Our old friend, Lord Rees-Mogg, writes in the TIMES :

"Daniel Webster's opinion should never be forgotten. Of paper money he says: 'We have suffered more from this cause than from every other cause or calamity. It has killed more men, pervaded and corrupted the choicest interests of our country more, and done more injustice than even the arms and artifices of our enemy.'

"In the 1930s some nations tried to beat the slump by competitive devaluations. In the present crisis, Britain has already experienced a very big devaluation of the pound, taking it down by a quarter against the dollar. Every country, led by the United States, has been issuing money, often in very large amounts, in order to bail out its banks. No one knows the total value of these national injections of cash into the banking systems. As the earlier injections have not restored stability to national economies, further injections inevitably will be made. All will be made in unconvertible currency, and over-issue will occur.

"Governments need to create a new world system, in which gold, as a stabiliser, should play its part. For individuals, gold remains the best insurance against future shocks and the best store of value."

Yesterday, the Dow fell another 297 points...as the market continued to react to Obama's $787 billion bailout. "Too little," say some. "Too late," say others.

But the worst may not be over for this market. Earnings are falling...for the very simple reason that people are spending less money. People spend less. Business makes less. Lower revenues; lower earnings. As we mentioned yesterday, for the first time in history, S&P stocks are losing money.

Savings rates are climbing in the United States. The trade deficit is falling. These are healthy trends for the long run. But they are hard to take in a depression.

Not only are earnings falling, P/Es are falling too. Stock prices are adjusting not only to the lower earnings, but to the new psychology of a depression era. There are times when people will pay $20 for one dollar's worth of earnings. Other times, they'll be reluctant to pay even $5. We've seen the $20 figure as recently as a couple years ago. Now, the trend is moving in the opposite direction. We're headed towards 5 bucks. That's what people will pay for $1 of earnings when this market finally reaches its bottom. Or thereabouts.

The combination of falling earnings and falling P/Es does to stock prices approximately what the Romans did to Carthage in the third Punic War. That's why we have our Crash Alert flag flying. Stock prices delenda est.

Typically, depressions come with bear markets. And bear markets come with bounces and rallies. We expected an O! Bama! bounce after the election. We got one...but much less than we expected. Stocks only rallied about 15%.

A stronger bounce will come, sooner or later. But we've put up our Crash Alert flag again - just in case. Stocks could go down another 30% - 50% first.

The news from the economy is not all bad. The shipping index has rallied - up 147% from its bottom. So, somebody must be moving something.

Beyond that, the headlines are grim. The automakers are headed down a dead end road, say the papers; they say they need $18.5 billion. Where are they going to get that kind of dough? The corporate bond market - to which corporate borrowers turn to raise money - is dead. When it comes to borrowing money, private borrowers just can't compete with the U.S. federal government. Even the states can't compete; they don't have printing presses either. California is facing a "lockdown" of public services, Bloomberg reports.

All over the world, the search for the bottom continues. Ireland seems to be edging towards default. And Japan is in a "dreadful state," says the Economist .

Things are so bad in Japan that the finance minister, Shoichi Nakagawa decided to drown his sorrows in drink. Alas, he chose the G7 meeting - at which he represented his country - to get drunk. Now, according to the New York Times , he is being forced to quit.

From what we can tell, Nakagawa is the only G7 finance minister who should stay on the job. The rest of them clearly don't know what's going on. Otherwise, they'd be drunk too.

*** Gold, as Lord Rees-Mogg notes, is the "best insurance against future shocks." A lot of people seem to think so. Gold rose $25 yesterday, to $967, and soon will be crowding $1,000 an ounce again.

Technical analysts are warning that gold is headed for a correction. "What should we do?" asks a colleague. "It looks like gold might go down in the near-term...but we don't want investors to sell out and risk being out of the market when the big move comes."

Unless you enjoy the thrills and spills of trading in and out, we don't recommend that you try to time the gold market. It's too treacherous. Yes, gold may go down in the next few months. But that has been true for the last 10 years - ever since we began recommending it. It goes up. Then, it corrects. And then, before you know it, it goes up again.

We don't think that pattern is going to change anytime soon. Gold is in a bull market that will only end when the final bubble pops - the bubble in paper money. How that will happen is anyone's guess. When it will happen is a matter of guesswork too. But the dollar delenda est too. In the meantime, we hold onto our gold and await developments.

And we suggest you do the same. Yes, the price has gone up in the past couple of days...but that doesn't mean you can't still get the yellow metal at a bargain. In fact, you can still buy an ounce of gold with the change you find under your couch cushions...no joke. Learn all about penny-per-ounce gold here .

*** Here's an interesting little item: "US Military Will Offer Path to Citizenship," says the New York Times . Why not? It worked for the Romans - for a while. Then, when the barbarians in the ranks became numerous and powerful, they took over.

Richard Florida, writing in The Atlantic :

"'One thing seems probable to me,' said Peer Steinbrück, the German finance minister, in September 2008. As a result of the crisis, 'the United States will lose its status as the superpower of the global financial system.' You don't have to strain too hard to see the financial crisis as the death knell for a debt-ridden, overconsuming, and underproducing American empire - the fall long prophesied by Paul Kennedy and others.

