If there was ever a time to find out about gold as an asset class and gold as money, it's now. With gold making new highs side by side with the Dow, we reckon a lot of people will put off looking into gold because it seems like everything in the economy is back to normal. That's not the case.

It's a big mistake to trust the sooth platitudes from politicians and economists right now. Remember, these were the same schmucks who didn't say a word as the world's biggest credit bubble ever inflated. Now, all they do is blame corporate greed.

What they don't want you to investigate - perhaps because they themselves don't understand it - is that there is no free market economy to speak of at the moment. And nowhere is that more true than the market for money. The government has granted a monopoly on the supply of money to organisations made up mostly of bankers. Their main goal is to get you into debt and keep you there.

Gold is not anyone else's liability. And the government can't print it. For thousands of years, people have found it to be most useful, stable medium of exchange and store of value. If you don't quite understand that yet, or why it's the case, or what to do next, you should learn more. The gold show is a good place to start.

Dan Denning
for The Daily Reckoning Australia

• Crude Oil Becoming Much Harder to Find
• Paying More Than 3 Times as Much for Gold
• Everyone is Busily Debasing Their Currency
• Finding Assets that Out Run Inflation as Bond Yields Move Up
• Themes from Day 1 at the Agora Financial Investment Symposium

Roach was what I call a realist, but he was more commonly labelled a bear, a pessimist, and a crank. When the market was soaring to new highs, Roach spoke about his professional ostracism, where so-called colleagues would pass him by, their heads lowered in embarrassment...for him, not themselves, in being so stupidly bearish.

Perhaps for the stress that this treatment brought about, Roach slightly wavered in his conviction and become more sanguine about the global economy he had for years rightly poo-poohed. This was just before credit markets began to seize up.

But he hasn't turned to the sunny side, in all its unthinking radiance, just yet. Roach began a recent column for the Financial Times with, "Hope always seems to spring eternal in liquidity-driven financial markets. That is very much the case today in the aftermath of the biggest liquidity injection in modern history."

Hope is indeed springing eternal, and it is again unfashionable to be pessimistic. Brokers, analysts, and investment bankers are doing a roaring trade in peddling hope over reality, and it pays very well.

Such behaviour is a product of ignorance and, more importantly, the massively conflicted financial services industry. That industry has developed and grown throughout a 25 year bull market. It is an industry plagued by overcapacity, groupthink, and incurable optimism. It is hopelessly ill-equipped to deal with the prolonged bear market we are now entering into.

That may sound like a dumb statement considering the ASX has bounced by more than 50% from its March lows and the S&P500 has surged by around 60%. But bear market rallies tend to be very convincing, and this one appears to be convincing just about everyone. Global central bank induced liquidity is driving this rally, along with huge fiscal stimulus. The fundamentals remain terrible.

As Roach says in his FT commentary, the policy responses have done nothing to correct the global imbalances that caused the crisis in the first place. He writes that, "US authorities cannot resist opting for another dose of excess consumption - despite the fact that the consumption share of real gross domestic product remains at a record high of 71 per cent.

"Nor can the Chinese wean themselves off investment-led growth - even though the fixed investment share of their GDP appears to have surged beyond the already unprecedented reading of 45% in mid-2009. Far from rebalancing, an unbalanced world once again appears to be compounding existing imbalances."

Why let sober reality get in the way of a good market rally? Instead of cautioning their clients to take money off the table as the market has surged from undervalued to overvalued, most market cheerleaders have become more delirious. The reasons to be bullish? The market has bottomed (for good, apparently) and there is still a huge amount of cash on the sidelines waiting to enter the great game (without needing substitution) the recession is over, and people are more confident.

There's a term for such behaviour and it's called "making hay while the sun shines." The clouds have indeed broken over the past six months and the sun is shining through. The finance industry sees an opportunity...get that cash off the sidelines, put it to 'work' and clip the ticket on the way through. All is normal again.

But is it? Normal for whom? For the industry, or for the people the industry is meant to serve. I have a number of questions I'd like to ask the optimists.

What does cash on the sidelines mean? If you're referring to money market instruments, like bank bills, short term commercial paper and short term government debt, why are these interest rates not rising around the world, signifying the flight from 'cash' to higher risk equities? Could it be that freshly minted central bank stimulus is flowing into risk assets, while the 'cash on the sidelines' is displaying more inertia that initially thought?

I would also ask the optimists what has changed in the global economy over the past year to make them so...optimistic. How does a huge increase in government debt do anything but provide a short term boost, masking long term structural problems? How can more debt solve problems caused by too much debt? How do they expect ultra low interest rates - which encourage consumption and discourage saving - to correct the imbalances?

I'm guessing the answers would have something to do with faith in governments and policy makers to get us out of this mess. The fact that they didn't see the mess coming doesn't seem to register.

Roach's analysis is far more realistic. He writes that, "This [government attempts to 'fix' things] is the same dubious script the world followed in the aftermath of the bursting of the equity bubble in the early part of this decade. And look how that ended. With far more excess liquidity currently sloshing over into asset markets, there is great temptation to erase the memories of the Great Crisis. Therein lies a pitfall for the markets - as well as for a still unbalanced post-crisis world.

After a 50% fall on the ASX, which occurred from the 2007 peak to the low back in March, many market pundits were 'cautiously optimistic', the correct call given the significant amount of value opportunities. Now, after a 50% rise from the March low, and the absence of any attractively priced companies, the correct call is to be cautiously pessimistic.

Greg Canavan
for The Daily Reckoning Australia

• More Money in Cash Right Now Than Equity in U.S. Companies
• Three-life Leases are Still Alive and Well
• Oil Prices Has The Mogambo Guru Sticking His Thumb in His Eye
• Rosenberg Let His Clients Know He Thought the Sucker’s Rally Was Over
• Geitner Plan Falls Short

Let's take the earnings recovery story first. Tomorrow we're going to have a look at the outlook for Aussie bank earnings. But for now, is there a case to be made for stocks as an asset class? Are they really recovering?

