on street-corners."

Inflation is needed. Not just more credit from the bank. But money...cash...free cash...piles of it.

The U.S. currently has about $1 trillion worth of spare output capacity. It has about $6 trillion worth of private debt - above and beyond what is traditionally considered 'normal.' And unemployment is rising. As long as those things persist, prices are not likely to go up. First, because business has no pricing power - not when there is excess capacity. In our example above, for instance, the baker can double his output of pastries with no further investment nor additional costs. He cannot raise prices; instead, he'll probably lower them in order to compete with the baker down the street who also has excess capacity. Nor are labor rates going to go up - not when workers are still being laid off. The proletariat has no more pricing power than the bourgeoisie. And as for consumers...they won't go back to consuming until they've lightened their debt burden. With $6 trillion, more or less, to unload it will be a long time before they're ready to spend again.

So don't expect miracles from the Boondogglization programs. Prices won't rise until central bankers Go Gono. And once they've gone Gono...things will really start to pop! Stay tuned.

*** Our friend, Nassim Taleb, author of the The Black Swan , told the Davos crew that "we should not trust these bankers. Look at their track record. The only way to stop the process is for the government to own those banks."

Yes, dear reader, everyone is jumping all over the bankers. As we pointed out two weeks ago, there are two schools of thought. Either the bankers are evil. Or they are just very, very stupid.

Jamie Dimon, chief of JPMorgan Chase, joined the 'they are stupid' camp.

"God knows, some really stupid things were done by American banks and by American investment banks," he said. But he went on to suggest that maybe the bankers weren't the only morons. "To policy makers, I say: 'Where were they?'"

The grammar suggests he really is stupid enough to be a politician. He probably meant to say: "To policy makers, I say: "Where were YOU?"

But the thought seems correct to us. Where were the regulators...the policy makers...the economists...the commentators...the media...the analysts...the rating agencies? And where were investors? Of course, they were all in the same place as the bankers - fantasyland.

And now, guess what? They're still in fantasyland...imaging that these trillion-dollar boondoggles will erase the mistakes caused by their earlier fantasy.

Oh, Mr. Gono, wherefore art thou?

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

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