"Big international economic crises - the crash of 1873, the Great Depression - have a way of upending the geopolitical order, and hastening the fall of old powers and the rise of new ones. In The Post-American World (published some months before the Wall Street meltdown), Fareed Zakaria argued that modern history's third great power shift was already upon us - the rise of the West in the 15th century and the rise of America in the 19th century being the two previous sea changes.

"But Zakaria added that this transition is defined less by American decline than by 'the rise of the rest.' We're to look forward to a world economy, he wrote, 'defined and directed from many places and by many peoples.' That's surely true. Yet the course of events since Steinbrück's remarks should give pause to those who believe the mantle of global leadership will soon be passed. The crisis has exposed deep structural problems, not just in the U.S. but worldwide. Europe's model of banking has proved no more resilient than America's, and China has shown that it remains every bit the codependent partner of the United States. The Dow, down more than a third last year, was actually among the world's better-performing stock-market indices. Foreign capital has flooded into the U.S., which apparently remains a safe haven, at least for now, in uncertain times."

We remember our Five Big E's from a couple of years ago.

They were the underlying trends that we thought were unstoppable. Let's see...

1. Our Experimental money system - with faith-based paper dollars at the foundation - was doomed
2. The U.S. Empire was peaking out
3. Energy was becoming more expensive
4. Wealth and power were moving to the East.
5. And the Economy was headed for a crisis.

The only one of those that looks like a bad bet is number 3. Energy is a lot cheaper now that it was a year ago. But does that mean that the trend towards more expensive energy is over? Maybe...maybe not.

The price of crude oil dropped below $35 this week. Yesterday, it traded at about $37.
"I think we've seen the bottom," says colleague Simone Wapler.

Simone explains that many of the projects that were supposed to bring more oil on line have been abandoned. That will mean shorter supplies than forecast. Economic growth forecasts have been cut too...which will cut consumption. But inevitably, Asian economies will grow...and they will use more energy. There are 700 cars per 1,000 people in the US, she points out. In China, the figure is barely 20. One way or another, Asia is probably going to use more energy in the future...which is probably going to increase the price of oil.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

P.S. Colleague Byron King warns that although it's easy to be lulled into believing that low energy prices are here to stay, he wouldn't get too used to the idea. In fact, Byron thinks we are heading into what could easily be the most vicious and unpredictable financial cycle of the past 150 years. Learn how to prepare yourself (and even profit) from the 'forever oil crash' by clicking here .

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• Bear Markets Do Not End With Stocks Still Trading at Nearly 20 Times Earnings

Today's Daily Reckoning is equal parts optimism and reality. The reality could be construed, by some, as negative. But it is what it is. So let's get to it. Optimists may want to smile obliviously at this point.

First cab off the rank is oil. Crude futures fell by as much as eight percent in New York during Tuesday trading. A global recession tends to dampen demand for oil. And with traders expecting today's American Petroleum Institute Inventory report to show high gasoline stocks in the U.S., crude it taking its direction from other economic news in the U.S, most of which is awful.

Call us a common horse fly, but we find bad news strangely attractive. There's just something about it we can't resist. Having just completed a fuller look at the oil market for the January edition of Diggers and Drillers, today's oil price action is a good sign. That is, the short-term focus on the fall in crude demand is making energy stocks extremely attractive for the upcoming "back draft" in oil prices you can expect to see later this year.

The seeds of future scarcity in the oil market have been sown by this price crash. The nice thing about stocks is you don't have to wait long to reap. For example, Oil Search (ASX:OSH) was up 4.8% yesterday on the Australian market. It was no Rio Tinto (ASX:RIO), up 10.9%. But it was better than the 3.1% gain on the ASX/200, which itself was a welcome relief for investors shocked by Friday's freefall.

As mentioned in the January D&D issue, Oil Search is one of Credit Suisse's top energy picks for 2009. Credit Suisse rates the firm as "outperform" and says it has target price of $7, an upside of 60% from yesterday's close at $4.36. The other tip from Credit Suisse, by the way, is Santos (ASX:STO).

Neither of these tips are exactly State secrets. But what's interesting is that investors seem to be focussing on Oil Search's LNG future, and not its crude oil production in Papua New Guinea. Fourth quarter sales fell by 42% at OSH, which is what you'd expect when both prices and production volumes fall.

What's more, OSH averaged US$58.15/barrel for its oil in Q4. That was down 39% from the year before, when its average price per barrel was a robust $95.18. You should watch for just this same phenomenon-lower prices and production volumes-to sweep through the base metals and bulk commodity sector earnings later this year (especially after contract prices are renegotiated for iron ore and coal in March and April).

The good news for OSH? It has more cash now that it did the same time last year! Cash increased from $326 million last year to $517 million this year. And the company has no debt, which is nice during a Credit Depression. But the big driver for the stock price, at least according to Credit Suisse, is the $11 billion LNG project the company is planning with ExxonMobil.