Well, the S&P 500 closed down in New York. But it's up 57% from its low. That's impressive. It's also expensive. The index now sells for 20 times operating profits, which is pretty optimistic, given how crappy the world economy has been in the last year.

"But that was last year," you say. In the future, things can't help but be better! And relatively speaking, that's probably true. Our friend Dan Ferris writes, that, "Last year, the S&P 500 lost $23.25 per share for the fourth quarter. In the second quarter of 2009, 369 out of 478 companies, representing perhaps 97% or 98% of the total market cap, reported negative earnings over the previous year."

Compared to last year, this year HAS to be better. You can't get much worse than negative earnings. And with trillions in credit backstopping the financial system and making it possible to generate profits on paper assets, you'd expect to see at least some engineered earnings in the next two quarters that look absolutely dazzling when compared to last year's numbers.

"So," says Dan, "for the next two or three quarters, you can expect plenty of reports of vastly improved earnings, even if those results aren't really so great. As you parse the news and evaluate your own investment goals, keep your head about you and don't be afraid to spend extra time getting deeper into a company's numbers, its market, its history, and its future prospects than you normally would. And for Newfoundland's sake, don't buy anything that isn't dirt-cheap."

Absolutely speaking, the popping of the credit bubble fatally undermined the business models of a lot of heavily leveraged companies, including many, many banks (both big and small). We reckon that the capital cushions of those banks are still in danger from further falls in asset values. Yes, that's not a popular or even common view. But we'll expand on it tomorrow.

In the meantime, you can always tell when stocks are out of favour in Australia. Everyone starts talking about what a good investment property is. But Australian housing is not exactly a cheap asset. The Governor of the Reserve Bank, Glenn Stevens, said as much earlier this week.

And this morning, we peeled our eyes over this paper on Aussie houses by RBA man Tony Richards. Richard's inadvertently made a lot of interesting points. One was that the so-called improvement in affordability over the last year is, "mainly due to movements in interest rates rather than in house."

He added that, "Mortgage rates are particularly low at present and, as the Bank has noted on a number of occasions, it is not reasonable to expect that interest rates will stay at the current low levels indefinitely. When they do rise towards more normal levels, discussions on housing affordability will again focus more on the level of housing prices relative to incomes."

That is clever to suggest that when rates rise people will have to find another way to say that houses are affordable. But we reckon when rates rise, as they eventually must, a lot of new home buyers will find out that access to cheap credit does not make a house affordable. It just makes the amount of debt you owe to the bank a lot larger.

The most interesting part of the paper, for our twenty minutes, was the discussion of 'underlying demand'. 'Underlying demand' is the phrase that gets trotted out when the banks and real estate brokers tell you there's a housing shortage, or when the RBA tells you not to worry about a house price crash in Australia. But what does it really mean?

Richards says the four components of 'underlying demand' are population growth, household size, new houses to replaced demolished homes, and demand for "second or vacant homes." Note that none of these are like the Ten Commandments. They aren't carved in stone. They are changeable.

By the way, who on earth can afford to own a home they neither live in, nor rent? "Honey we're going to buy a third home. But we're not going to generate any rental income from it. And we're certainly not going to live in it. We're just going to pay the mortgage on it."

"But why would we do that dear?"

"Because we can. To show how rich we are. We can afford it. And to support underlying housing demand. What else are we going to do with that money, buy stocks?

Returning to reality, Richards says that a preference for smaller household sizes, along with rising incomes and a rising population all factor in to strong "underlying demand." But if you spend exactly forty two seconds scrutinising this claim, you'll find that it simply doesn't hold up. "Underlying demand" as a bullish factor in Australian housing is a fiction propagated by property spruikers and money lenders.

Take rising incomes. Rising incomes are a function of a growing economy. But in a prolonged recession—or just a period of slower growth, or a world in which wages in the Western world are gradually deflated as the global work force grows (especially in manufacturing)—income growth is going to be harder to achieve across the economy.

And rising populations? Well, it's always possible for the government to reduce legal immigration if it's concerned about too many people competing for too few jobs. That knocks another plank out of underlying demand.

And then there's the preference for smaller households. Of course there's a preference for having your own castle and being your own King, if you can afford it. But the RBA's own data show that after many years of smaller and smaller household sizes, the trend is now swinging to larger households.

This could be by preference. After all, living alone has its benefits, but it can be awfully lonely. Or it could be by necessity—children living at home longer to save money or taking on flatmates to ease the pain of higher rates.

But whatever is behind the trend in rising household sizes, the main point is that the elements that go into "underlying demand" don't automatically suggest a level of demand for houses that will always rise. Quite the contrary, in fact.

And of course one of the biggest factors in demand for housing is the availability of credit via low interest rates. We reckon that when you add a couple of hundred basis points to the current cash rate, you'd take quite a bit of momentum away from "underlying demand" for housing.

How about some reader mail?

Dear DR,

Phil Cantrill

Intriguing scenario. Politically, it's a mess. Financially, we reckon the big issue is the value of toxic CDOs to banks and financial firms. Regardless of what happens to homeowners, those CDOs are due for a haircut. And when that happens, watch out for more bank failures and a second buffeting of the financial system.

Hi Dan,

Peter H

Dan Denning
for The Daily Reckoning Australia

• Aussie Housing Market Actually Leads the U.S. by Three Years
• Property Spruikers Claim Australia Suffers from a ‘Chronic Housing Shortage’
• The Australian Resource Boom Isn’t Dead Yet
• The Mother of All Housing Booms
• Housing and Unemployment Are Weaknesses in the U.S. Economy

He writes that, "During the credit boom, from 1995 to 2007, the debt-to-GDP ratio rose quite a lot, to all-time record levels, eclipsing the 1920s by considerable margins. In our current system, money is created by debt: new debt creates more money. During that period the broad money supply in the US generally grew at about 8% per year, and in Australia about 10% (peaking at 23% year on year to January 2007). That extra money was spent in the real economy, thereby raising the GDP by about 1 - 2% per year. About 10 - 25 GDP points were artificially added by borrowing from the future (borrowing brings forward consumption from the future to the present)."

