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

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

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
for The Daily Reckoning Australia

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

Not that we're easing into the holiday break. Here in the U.S., bond yields are rallying. That means bonds prices are falling. Stocks, the dollar, and commodities are up. Existing home sales were up here in America, but prices continued to fall. There was also a downward revision to third quarter American GDP (originally it was 3.5%, then 2.8% and now 2.5%).

We'll see if that bothers Aussie shares. The miners and the banks drove the ASX/200 up 1.5%. But the U.S. lead today is mixed. Investors are selling bonds. But are they going to turn right around and buy stocks? You gotta do something with all that cash.

Here in the States, we can say that the U.S. dollar is cheap. Everything in America seems cheap compared to Australia. Food, beer, movie tickets, petrol, and of course, houses. The cost of living is definitely lower here, at least in this part of the country. But even though it's had its first monthly rally since June, don't go pinning your hopes on the U.S. dollar.

The major trends defining the world - the migration of wealth from West to East - are still in motion. But right now it looks like plate tectonics, powerful, but underneath the surface. It can lead you into a sense of complacency that nothing is moving at all. Or, it can lead you to send it a note like the one below (reproduced with its original inaccuracy in spelling).

--Dear Dan & Colleagues

Regards John Matheson

Merry Christmas to you too, John. The test of our big ideas here isn't a few months. It's a few years. And what exactly were we wrong about this year? That the Aussie market hasn't collapsed? That shares haven't retested the 2003 lows? Give it time mate.

But it's a fair cop. Will we be right (again) eventually, simply because of the passage of time? That isn't our investment objective. Our objective is to pick the one or two major trends and figure out how to profit from them. Unfortunately, the major trends in today's global economy (deleveraging, contraction) are threats to your wealth, not opportunities.

That's why the main mission in markets like this is to preserve your capital, not take risks with it by listening to the conventional wisdom. But if we were looking for places to dip our toe in the share markets it would be two broad categories: unconventional energy projects and oversold, world-dominating blue-chip value (as our friend Dan Ferris calls global franchises).

In other words, we'd be bottom feeders looking for a chance to build a small core portfolio of blue chip shares for the next 15 years. But our main preference is stay liquid and tangible, which means more cash than shares and more bullion than bonds.

If inflation picks up in 2010 (because of lending growth by banks) then we might even look to trade depreciating cash for real estate...but land...and not existing housing stock. Houses are cheap in America again - but getting cheaper. Now may not be the best entry price.

Of course nobody knows what will happen. We just know what has happened in the past when credit bubbles have collapsed. Some evaporate quickly and the economy returns to a normal growth path. When the needed correction is drawn out, as this one is, the distortions persist and investors do it even tougher.

So stay tuned in 2010 John. At the very least, reading the Daily Reckoning will give you the enjoyable sensation of being superior. And more positively, maybe you'll even learn something about preparing for the unexpected. But we're not betting any money on it.

Dan Denning
for The Daily Reckoning Australia

• The Only Thing Really Going Down Right Now is the U.S. Dollar
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar
• U.S. Dollar Index Showing All Sorts of Weakness
• U.S. Dollar Retreating Against Commodities
• A Sovereign Debt Crisis Bullish for U.S. Dollar and Bearish for Gold

But the task of today's Daily Reckoning is not to figure out where stocks are headed in the second half of the calendar year. No one knows. Our strategies are focused on energy stocks-both the conventional and highly unconventional kind. We're bearish on fixed income, a bit more bullish on cash, precious metals, and tangible assets.

What about housing? ANZ Bank published a report on the subject yesterday. Among other things, it declared that, "We expect dwelling prices to edge higher for much of the remainder of 2009 with upside risk presenting from intensification of strong fundamentals, a shift in price expectations and restoration of confidence."

Pardon?

That is some seriously tortured syntax. What does "upside risk presenting from intensification of strong fundamentals" actually mean? Does that mean there is a risk prices could go up? Blah blah blah.