"The story for Oil Search is not a production story and therefore by definition not an earnings story either-it's all about delivering the next phase of the progress on LNG," says the Energy 2009 Forecast. "The stock is a leveraged play into the PNG LNG project, which we believe will be one of the few (lower risk) conventional LNG projects to reach final investment decision (FID) in the next 12 months.

All of this is not to tout Oil Search, which is not a stock we've recommended in Diggers and Drillers (nor is it a stock we own). It IS to show that there is plenty of opportunity in the LNG sector in 2009. It's a story Kris Sayce has been dominating over at the Australian Small Cap Investigator for the last two months. What makes it an entrepreneurial story (rather than a strictly resource story) is that LNG is a relatively new industry in Australia. No one knows what its worth yet, or even how to measure which projects will be the most lucrative (or the most likely to find partners and funding and eventually reach production).

What we do know is that Australia has an unusual amount of unconventional energy reserves (coal-seam-gas, LNG, etc). The cost of extracting and producing those reserves is higher than conventional oil and gas production. But global integrated oil companies are eager to get their hands on new reserves wherever they can find them. Thus, start-up Aussie LNG firms are finding big partners with deep pockets. That's where the share price gains could come, despite the collapse in oil prices in 2008. See Kris' story below.

See? There is good news after all.

What about gold? We keep harping on about it. And yes, it's still shiny and money-like. But it did fall back under US$900 overnight. What gives?

The big driver of the gold price this year will be, as always, weakness in the U.S. dollar. Granted, gold is rising against other currencies too (the euro and the British pound). But it's the large increase in the supply of U.S. dollars that will ultimately catapult the yellow metal higher.

Keep in mind, though, that the unwinding of the dollar standard is not going to be a rapid affair. Too many people have too much to lose from a rapid dollar depreciation. We'd expect gold's move to be driven by gradual investor capitulation on common stocks and government bonds. And THAT will be driven by market returns and inflation concerns (both of which should mount as the year progresses).

Another date to watch for is September 26th, 2009. That's when the current European Central Bank Gold Agreement (CBGA) on sales expires. The first CBGA was signed in 1999, and depending on whom you ask, had a rather ambiguous goal. European central banks agreed to limit and publish their announced gold sales.

The reason, we suspect, is that European Central Banks own gold as a reserve asset. Signatories of the first CBGA controlled 43.6% of the world's above ground gold reserves, according to the World Gold Council. The second CBGA was signed in 2004 and limited sales to a maximum of 500 tonnes per year over five years (2,500 tonnes over the length of the agreement). With the expansion of the EU, CBGA signatories now control 46.1% of the above ground gold reserves.

So why cap official CB sales? As much as they prefer their own product-paper money-central banks own gold as a reserve asset. In 1999, the gold price languished at just US$252/ounce. For the CBs, this meant that value of a reserve asset was falling. And with the market wary that further CB sales could flood the gold market with excess supply at a time of lethargic demand, something had to be done to put a floor under the gold price.

In order to assure the market that Central Bank sales would not (at least publicly) be used to suppress/depress the gold price, the CBGA was signed. Since then, it's provided transparency to planned central bank sales of gold. According to the WGC, France and Switzerland were sellers of gold least year, while Russia was a notable buyer.

What will happen, then, when the current five-year agreement expires on September 26th of this year? Well, there's every chance a new agreement will replace it. But since we're in the business of looking for Black Swans, let us entertain the possibility that Central Banks abandon the agreement this year. Why would they do so?

Global central banks are also large holders of U.S. dollars and U.S. dollar-denominated bonds. How reliable do you think either of those as reserve assets? Hmm.

Also keep in mind that gold is now accessible to retail investors in a way it wasn't in 1999. Gold ETFs (if you take them at their word) own over 1,000 tonnes of gold. This makes ETFs the sixth-largest holder of above ground gold (behind the U.S., Germany, the IMF, France, and Italy).

It's not a rash speculation to suggest that Central Banks will prefer to hold on to their gold this year rather than sell it at all. As competitive currency devaluation sweeps the globe in an all-out effort to fight asset deflation and recession, gold will become much more desirable as a reserve asset worth owning (not selling).

Bankers are bankers, after all. Their product is money. But they have gold in their vaults for a reason. It was money before paper was money. So September 26th may mark the end of the orderly and coordinated management of gold sales by European Central Banks. And it may mark the beginning of a new monetary era where gold reasserts its importance as money.

Is this good for gold miners? You bet it is! More on that tomorrow.

How about some reader mail?

Dan Denning,

Very interesting and I concur with the prediction regarding higher energy prices later in the year.
One thing I have a hard time accepting is the deflation argument. How can you have deflation with only fiat currencies left in the world? Deflation means that currency (paper) will rise in value relative to tangibles like houses, cars, oil, steel, copper, etc. etc. I suppose that argument is based on the belief that things will depreciate in value faster than currencies lose purchasing power.

Since there is nothing backing any currency except the good faith and credit of the issuer, how can that "paper" ever be worth more than tangibles when the issuer also controls the printing presses?

Frankly, I can only foresee more inflation big-time as nations print more and more currency to offset (pay off) the enormous deficits that are being created worldwide in the attempt to ward off a recession/depression. What am I missing?