"Now here is the thing. With the ending of the credit bubble (and it will end eventually, despite any stimuli), the debt-to-GDP ratio will return to normal, pre-bubble levels. People won't carry abnormally large debts unless asset prices are rising quickly, so the debt-to-GDP level cannot stay permanently elevated. Reduced debt reduces the money sloshing around the economy: retiring debt destroys money, in our current system. So as the debt-to-GDP ratio returns to normal, that 10 - 25% of extra economic activity brought from the future by extra debt will now be removed from the GDP.

"The main economic issue of today is how fast the 10 - 25% reduction in GDP is going to take place. We could do it quickly in one year, with a sharp short depression. Force bad debts out into the open, those who are broke go bankrupt, and everyone starts over in a dynamic economy. Or we could drag it out indefinitely like Japan after its bubble popped in 1990, but pay the price of a moribund economy with hidden unresolved debts. Or we could go for something in-between, maybe giving back 1 - 2% of GDP per year for the next 12 years.

"So far policy makers have tried to postpone the GDP decline by simulating to keep the bubble going a bit longer. History suggests they can pretty much be relied upon to keep trying to put it off, and eventually reach for the printing press and inflation to lower the real value of debts (most voters are borrowers, not lenders) and disguise the reduction in real GDP (with enough inflation, no one will be sure).

"In the 1970s, after the smaller credit bubble of the 1960s, the formula was to run about 10% inflation from 1973 to 1979 before radically raising interest rates to bring an end to the inflation in 1980. Seven years of 10% inflation halves the real value of debts. Of course, all this will bring the nature of debt-and-fiat money into question, and the price of gold and silver relative to other items will probably increase dramatically (they went up 20-fold in the 1970s).

As Dr. Evans points out, if the gold price repeats its 1970s run, knowing which Aussie gold stocks have the lowest production costs will come in very useful. Goldnerds does a great job of helping you suss out who the low-cost producers are.

In the meantime, as one reader wrote in this week, don't forget the cash. The Aussie dollar is enjoying its moment in the sun as the most attractive currency in the G-20. The interest rate differential and rising commodity prices ad to its allure. But cash itself as part of your preparation for further economic turbulence is always a good idea. Don't forget it! Until next week...

Dan Denning
for The Daily Reckoning Australia

• Dr. Woody Bock’s Essay: The Future Evolution of the Debt-to-GDP Ratio
• Price-to-Earnings Ratio of the S&P 500 Index
• What’s the Best Way to Get Through a Debt Crisis?
• Now in Post-bubble Era as Financial Industry Bombs Out
• Rumours Swirl Over Chinese Equity Stake in BHP Billiton

House prices were up 3.3% nationally in the second quarter of the year, according to Australian Property Monitors. The group said that the weighted average median house price in the most expensive capital city suburbs was $796,559. In the slightly less expensive suburbs the weighted average median house price was $405,872.

Ouch.

Aussie stocks are up as we write, bucking the global trend from yesterday. This comes after a 7% retreat by Chinese stocks in Shanghai and lower stocks in New York. What happened in China? Well, China's benchmark CSI 300 Index was up nearly 93% for the year before yesterday's retreat. China's monetary authorities have ignited a speculative bubble and made noises about reining it in yesterday.

Bloomberg reports that Chinese stocks, "Plunged amid speculation the central bank is poised to order lenders to set aside larger reserves, Beijing-based Caijing magazine reported today on its Web site. Market News International said Chinese equities fell on speculation regulators will increase a tax on stock trading."

Yesterday we asked the question of what would make Australia's economy grow in the next twenty years. We return to that question today. The Reserve Bank has said that Aussie banks will have to move cautiously as they repair their balances sheets. This suggests growth through debt may be harder to achieve. The RBA also said that the household sector's twenty year credit binge is over (now that asset prices are returning from orbit). Again, growth through debt is looking dubious as a national survival strategy.

Let's also assume that the government cannot borrow its way to larger stimulus payments. With lower spending forecast for government, businesses, and households, you begin to wonder if Australia's economy has a home grown engine, or if it will rely on something else, or someone else beyond the borders. If domestic demand falls, that leaves housing as the only industry firing on all cylinders (for now).

Now you can try building a national economy around the housing industry. But what you get is a nation of mortgage lenders, builders, real estate agents, speculators, and bombastic television presenters. You also get a huge speculative bubble. It's been tried in America and didn't work out so well.

If not housing, then why not resources? "Over the medium term," said Glenn Stevens earlier this week, "the emergence of China (and other countries such as India) will continue, and will offer opportunities for Australia." This is not news. But what the Governor said next is newsworthy.

"If commodity prices do stay at their relatively high levels on the back of strong emerging world demand, the mineral extraction sector and all those parts of the Australian economy that service it and feel its flow-on effects, will expand. Other sectors, will, relatively, contract over time."

Hmmn.

Does this make the Aussie economy a one trick resource pony? And even if it does, so what? Investors can still profit by finding the lowest-cost mineral extractors with the best ore bodies. As Mr. Stevens noted, even the correction in commodity prices has left them at higher inflation-adjusted levels that previous corrections. Prices came off. But they didn't crash permanently. Stevens doesn't think they will, either.

"A significant structural rise in demand for energy and resources has occurred, as a result of the cumulative growth of the emerging world. This seems more likely to be a feature of the international economy for some time than to go away," he says.

That could either be very true, or famous last words before a burst Chinese credit bubble rips the legs off of Australia's economy. But we'll go along with the Governor in the assumption that China's emergence as an industrial giant is a decade's long affair. It will have its ups and downs. But the general trend will be mostly up, accounting for the structural rise in demand for energy and resources."