On the plane to Adelaide yesterday we had a much more down to earth conversation about property with the man sitting next to us in the exit row on our Boeing 737. He was reading a story in yesterday's Australian about the new "boom in the bush."

"According to RP Data-Rismark, the national median house price of $468,819 is just $520 shy of the record set in February last year, before the global economy sank into recession. Melbourne is leading the housing recovery, with a 6.1 per cent growth in prices between January 1 and May 31 and auction clearance rates in excess of 80 per cent for the past seven weeks. Sydney recorded 5.2 per cent growth in prices over the same period."

Adelaide was not near the top of the list. And that had this passenger concerned.

"My wife and I decided to buy another property about 18 months ago. We thought the financial crisis was a good buying opportunity. You had a lot of people scared. But now, I just want to get rid of the thing. It's keeping me up at night."

"But I've heard Adelaide is a nice place to live."

"It's lovely. But I bought around $410k and already the median price is below that here. I don't care what I get now. I'd be happy with $408. I'm going to call my agent and let him know. My wife tells me I'm being silly. But I just want out. I have my pay stubs from back when I bought my first house and I have the mortgage too. I made $8,000 a year and the house was $25,000. Today, though, we need that money for retirement...I don't wanna be caught selling when everyone else is. I want out."

It sounded like he wanted out of the market.

"I get worried when people saying prices always go up. I mean there must be some evidence to show that isn't true. Wouldn't people want to know that before they took out a big mortgage...especially with interest rates. They have to go up sometime don't they?"

Your editor didn't say much because he was nodding the whole time. Choir, meet preacher.

Of course this preacher and this choir may be excommunicated from the Church of Aussie Housing. Median home values are within shouting distance of their all-time highs, thanks for the first buyer's grant. It's a disaster in the making.

Demographics, immigration, the concentration of the population in urban centres, and the much ballyhooed supply gap are all trotted out as reasons why house prices always go structurally higher in Australia. This also explains, apparently, how Aussie house prices can defy household earnings gravity.

That is, people spend much larger multiples of their income on housing here than anywhere else in the world. How is that affordable? A reversion to the mean ratio (3:1) would mean a serious correction/crash. That seems impossible and psychologically impermissible to a lot of Aussies. But once you wrap your head around the idea that, historically, house prices don't go up much faster than the rate of inflation, it begins to make sense.

There may be multi-year periods (we call them credit bubbles) when low interest rates create a boom in mortgage lending. This leads to house price inflation. But those booms always go bust.

Governments seek to avoid the bust by reigniting another round of inflation to keep household nominal wealth from utterly collapsing (or simply reverting to a more sensible mean). Hence, the Aussie government sparking a lending boom to those people in Australia with the most to lose from taking on huge mortgage at the low end of the interest rate cycle; young Aussies who are the most vulnerable workers in the job market and spend the highest percentage of their discretionary income (not much) on an asset they bought at the top of the boom.

Come to think of it, if you were deliberately trying to wipe out the financial prospects of an entire generation by saddling them with crushing debt, increasing the first buyer's grant is probably exactly what you'd do. And you'd laugh along with your banker friends.

Incidentally, two of our confirmed panelists for the Debt Summit later this month will have a lot to say about Aussie property. Stay tuned.

Finally, some reader mail. It raises a problem that's been growing in the back of our brain. Credit is not money. So what happens if the credit bubble deflates and the liquidity measures (which are not money) instituted by the Fed and other central banks never turn into new money supply. Does this invalidate our entire position on inflation, and the investment strategy that goes with it? No! More on why tomorrow.

--Dear DR,

David W.

Dan Denning
for The Daily Reckoning Australia

• American House Prices Continue to Fall While the Same Can’t Be Said About Australian House Prices
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• Are Aussie House Prices in a Bubble?
• Aussie Housing Market Actually Leads the U.S. by Three Years
• Australian House Prices Are Severely and Seriously Unaffordable