Thanks,

Arthur

You're not missing anything Arthur, as far as we can tell. In a world where the output of goods and services is declining, while the supply of money is going up, you would expect rising prices. The hitch in the giddy up is the massive overhang of debt in the Western world. With $52 trillion in total credit market debt in the U.S. alone , asset values (housing and shares) are already grossly inflated. We reckon they will have to fall a lot more before the factors you cite-paper currencies and deficit spending-begin to cause inflation. The money supply is headed in one direct (up), while total credit market assets are headed in the other (down). The closer they get to each other, the more you'll start to see rising prices.

Dan,

I think you are overlooking one factor on the housing affordability. And that is the standard of the house. This is why housing affordability has gotten less - expectations. New 21-year old home buyers now want a modern 4-bedroom first home with a gourmet kitchen, not a ramshackle 2-3 bedroom house to get started like we all bought 30 years ago. Australia may have the least affordable housing, but it is probably the highest housing standard too in some pretty nice bits of the world. Sure a flash house on the Gold or Sunshine Coast is going to be more expensive that a crappy house in the US mid-West.

Nigel.

You get what you pay for? Maybe. Location certainly matters. In the beautiful parts of the world, we reckon there is always someone willing to pay just a bit more for the privilege of a good view. But eight times median income? Is that some kind of new sunshine/square metre multiple we're unaware of?

Dan,

I'm puzzled by your support for the theory of Peak Oil. It seems to me that this theory belongs with the predictions of Thomas Malthus, on the scrap heap.

While it's true that there is only a limited amount of oil in the world and that therefore production must eventually reach a peak and decline, that only addresses the supply side of the equation, and only in part. It could make a difference in the short term, but the shorter the term you are using to judge it is, the less impact it can make.

Over a longer term, one must also look at demand. As prices rise, demand contracts. People start taking public transport more often, car-pooling, or switching to hybrid or electric cars (which are fuelled, ultimately, mostly by coal or uranium). As prices rise, demand falls, over the medium and long terms. Further, demand switches to alternatives that, like uranium, have much greater reserves.

The price rises also affect supply. Suppliers pump their existing facilities faster. Alternatives to drilled oil that are more expensive to produce, such as oil/tar sands, deep-sea oil deposits (if they exist) and biodiesel, become economically viable, increasing supply. Supply does not necessarily increase sufficiently to replace that which has been lost, and because some of it is more expensive it puts a higher floor price under oil. However, it does mitigate the increase in oil price.

The overall effect of this is that even though oil production is declining, any rise in price caused by that decline will act to increase supply and reduce demand. Even though this may not happen much in the short term, nor will oil supply decline much in the short term (or rise - oil production facilities take a long time to turn on or off). So whilst I agree with you that oil prices will go up this year on short-term supply and demand, I think you are very mistaken to cite Peak Oil as a reason.

LM

Be puzzled no more! You write a very sensible e-mail which we'd not argue with too much. It comes down to a few issues: production and substitution. It's true high prices induce producers to produce more.

But this, in our view, only accelerates the rate of production decline(depletion) in the world's major oil fields. And it's worth noting that the incentive of high prices has not led to new highs in annual world oil production (about 86mbpd). It's hard to argue that global oil production has not truly peaked.

Price rises also reduce demand, as you note. But that merely lowers the depletion rate of existing oil fields. It doesn't solve the problem of inevitable production declines as reserves are fully produced. And you are also right than in a normal market, rising prices lead to substitution. Savvy shoppers begin looking for cheaper ways to get the same benefit or service.

The trouble is there is no easy substitute for oil as a transportation fuel. If you're eating bananas and they get expensive, you can always switch to apples or grapes. But oil is not fruit.

We have nearly 100 years of fixed capital investment in a transportation and industrial production system based on hydrocarbons. That amount of sunk investment can't just be switched over night to, say, biofuels or electric cars. It's a massive economic and social transformation.

Or, put another way, there is no easy substitute for oil. Malthus was wrong because he did not account for human innovation and increased in productivity through technology (which allow us to feed more people). Malthus assumed that human population would grow faster than human food production (geometric vs. arithmetic growth).

But, in no small part thanks to the use of petroleum in fertiliser products, it was food production that grew even faster than human population growth in the 19th and 20th centuries. This allowed for millions of people to move off farms in the country and into factories in the city powered by oil, and building goods that would run on hydrocarbons. The energy boom created massive caloric surplus.

In fact, population growth has since exploded. The planet has plenty of resources to feed 6.5 billion people. But bungled national trade and farm policies get in the way and make food more expensive than it ought to be. However we digress.

The plenitude economist Julian Simon held that resources are never physically scare, only economically scare. Simon believed that when a thing became too expensive to use (price signals) a free economy would find or migrate toward a cheaper substitute or alternative. All things being equal, we believe Simon is generally right.

In this case, the energy we get from oil has to be replaced by energy from somewhere else. But where? That is a question for physics, not philosophers. The energy returned on energy invested (EROEI) is a real calculation that measures how realistic any given energy source is as a substitute for oil. There are not a lot of good substitutes, and by good we mean competitive with oil and an EROEI basis.