It sounds, generally, like pretty good news. Of course, you want to be more than just a giant quarry. Wages and profits will be higher for Aussie firms if they can figure out ways to increase productivity and add more value. Investors can capture some of these rising profits and productivity increases through dividends or share price gains.

But adding value in the resource extraction business-and capturing that value added as an investment income-is not a simple proposition. The biggest value add (with the biggest profits) comes higher up the economic food chain (somewhere between retailing and pure intellectual property, where you produce nothing physical, but still collect rents or royalties on your production).

Australia's national income could benefit from a few industries higher up in the chain of production. But the country's current position is not a terrible one to be in either. That's not to say there aren't a few risks with hitching your wagon to China's rising star.

"If we are more integrated into China's expansion," Stevens said, "will be similarly more exposed to the consequences of whatever might go wrong in that country. So our understanding of how the Chinese economy works and what risks may be accumulating there, will need continual work."

Speaking of accumulating risks, one final note today. Reuters reports that, "The U.S. Treasury sold $39 billion in five-year debt Wednesday in an auction that drew poor demand, raising worries over the cost of financing the government's burgeoning budget deficit." The big-to-cover ratio for the five-year notes was just 1.92, its lowest level in a year.

Will a U.S. bond auction fail this year? It's not likely. The Feds will rig it to avoid that. But if investors are getting choosier about financing government debt, you wonder how that may affect the ability of the Australian Office of Financial Management to fund this country's growing fiscal deficit....

Dan Denning
for The Daily Reckoning Australia

• Glenn Stevens Says Australia’s Economy Has Been Travelling Better Than Others
• Australian Iron Ore Shares on China’s Menu
• Australian Housing Market Getting Stronger Despite Fear of Inflation
• IMF Report Concludes Aussie Banks are “Very Sound”…
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package

This denial of reality should be interesting to watch. When a credit bubble deflates and an economy breaks its addiction to reckless debt, the sensible thing to do (since you're repairing your balance sheet) is dial things back a bit. Save. Cut back on the gadgets. Eat more staples. Wear a sack cloth.

But if you still believe that you can get something for nothing-well then yes-you'd continue to borrow and spend like a madman.

Speaking of borrowing, we'll have an idea tomorrow of whether borrowing costs are headed up, down, or nowhere. The Reserve Bank of Australia meets to determine the price of money (in whatever mysterious way it manages to do this).

It will have to consider another piece of data from last week: a 12.5% seasonally adjusted decline in building approval for new homes. This is a provocative little nugget, isn't it? That's a steep month-over-month drop. Year-over-year, total approvals for new homes fell 22.4%. But wait...there's more!

Approvals for multi-unit "other" dwellings fell 43.6% month-over-month and 57.5% year-over year. We assume this means multi-room apartments and not houses. But either way, that kind of one-month decline looks an awful lot like hitting a brick wall. The Australian Bureau of Statistics says that's the lowest level of approvals since 1987.

What could it mean? There may be a perfectly reasonable explanation for such an ugly number. One that comes to mind immediately is that developers think there is plenty of existing inventory already (much of it unoccupied). With a large supply on hand, why build more?

Another reason is that developers don't expect prices to rise higher. Why add more new housing stock if you conclude that A.) the housing market is adequately supplied (not short, as is so often claimed) and B) the demand for new mortgages (new housing finance) is also going to fall off a cliff when the first home buyer's grant expires or interest rates begin rising (whichever comes first).

Dan Denning
for The Daily Reckoning Australia

• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• Economy Free to Recover?
• Job Losses From Private-sector Rose Since Beginning of Recession
• Traders Sell Bank Stocks Due to Goldman Sachs Surprise

If, on the other hand, you want to know why oil prices could double this year, or how $52 trillion in total global debt will utterly suffocate central bank attempts to resuscitate bank lending, or Ben Bernanke's secret plan to turn trillions of dollars worth of toxic assets into shareholder equity, read on!

You're still with us? Good. Now, why are oil prices lying?

Prices communicate information. The NYMEX February oil contract fell over 5% today in New York trading to $34.40. This suggests oil is falling in value, at least in the short term. And maybe that's not totally a lie.

After all, the current oil price results from two factors. First, the absence of leverage from the oil futures market leaves prices reflecting immediate supply and demand. With inventories full, the market seems well supplied (so much so that OPEC is cutting production). Second, the reality that oil demand will be flat or slightly fall this year because of the worldwide financial pandemic.

Adequate supply plus stagnant demand equals $35 oil. So why is the December 2010 oil contract trading nearly 80% higher at $61.80? What could possibly happen between now and December 2010 that would cause oil to go up 80%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010). First, the lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with. But the crash in prices has put the kibosh on exploration and production.

Second, as Diggers and Drillers contributor Mike Graham explains in a January article on the subject, the clear trend within the oil market is that historical exporters are exporting less oil. There are several reasons for this, which Mike gets into in his story.

One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world's largest oil exporters face declining production trends thanks to...you guessed it...Peak Oil.

Yes. Peak Oil has not gone away. It's been sent to the corner while the Credit Depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, "swift and violent rise" in oil prices in the second half of 2009.

Currie told a conference in London that, ""Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven't gone away. We still believe the day of reckoning is to come." What problems?

There are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, "This is not 1982-1983 all over again. The supply picture's radically different...the demand picture's radically different. The key difference is that today there are no large-scale next generation projects that are going to save the world. Commodity demand is exponentially higher than it was."

This brings us to the third reason oil prices should rise later this year: the oil trade is back on. Sure, credit may still be a scarce commodity. But if you judge traders by their actions, you can see the market is setting up for a big oil back draft. As evidence, Bloomberg reports that, "Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, two shipbrokers said."

Our friend Dan Amoss back in America calls this the oil arbitrage trade, where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What's less normal is the amount of oil being stockpiled offshore. "Frontline Ltd., the world's biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years," Bloomberg ads.

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What's more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

So what should you do? That's the subject of the January issue of Diggers and Drillers. More on that after we publish it for subscribers first later this week.

Next is a massive topic we are reluctant to introduce today. But we have to. There is no other way around it. It begins with a question: how much air is left in the credit bubble?

Actually, the question comes via Howard Ruff and Steve Hochberg. Let's start with Hochberg.

He's the lead analyst at Elliott Wave International. Bob Prechter's folks have been forecasting for years that the collapse of the credit bubble would lead to a general and massive deflation, including much lower gold prices. In his latest analysis, courtesy of a DR Reader, Hochberg explains:

"The systemic build up of total market credit is so large, currently about $52 trillion, that its implosion will swamp the Fed's attempts to inflate. And as CTC [Conquer the Crash] discusses, the remaining dollars that are not extinguished through bankruptcy, restructuring and write-offs, will increase in value. The thirst for cash will be insatiable relative to all other assets.

"Initially, the Fed's attempt to inflate was akin to using a garden hose to refill Lake Mead after the Hoover Dam collapsed. Over the past five months the chart shows that the Fed has graduated to a fire hose. But creating just over $2 trillion in the face of a contracting pool of $52 trillion in total credit market debt is just not going to get the job done, and the only thing getting hosed right now is us."

" Eventually credit will contract to the point whereby the income generated from economic production will be able to sustain it and at that point, yes, the U.S. dollar should indeed collapse of the weight of all the Fed's machinations and gold should soar. But before the market arrives at that point, deflation must run its course. In our opinion, there is still a long way to go."

But how far? A lot depends on the composition of that $52 trillion in credit. It can't all just vanish can it? But how much of it is securitised by relatively stable assets? And how much of it could potentially melt away under the intense heat of deflation?

This is not an easy question to answer. But it begins with knowing what you're dealing with. Specifically, you have to know who owes how much, and who owns how much. Those are two different questions. Let's deal with the first one. And we promise we'll make this as painless as possible. If you want to review this data yourself, by the way, you can find it here.

Keep in mind this data deals just with the U.S. And keep in mind it is government data. But the general question is this: how much deflation is left in the credit bubble and who stands the most to lose from it?

The Fed breaks up the total credit market debt outstanding into three categories: Domestic Nonfinancial Sectors (households, farms, nonfinancial corporations, state and local governments, and the Federal government), Financial Sectors (commercial banking, REITs, broker dealers, savings institutions, Government sponsored enterprise, Agency and GSE pools, and issuers of asset backed securities), and finally, the rest of the world.

What we find is that $32.9 trillion in credit market debt outstanding, as of the third quarter in 2008, was owed by the domestic non-financial sector. That's 63% of the $52 trillion total. Households are on the hook for most of that, with $13.9 trillion owed (or 26% of all credit market debt outstanding). That would mostly be home mortgages we reckon.

Next within the financial sector are non-financial corporate businesses with $7 trillion, non-farm corporate businesses at $3.7 trillion, state and local governments at $2.2 trillion, and the United States Federal government at $5.5 trillion.

So what does it tell us? Well it tells us that if U.S. house prices continue to fall, there is a lot of room left to deflate in the credit bubble, at least several trillion dollars. It's not hard to see this happening, given the rise in foreclosures, the prospect of even less federal funding for refinancing of mortgages, and the sudden collapse of America's banking model.

But the lack of credit for refinancing and the looming wave of Alt-A recasts this year and next is, in some sense, already old news. What also keeps us up at night is the $16 trillion in credit owed by the financial sectors. How much of that is at risk to further deflation?

You can get an idea by looking at the L2 table on page 59 of the Flow of Funds report. There is $6 trillion in corporate bonds outstanding. Nearly $5 trillion in Agency and GSE-backed securitised mortgage pools are on the books, and another $3.1 trillion in GSE debt itself. This does not include $1 trillion in "other loans and advances" which may or may not include home equity lines of credit.

We're sure you get the picture by now. There is still at least $8 trillion housing related assets owed by the financial sector. That might be kind of tough to pay off, given the falling value of the assets which securitise that debt. So who stands the most to lose if households can't pay their mortgages, corporations default on their bonds, and housing-related assets held by financial corporations continue to fall?

The financial sector combined holds $37 trillion in credit market "assets." It owns $37 trillion in other people's promises to pay. Those promises, all $37 trillion of them, are on the books at face value. What's more, U.S.-chartered commercial banks (Citibank, Bank of America for example) own $8.2 trillion in credit market "assets." Life insurance companies own another $2.9 trillion. Money market mutual funds own $2.1 trillion in credit market assets, while mutual funds own $2.3 trillion.

Do you see what we're getting at? The institutions that have the most to lose from a fall in the value of their credit market "assets" also have large obligations to shareholders and pensioners. Those institutions are counting on those assets to meet their own future liabilities (which do not fluctuate in value). And households are relying on those assets to retire, or in some cases, to live month-to-month on a fixed income.

Someone is going to lose, somehow. Or everyone will.

Households win if the value of the credit they owe (their mortgage) is written down or managed lower by some new law. But investors counting on that asset (often the household itself through a pension or life insurance) don't win if the amount they are owed is arbitrarily reduced.

Either way, Prechter's group is probably right. There is more deflation ahead. A lot of it. And not just in housing.

The corporate bond market would be another place to look. Corporate defaults haven't begun to rise noticeably yet. But faced with a much slower economy and much higher borrowing costs, it's going to be tough for highly indebted firms to roll over their debt, much less take on anything new. Dividends are already being slashed here in Australia.

And where does the deflation of the $52 trillion credit bubble leave us? Well Howard Ruff reckons we get a period of serious deflation, punctuated by a period of hyperinflation. Over at Kitco, he writes that, "First, we will continue to plunge into a major deflation period which will be characterized as a 'recession,' and later in the year as a 'depression.' Deflation and inflation are always monetary phenomena."