Our forecast? The car is here to stay. But the internal combustion engine's long reign of dominance may be at an end. Over at the Australian Small Cap Investigator, we've been looking at electric cars and plug in hybrid electric vehicles (PHEV). New batteries (with lithium and rare earth elements) are the key to viability of this new industry. And surprisingly, Australia has several firms with some cards t play. It's not all bad news!

How about one more?

Is it possible in your view, that the present turmoil is an early warning that while capitalism is a fine self regulating system in the short to medium term, it must by definition ultimately fail?

Since it is dependent on constant growth, and a reduction in the rate of growth seen as recessionary, does it not breach the fundamental law that perpetual growth in a finite system must ultimately implode?

If growth is the product of consumption and population is it not inherently self limiting?

John C.

Gladstone Queensland

This is too big a subject for today's e-mail. But we promise to address it tomorrow. Send your own thoughts to dr@dailyreckoning.com.au

Dan Denning

for The Daily Reckoning Australia

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And yet, now we have the water rising all over the world... and whole towns in California already submerged. Where are the plumbers?

Who knows? Maybe they had something to do with yesterday's rally. The Dow rose 552 points. The dollar went down hard - with the euro up to $1.28. And gold rallied $16 too - to $734.

The feds are doing all they can to bail out the economy. If they wanted, they could give the stock market a little boost from time to time. But probably not much more than that - and a great cost. And for all their bailing, the water is still rising...

Foreclosures are increasing at a 25% rate. GM is on the verge of bankruptcy; it's stopped talks with Chrysler. Joblessness is at a five-year high - and rising.

But there is good news too - prices dropped 65% at a wine auction... White truffles are down 84%.

This just in from colleague Ingrid Labuzan at MoneyWeek:

"In England, the housing slump is catching up to the U.S. Prices are officially down 14.6%. The average U.K. homeowner is losing money faster than he makes it. The housing bear market is reducing house prices by about 27,000 pounds per year - while the average bloke earns only 24,000. And every day, 121 houses are repossessed.

"The unemployment lines are getting longer too. There are expected to be 2 million people in Britain without jobs by the end of this year. Next year, the number is supposed to reach 3 million, above 10% of the workforce."

The OECD, meanwhile, says the floodwaters are rising all over the world. They expect the soggiest year in a long time... with negative growth in the developed world in 2009. Germany says it already faces the worst recession in 12 years.

For us, here at The Daily Reckoning, the crisis comes as no surprise. Heck, we saw it coming years ago. Of course, even we didn't think it would hit so hard... and so wide. We thought Japan, for example, would be spared. The poor Japanese are already black and blue from having been beaten up for the last 18 years; we figured they'd had enough. Instead, the Tokyo stock exchange got whacked again - taking stock prices down to levels last seen in 1986.

India, too, we thought would stay out of it. After all, Indians are pretty sober people. Almost party poopers. But the same stiff, moronic regulations that kept India from participating in the global credit expansion also meant that India's banks and consumers were less exposed to the global credit contraction. No party; no hangover. Still, that didn't stop investors from selling Indian stocks along with everything else.

We're surprised at how violently the downturn hit commodities too. Rightly or wrongly, investors are expecting a long, deep, deflationary correction.

"We are all Japan, now," says Albert Edwards at Societe Generale.

Of course, we know how it works: the correction must be equal and opposite to the shenanigans that preceded it. But which shenanigans? What, exactly, is this correction going to correct?

So far, the financial industry and the housing industry have had their fannies paddled. Just as you'd expect. They deserve it. Go ahead, Mr. Market, let 'em have it!

The U.S. auto industry too deserves a good spanking. It failed to hold down costs and continued making inefficient, gas-guzzling vehicles long after the market had turned away from them. It should be allowed to fail. Get it over with. Make room for new blood. There are a lot of automakers in the world; we don't need these dinosaurs.

America's retailers... and shopping malls... and fast-food joints... Well, the list of industries in need of a good whack is long and obvious.

But right now, it's the consumer who's bending over. In fact, from MarketWatch we get the news that "retail sales plunge a record 2.8% in October."

*** "Consumers stop shopping," is the stark headline at the Chicago Tribune. We know that that is just what he should do. He's got to pull himself together, get on the wagon, clean up his balance sheet.

But here come the feds - determined to stop him. They pull up to his house in a shiny convertible. "C'mon... it's happy hour all night long... No money? Don't worry, I'll lend you some... "

Here's the report from the New York Times:

"... with a little more than two months left before President Bush leaves office, Treasury Secretary Henry M. Paulson Jr. is hoping to put in place a major new lending program that would be run by the Federal Reserve and aimed at unlocking the frozen consumer credit market.

"The program, still in the planning stages, would for the first time use bailout funds specifically to help consumers instead of banks, savings and loans and Wall Street firms.

"Treasury officials said they hoped to invest about $50 billion from the bailout fund into the new loan facility, with the aim of helping companies that issue credit cards, make student loans and finance car purchases."

Paulson's new plan is simple enough. Borrow money from savers all over the world and give it to spenders in the United States of America. Put things back to 'normal' - or at least to what they were a few years ago. To a thinking man, of course, this plan is absurd. It merely encourages Americans to continue making the same mistake - spending money they don't have on things they don't need. Rather than cleaning up their balance sheets, they'd be making them worse.

But you couldn't put together a chess team with the few people who have their thinking caps on. This is a crisis; everybody says so. And in a crisis, you don't stop to think - you act! You act like a jackass, usually.

Paulson was the front man at Goldman up until 2006. You'll recall that that was when Wall Street's party was completely out of control... when financial shenanigans reached their crazy apogee. Now, the very same Henry Paulson is working his magic on the whole U.S. economy - good luck to us all!

But it really depends on how much correction Mr. Market has in mind. Is he correcting the excesses of the 2002-2007 period? That would take the Dow back to 7,000 or so... and cut housing down a few more percentage points.

But it would leave the fundamentals of the economy intact. Or is he correcting excesses of the entire bull market from 1982-2007? Or is he aiming to correct the whole, grotesque dollar-based post-'71 money system? That is, is he merely trying to correct the bubble or the pump? The speculative hyperbole of the last 5 years... or the source of so many bubbles... and so much economic distortion - the paper money system created by Richard Nixon in 1971?

We don't know. But judging by the way things are going... our guess is that he has bigger fish to fry than just the stock market... or the housing market. This looks like the big one to us - the "Greater Depression," as our old friend Doug Casey puts it.

Our guess is that he aims to take America down a peg or two. Its money. Its standard of living. Its power and its prestige. It won't be pleasant for many Americans... but in the end, they will be standing on more solid ground.

*** Chris Mayer assures us that there are still some companies that are doing well...

"By and large, at Mayer's Special Situations, it seems we've been successful in finding the little creases and pockets where companies are still doing well and reporting strong results. The stock market, though, isn't giving them much credit. At some point, the market will change. Investors in companies like this will get their reward in a better multiple and a much higher stock price.

"In the meantime, we can only watch our companies grow their businesses and execute fundamentally. The price will catch up eventually. But the wide discounts give us plenty of chances to build low-cost positions in a number of exciting opportunities."

Chris' latest alert has more than a few exciting opportunities for you, dear reader. Check them out here.

*** This from colleague Dan Denning in Australia:

"I ran across Dmitry Orlov's book, Reinventing Collapse, in which he compares present day America to Soviet Russia prior to its... collapse."

"Orlov outlines five stages of collapse, and where the U.S. along the way:

"Financial Collapse. Already in motion."

"Commercial Collapse. Just started."

"Political Collapse (a loss of faith in ideology). First part is over (the recent election in the US). Second part is going to be nasty."

"Social Collapse. Potentially the end state or stable equilibrium point for most of the world. Everyone against everyone with points awarded by the global marketplace."

"Cultural Collapse. Full meltdown. Global market breaks."

*** Finally comes word that "VP-elect Biden aims to be a hands-on No. 2." What a disturbing thought. When an empty car drives up to the White House for a meeting with Obama, it will be Joe Biden who gets out.

• No Great Slump, but Stagnant Inflation Looms
• The Fed Cut Rates – But How Low Will They Go?
• Baby Boomers Face Early Retirement With No Money Saved
• Fannie and Freddie in a Free Market Economy
• Gold ETFs Aren’t Looking as Good as They Used to Be

Oil fell to $56 a barrel; investors feared that the world's drivers would leave their cars in the garage and the world's teenagers would begin turning off the lights when they left their rooms.

And they seem to be right.

"Buying binge slams to a halt," reports the New York Times. It is a "crisis of confidence" among consumers, the paper explains.

Crisis of confidence? No... it is more like an attack of good sense... a bout of sanity... a brush with sobriety. This is a 'balance sheet recession,' remember. Consumers, businesses and speculators are all acting perfectly reasonably. They haven't lost their senses, in other words, they've come back to them. They finally realize that they need cash... savings... money in the bank "for a rainy day."

The weather forecasters on Wall Street and in the press said it would never rain again. But here it is - pouring down!

Even gold is running for shelter. The price of an ounce of gold fell $22 yesterday.

A hard rain is gonna fall. No doubt about it, it's falling already.

And now, the whole world turns its weary eyes to America's president-elect - Barack Hussein Obama:

"Mr. Obama, please... do something!" they beg. "Save me! Spare me! I promise I will never do stupid things with my money again. "

Will Obama be able to restore consumers' confidence? Will consumers recover from their bout of sobriety? Will the feds be able to lure them off the wagon with more cheap booze?

And so... those questions before us... the world moves closer to its first trillion-dollar deficit. Wait... did we say 'trillion dollar?' Make that $2 trillion.

There is now no doubt about the general direction of the markets and the economy - they're going down. That's not to say we can't have a nice rally. We'd be disappointed if we don't get one. Following the crash of '29, for example, the Dow rallied back to within 60 points of its all time high. The rally took 6 months and gave investors plenty of time to get out.

Instead, many concluded that the good times were rolling again. Alas, it wasn't so. The good times were over... and wouldn't really come back until the 1950s - 20 years later.