"Second, deflation will evolve into a run-away-hyper-inflationary depression because of what government will do to try to prevent deflation, which is synonymous with depression and has overtones of the 1930s."

How will government accomplish that? More on it tomorrow. Meanwhile, and finally, some timely reader mail.

"why do your emails have to be so long winded.... they waffle on toooo [sic] much, one metaphore [sic] after another... can any one really be bothered in there busy lives readin [sic] over all that.... I actually find some of the factual input useful, but there isnt [sic] much of that... a friendly tip, cut your newsletters/emails by 80%, get to the point and lose the metaphores [sic] and long winded useless stories.... the genuine potential investors your trying to pull in wont [sic] be inpressed [sic] with such dragged out point of views...I am a member of a well known share forum, many think the same as I do... the dailyreckoning could do allot [sic] better, it has so much potential, yet your [sic] boring people..."

Zzzz. Huh? What's that? Oh yes, this free daily e-mail about world historic financial events is too long and won't impress interested investors.

First, a tip. Maybe you should spend more time on spelling and grammar. But that is beside the point.

Sure the Daily Reckoning can be long. And we're grateful that you invite us into your living room and office each day to hear what we read. We don't take your time for granted, which is why put time and effort into what we write. And some times it takes time and effort to unwind a complicated subject.

If we had more time, the DR would be shorter. And in fact, we'd like to launch a subscription-based DR later this year. It would be a shorter, more to-the-point version of the DR with action to take. But in the meantime, we don't have the time for a shorter DR! So you'll have to deal with the long one. Or watch television instead. Your choice, if you're still reading that is.

Dan Denning,
for The Daily Reckoning Australia

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This is very good news. It means you will have a chance to buy gold at lower prices before it goes up higher later this year. Much higher, in fact, according to the 2009 forecast made by Diggers and Drillers editor Al Robinson. Look for Al's special gold forecast issue later today in your in box.

Not everyone agrees that gold is going higher, mind you. "The deflationary scenario is still incredibly intact, even though the government has thrown trillions of dollars at it," one Leonard Kaplan told Bloomberg. Kaplan is the president of Prospector Asset Management in Evanston, Illinois. "Gold has a long ways to go down," he added.

Daloob. Seriously daloob. Daloob is a word that means whatever you'd like.

But what does it mean to say that the deflationary scenario is "incredibly" intact? Does this mean that the scenario is "not credible?" Or does it mean the scenario explains and predicts what's ahead? The statement is incredibly opaque.

Either way, the deflationary scenario that Kaplan refers to is worth a few lines. The scenario is one where commodity and stock prices fall as the credit depression gets its hands around the neck of the economy and squeezes. Under that scenario, gold would fall. And under that scenario, the cost of paying off debts would rise massively as cash gained value. Old debts would become economy-killing burdens for households, businesses, and, dare we say it, governments too.

In fact, the real economic consequences from this kind deflation are so destructive that we would bet our left big toe that the Federal Reserve is going to do everything in its power (and perhaps some things not in its power) to prevent it. It's not a risky bet. The Fed is firmly moving down the path to monetary weirdness. We are well and truly down the rabbit hole in 2009.

In the meantime, falling commodities prices are telling you that the forecast for the economy in 2009 is not good. Gold, oil, metals, and grains all moved down yesterday while the U.S. dollar moved up. It will be worth watching if commodity shares follow commodity prices down. Commodity shares, as we know all too well, were decimated in 2008.

But based on some analysis from our old friend Dr. Marc Faber in his latest Gloom, Boom, Doom report, commodities as an asset class are about the only stocks actually in a similar position to where stocks found themselves in 1987. That is, while the entire market was savaged last year, commodities may be the only sector worth taking a punt on in 2009, based on Dr. Faber's analysis of previous bull and bear cycles in various asset classes.

What cycles? Faber says that the length of the cycle immediately preceding a correction or crash has a lot to do with what you can expect next. "If an up-cycle was brief," he writes, "the down-cycle is also likely to be brief. If the up-cycle lasted a very long time and was accompanied by huge excesses, the downturn from the peak of such a cycle is likely to be lengthy-as was the case for gold after 1980, and for the Nikkei and the Japanese economy post-1990. Similarly, if a down-cycle lasted a long time (20-30 years), the up-cycle is also likely to last for an extended period of time."

The bull market in commodities began in 1999 and was preceded by an infamous 20-year bear market. Equities, on the other hand, enjoyed an 18-year bull market from 1982 to 2000, but have been in a bear market since then (with a robust, credit-induced bear market rally from 2003 to 2007).

By that logic, the down-cycle in equities should be a lot longer because the up-cycle preceding it lasted so long. On the other hand, the down-cycle in commodities should be shorter because it was preceded by a much shorter up-cycle and a very long down-cycle. Stocks down. Commodities up. Got it?

But is it right? The reasoning makes sense, especially if you compare it with the historic numbers Dr. Faber presents (which we will not replicate here for the sake of space). But there is a simple objection that must be dealt with. What if the commodities cycle is itself a function of an even larger cycle, namely the credit cycle?

If you argue that the bull market in credit began in 1973 and a world of floating exchange rates and competitive currency devaluations (or 1913 when the Federal Reserve was founded, or 1694 if we want to go all the way back to the Bank of England again), then the direction of asset prices would be dictated by whether credit was in an up-cycle or down-cycle.

It's pretty safe to say that credit appears to be in a down-cycle, starting in August of 2007. What's more, it was preceded by a massive "up-cycle" in which the supply of money and credit grew globally. That "up-cycle" drove up all assets in all countries simultaneously. We will find out this year if another "up-cycle" can be artificially by Obama and Bernanke.

But if we are now in the "down-cycle" for credit-the Credit Depression-then how can commodities possibly outperform equities and rally while stocks fall?

Well, the only possible way for commodities to go up in price during a credit depression when global economic activity shrinks...is if we experience massive, central-bank backed money printing and the inflation that ensues. Not that this is an outcome we find desirable. But it's clear as day from the Fed's actions and words that it will produce inflation at any cost to prevent being crushed by debt and deflation. For all its real wealth destruction, the Fed appears to prefer hyperinflation to credit depression.

And don't worry that the Fed is out of interest rate bullets in its pursuit of reinflating the credit bubble. There are other weapons. It will mail checks directly to people or buy assets directly on stock markets. You can expect the debt-to-GDP ratio in the United States to approach and exceed 100% before Obama's first term is over. You can also expect to see more direct government asset purchases and intervention in markets.

How can we be so sure that we're on the verge of a brave new world of government-managed markets and economies? It's simple. Central banks and national governments the world over face an existential crisis-the loss of public confidence in paper money. Action must be taken to restore confidence or real economic activity (lending, borrowing, spending, and investing) will grind to a halt.

Perversely, the monetary authorities will destroy public confidence completely through massive inflation. It will also unleash a great deal of social and political disorder. But the authorities appear to prefer this chaotic result (which they can then police and manage with new rules) to another Great Depression characterised by too little money and price deflation. The excesses of the credit bubble will not be liquidated. Instead, they will be perpetuated and subsidised. The resulting economic and social disorder will be met with more State activity in your personal and economic life.

All of this is a long way of explaining why the current lull in the gold price is a great buying opportunity. You know the tactics and strategy of the central bankers. And you have a pretty good idea that any rally in the stock market is a fake out rally, not sustainable based on the economic forecast OR previous cycles (where markets are coming off 20-years of rising prices). What you don't know is if gold prices are going to fall further before eventually heading higher.

To find the answer to that, you can consult 1974. At that time, stock markets looked oversold and gold had begun to move and was on the verge of a correction. "If someone really felt that the similarities between the 1974 low and the current market conditions are overwhelming," Dr. Faber adds, "he should consider purchasing gold and oil rather than U.S. equities (and also shorting U.S. bonds)...Gold corrected between the end of 1974 and the summer of 1976 by 40%, while the stock market surged. But from its August 1976 low, the gold price increased eight-fold."

"If we are really in an environment such as we were in at the 1974 lows (and I have serious reservations about this assumption), then we should expect some further weakness in gold prices when equities rebound. Such weakness would then provide an excellent buying opportunity."

"However, keep in mind that even if you bought gold at its 1974 high at US$196 per ounce, by 1980 you would still have quadrupled your money, which was far better than the return the stock market provided. So even if you endorse the view that we are in a similar situation as in 1974, I would be reluctant to stay out of the gold market entirely in the hope of buying it at lower prices."

"Another reason why gold may not sell off as much as it did between 1974 and 1976 is that governments' interventions with monetary and fiscal measures around the world are unprecedented. ..Therefore, based on my time/cycle analysis above, commodities and commodity-related shares would also seem to be in a far more favourable position to resume their up-trend than broad U.S. equity indices, which (a sharp rebound aside) are unlikely to enter a sustained longer-term bull market."

If Faber is right, what will it mean for Australia's broad equity indices? Well, you'd expect them to go higher as commodity prices react to the increase in global money supply. It certainly seems like most of the deleveraging is done in commodity stocks, meaning it would take something monstrous for mining shares to retest the 2003 lows.

Monsters are real though, so we can't completely discount the possibility that 2009 will be worse for resource shares than 2008. However, one needn't be a raging bull on Aussie resource stocks to see that the case for gold looks good. It's distressing that gold looks so good because the outlook for the economy is so bad. More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

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Yes, that is what it is... a credit bubble that is deflating. The tide is going out, as Warren Buffett puts it. Now we see who's been swimming naked. Not a pretty sight. So ugly, in fact, that people can't stand to look.

"Fed takes boldest action since the Depression," says an article in the London Telegraph.

Yes, dear reader, our leaders are doing something. Now, we just wait to find out how much damage they have done.

The hardest thing to do is nothing.

But in matters of politics and money that is usually the best thing to do.

As we've pointed out many times, nothing gets no respect. "Do something," come the cries from all corners. Even those who should know better implore public officials to take action:

"When a man is having a heart attack, you have to intervene... you can give lectures about his diet later," they say.

But the U.S. economy is not dying. It is merely adjusting to a new set of circumstances. The consumer is tapped out. Without more income he cannot increase his buying. And without more spending, the consumer economy stalls... and contracts. No, don't even think of lending the consumer more money - he has too much debt already.

This is an election year and the politicians want to dodge a contraction in the worst possible way. What would be the worst possible way? Easy - add more debt. That is precisely what the Bernanke Fed is doing. Yesterday, they offered another $200 billion to their friends in the banking industry - lent against the trashy collateral that no one else would accept. Now, the Peoples' Bank of America - ultimately, the taxpayer - will be holding the bag.

Bill Bonner
The Daily Reckoning Australia

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The debts covered by the Bank of England, however, totaled $309 million on one estimate. They took 10 years to clear from the Bank's balance sheet.

The Swedish government then stepped into the Scandinavian banking crisis of 1992, buying the 13% of Nordbanken shares that it didn't already own at a 10% premium. That defended investors as well as depositors.

Washington even managed to contain the US savings & loan crisis of the late 1980s, protecting savers but letting more than 1,000 finance companies go under.

The direct cost to the US taxpayer was $124.6 billion, according to the General Accounting Office's report - right about the total bank losses in the subprime collapse so far.

All told, the S&L crisis cost "more than the cumulative loss of all US banks during the Great Depression, even after adjusting for inflation," as Jean-Charles Rochet, then a visiting professor at the London School of Economics, put it in a speech on banking crises of 2002.