What we had in the '30s... in Japan in the '90s... and now worldwide... was a massive destruction of wealth. Well, wealth... such as it was. In all three cases, a huge, credit-led boom led to a huge build-up in speculative debt. Then, when asset prices fell... balance sheets looked terrible. People had to pay down debt and build up savings. That takes many years. And while it is going on, spending, investing and living it up are depressed. Obviously; people need the money for other things. Just look at Starbucks - the stock is down 75%. And Coach (maker of expensive leather handbags) - down two thirds. Tiffany has been cut in half.

Yes... the hard rain is falling on everyone, rich and poor alike.

*** Central banks lower interest rates to try to gin up some activity. They set up another round of drinks, hoping the party will get going again. The Fed cut rates decisively (if a bit slowly) in the '30s. Japan's central bank went further - taking rates down to near-zero and leaving them at that level for years. The U.S. Fed, meanwhile, has already hacked its key rate down to 1%. It's ready to cut more... if need be.

But the central bankers are missing the point. They're like a liquor salesman at an AA meeting. Everyone is desperately trying to sober up - not go on another bender. Of course, the feds will get a few people to take up the bottle again... but these poor saps will be even worse off.

In this type of correction, people need to correct the mistakes of the late bubble. That means getting balance sheets back in balance. And that means spending less and saving more.

Economists describe this problem as "pushing on a string"... or a "liquidity trap." The central bank can make more credit more readily available, but it can't force people to borrow.

Yesterday's news headlines included one that went to the heart of the matter; "Government to force banks to lend." But the problem is not so much the banks - it's the economy itself. Banks would be happy to lend - if they could be reasonably assured of getting their money back. But in a crumbling economy... who knows?

This is the tough financial situation that President Obama will face.

While monetary policy won't do much good, fiscal policy might. At least, there's plenty of temptation in fiscal policy... so much that powerful, ambitious and/or corrupt politicians - forgive us for repeating ourselves - always find it irresistible.

The principle is simple. If businesses won't spend... and consumers won't spend... the government will do the spending. This is the idea made popular by Keynes and known today as "Keynesian" economics.

"We are all Keynesians now," said Richard Nixon back in the '70s. As we said, the idea was irresistible.

Keynesian spending doesn't really make people better off, but it has three things going for it:

1) It gives politicians an excuse to spend more money

2) It looks like things are getting better... and at least government is "doing something"

3) It tends to keep the lights on

In the coming U.S. downturn, (we say "coming" because the worst of it is still in the future) consumers are likely to pull hard on their belts and send the rate of saving soaring. Maybe not the 20%-30% you see in Japan and China, but at least back to the 10% we saw before the 1990s. That will remove more than $1 trillion from the economy. Directly. Indirectly, it will remove a lot more.

And here we bring bad tidings of Christmas.

"Balloon bursts on festive parties in tough times," is a headline at the Financial Times. Companies are cutting back sharply on their holiday celebrations. We know that from personal experience. A memo just received from corporate headquarters in Baltimore tells us that the annual Christmas party will be greatly scaled down. "Employees only," is the word.

Well, the grinches in our own little company are generous compared to those in other firms. The big Wall Street firms "have scrapped extravagant parties," comes the word from the street. "What's there to celebrate?" asked one executive. "It's the year from Hell."

Certainly a "glass is half empty" way of looking at it. It's a correction. And in corrections, spending goes down as people correct the errors of the past.

In Detroit, GM and Chrysler have cancelled their big holiday bashes, too. Oh, the poor caterers! It's not as if there were a lot of upper-end work in Detroit these days. The caterers probably waited all year to put on a big do at Christmas for the carmakers. Then, wham, they cut off the juice... the party lights go out... and it's a cold, cold winter in Detroit. As if it weren't cold enough already!

The automakers are trying to cut costs as rapidly as they can. But revenues fall faster. Vehicle sales fell again in October - for the 12th straight month. This is the longest losing stretch in 17 years.

A writer for Britain's Spectator Business took a drive to Detroit to check on the state of things. Spotting a live human being in a huge parking lot... apparently guarding an abandoned factory... he stopped to chat.

"Ten years ago, this place was booming," said the guard. "Hard to believe isn't it? Back in '85 I used to work for General Motors fitting radios and cruise-control switches to the dashboards of cars. But they moved the factory somewhere else and that was that. Now I do security. Although what they're guarding this for, I do not know. There's nothing here."

Behind him was the apocalyptic scene we associate with Detroit. Then, referring to the American Dream, the guard took up his reflection:

"I thought it was the auto industry... with jobs and pension and health insurance and what not, but that went pop. Now they say they are building condos everywhere down here, but I don't know who they think is going to buy them. I guess that's another type of dream."

"It's time to wake up, America," continues the reporter, "this dream has become a nightmare."

So, in addition to the $1 trillion taken out by the savers... there's also the effect of less spending magnified all through the economy. The caterer doesn't get to serve up a holiday party... the baker doesn't get to bake... the liquor bottles begin to collect dust... from the guys who park cars to the babysitters to the hairdresser... the whole economy spins fewer dollars... people earn less... and they pay less tax. Then, at the far back of the income bus, the most marginal workers fall off altogether. The jobs they could get anytime before can't be gotten at all now. McDonald's begins to get choosey. It wants someone with a master's degree in fluid mechanics doing its deep-frying. And over at the Bright Nails shop, heck, they're looking for someone who used to be a chemist!