Whereas, by its end, the current banking crisis will see total mortgage-credit losses of $400 billion according to Goldman Sachs' latest guess-timate. So "let's be clear and honest," as Housing & Urban Development secretary Alphonso Jackson said when launching Project Lifeline this week.

"One action alone will not solve every problem in the housing market," Jackson said as he gave US home-buyers an extra 30 days to try and stall foreclosure. He could just as easily have been talking about the entire banking industry.

One action alone won't solve it - not even if that one action does come from Warren Buffett. Or the White House. Or the Federal Reserve.

But altogether?

And what if we throw in an extra $3.3 trillion of foreign government finance, pouring out of the oil- and export-rich sovereign wealth funds of Arabia and Asia? Might that be enough to wipe the world's greatest-ever credit bubble from history?

"So far, institutions have raised nearly $75bn of capital from sovereign wealth funds and public sources," notes Joseph Mason, associate professor of finance at Drexel University and a senior fellow at the Wharton School, in the latest market note from his private consultancy, Criterion Economics.

"[But] while the seemingly unconstrained supply of capital has, thus far, been a blessing, it is not clear that the flow can continue. Recent events suggest that private capital sources may be reaching their limits, at least with respect to riskier institutions."

Citigroup just managed to raise funds at 5% interest. It is the world's largest bank, after all. But MBIA, the biggest "monoline" bond insurer, was forced to pay 14% on its AA-rated debt as Mason gasps.

"Ambac canceled their most recent recapitalization attempt," he adds, "ostensibly because the cost was even higher."

So step forward Warren Buffett! The stock market initially rallied - and rallied hard - on the idea that the Sage of Omaha might buy up bonds currently insured by bond-insurance giants MBIA, Ambac and FGIC. Yet as Buffett told CNBC, he only wants the municipal bonds these firms insure, and nothing else.

Because - get this - municipal bonds are currently cheaper to buy if they come with insurance than without!

A "classic kind of mispricing" for the Sage of Omaha to exploit, as John Authers notes in the Financial Times, this arbitrage also shows just how horrified the entire investment world has become by the "monoline" insurers, thanks to the very same junk that Warren Buffett will not step in and save.

Clearly, Buffett's offer makes great news for US towns and states wanting to raise fresh capital to fund their core services. With his prime-beek cherry Coke check-book at the ready, there's no need to repeat Sept. 1933 - when 28 American cities went into default - nor the Orange County default of 1995.

Especially not if the Federal government were to stand behind Buffett standing behind the municipals. Right?

Buffett himself, however, was quick to point out that his offer "doesn't do anything" for the subprime bonds, collateralized debt obligations (CDOs) and leveraged debt pushing down on the bond insurer's credit ratings.

Indeed, "I'm not sure anything is going to do much for the CDOs," he said. That doesn't mean state agencies and central banks won't try, however. "Direct government bailouts are gaining in popularity," as Prof. Mason notes for Criterion.

He's not kidding!

Here in London, the British government has told the two remaining bidders for Northern Rock - the top-five mortgage lender, hit by a banking run in Sept. '07 and now supported by �26 billion ($46bn) of tax-funded loans - that it's on the verge of full-scale nationalization.

Northern Rock was moved onto the British state's official balance sheet last week.

Germany's IKB, currently 38% owned by the state, may see the government-run KfW development bank raise its stake to 50% - effectively nationalizing the subprime-hit lender - because private-sector investors are unwilling to back a new capital raising.

In France, the state-controlled postal bank La Poste is rumored to be joining the government-owned Caisse des D�pots in developing a bail-out package for Soci�t� G�n�rale. The country's second-largest bank, SocGen managed to lose $3 billion on subprime investments - a little-known fact given the $7 billion it lost to "rogue trader" Jerome Kerviel.

This week SocGen raised capital by offering new shares at a 39% discount to its stock market price - itself already offering a near 42% discount from this time last year.

And in Switzerland, UBS - due to report its first loss in history on Thursday, worth some 4.4 billion Swiss Francs for 2007 as a whole ($4bn) - may gain financial support from the Swiss government if shareholders reject the capital restructuring proposed by the Singapore government. Along with an un-named Saudi investor, Singapore's Government Investment Council (GIC) has offered to put up 13 billion Swiss Francs ($11.3bn) without demanding a seat on the board.

But the GIC would take a controlling stake, however, since "on average, 30% of shareholders turn up to vote at the AGMs," as one UBS shareholder told FinanceAsia this week.

"Somebody controlling one-third of that" - and the GIC-Saudi investors would hold 10% of the total between them - "effectively controls the company."

Does it matter? Maybe. "The investment arms of foreign governments appear to have saved the day for American financial institutions," says Steven M.Davidoff for Deal Book. They've also piled into the biggest banks in Europe too, saving Western governments some $75 billion so far.

On one day alone last month, some $19 billion was raised by Citigroup and Merrill Lynch tapping the convertible bond markets - and Citi's funding "included investments from sovereign wealth funds in Singapore and Kuwait, alongside Prince Alwaleed bin Talal, the bank's second largest shareholder," reports Financial News US.

Whatever the Asians and Arabs can do, Washington can do better of course, starting with the little guy right at the bottom of the subprime pyramid - the over-indebted home buyer himself.

George Bush might have watched 226 mortgage lenders go kaput since late 2006 (the latest count from ML-Implode.com), but he just signed that $168 billion tax-rebate bill, hoping to stop the current slump in US house prices becoming a genuine depression.

Not enough, grumbles Senate majority leader Harry Reid. The package is "far from a panacea," he says, getting ready for a Democrat White House no doubt.

"Much more should be done. Another stimulus package or two."

Or three. Or four. You just keep writing the checks, Senator - and get the Federal Reserve to keep US interest rates way below inflation.

We'll just keep buying gold outright - with no default risk - and store it in privately-owned, ultra-secure gold vaults, far outside the world's banking system.

Adrian Ash
For The Daily Reckoning Australia

Photo Source: http://www.socalbubble.com

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