So the guys with few skills and spotty employment records can't get jobs at all. They should do like those fellows in Latin America and South Africa. They stand out on the roadsides, waiting for anyone to pick them up and put them to work... a day at a time... one hour after the other. They get paid at the end of the day - in cash. They should reduce the cost of their labor to the point where they're worth hiring, in other words. But this is the United States of America we're talking about. This is a democracy. And there are a lot of votes in the greater Detroit area... and a lot of Democrats who are going to be really cheesed off if their man in the White House doesn't do something to protect the voters from reality.

So what's Obama going to do? Simple, he's going to do what his most persuasive advisors tell him to do... he's going to borrow all those savings and put them to work. Everyone wants the safety of Treasury paper. Fortunately, the Obama Administration is going to give them plenty of it. They'll absorb the trillion or so in U.S. savings... and then everything else they can get their hands on - including much of the rest of the world's savings too. The U.S. deficit will soar - along with the national debt. Rates will rise.

And then... maybe 18 months from now... maybe 10 years from now... it will get really interesting...

• Detroit Wants Bailout
• O! Bama! The Whole World Turns Its Weary Eyes To You…
• World of Super Collides With World of Credit Crunch
• Obama Admits: America is Out of Money
• The Country is Going into a Recession with its Finances in the Worst Shape Ever

Daily efforts to "thaw credit markets," "provide liquidity," and "support financial stability" only add to the myriad market dislocations. And despite what we may hear from politicians and the news media, recovery is unlikely to be "just around the corner."

The party really is over. We are facing hard times, no matter what the government does. If it continues to prop up the sick markets, it will only delay and worsen the inevitable deep recession.

To survive the current financial crisis and the accompanying economic downturn, we must understand the big picture, and how it will be affected by the slew of "support" from the federal government.

Casey Research accurately predicted the specifics of the crisis in its International Speculator edition of March 2007:

For one thing, at the point that falling prices leave homeowners with mortgages exceeding the value of their homes, default rates will soar. This, in turn, will put lenders that hold large amounts of mortgage debt at risk, and possibly jeopardize the solvency of Fannie Mae and Freddie Mac, since they guarantee much of this debt. If these mortgage giants faced collapse - and they are already in well-documented trouble - a government bailout involving hundreds of billions of dollars would be a likely next step.

The impending calamity - mass housing foreclosures, failing banks, Fannie Mae and Freddie Mac in ashes, millions of personal bankruptcies - is so dire... most people can't even conceive of it. And indeed it may not hit us this year, or next, but the market always corrects itself, and this time will be no exception, sooner or later.

We have said before, and we repeat again: Rig for stormy weather.

Now the Casey Research team forecasts something outside the realm of any recent experience: the Greater Depression may be looming on the horizon.

Doug Casey coined the term "Greater Depression" in his best-selling book Crisis Investing, published in 1979. Today it resounds throughout the land; even CNN's Glenn Beck recently used it in an op-ed piece. And the signs are increasing that a depression may indeed be what we are moving towards.

On September 30, 2008 (end fiscal 2008), the Congressional Budget Office reported a record federal budget deficit for the year of $455 billion, up $293 billion (or 181%) from fiscal 2007.

And that does not yet include the Fed's bailout package for failing banks, Fannie Mae and Freddie Mac, and various other "economic stimuli." The chart below shows that the $700 billion agreed to by Congress may have been a very optimistic estimate.

On October 3, President Bush signed into law the Emergency Economic Stabilization Act of 2008. With this Act, Congress and the president have ensured a runaway government deficit next year...one sure to exceed $1 trillion. Along with total federal debt outstanding already around $10.3 trillion, unfunded liabilities of at least $50 trillion, and many new programs and tax rebates promised by both presidential candidates, this does not bode well for the global economic outlook.

As if that was not enough, during the past few weeks, the Fed increased the country's monetary base by as much as 20% to shore up the financial systems.

Federal budget deficits facilitate "loose" (expansionist) monetary policies, and these policies set in motion the business cycle. As the economy enters the cycle's "bust" phase, massive federal deficits have left the government with only one option - to try to inflate itself out of the current crisis, regardless of the impact on the value of the dollar.

A rapidly growing money supply at the same time the biggest credit bubble in 25 years bursts makes for a less than desirable scenario - one that could make the stagflation of the '70s look like a walk in the park. In March 1975, industrial production fell by nearly 13% while the yearly rate of CPI growth jumped to around 12%. It took another seven years and a second recession before the U.S. was able to break from the stagflation cycle.

What we are likely in for now is an unprecedented period of price inflation, economic depression, and high unemployment, i.e., not just stagflation but depflation (inflationary depression).

Depflation will affect the entire population, and its effects on people's personal finances will manifest in multiple ways.

• Purchasing power declines as prices for consumer goods increase faster than wages.
• Taxes levied on businesses and individuals increase when nominal incomes rise.
• Late recipients of new money incur cost of additional hidden tax.
• Cost of money (interest rates) increases, hurts investments in capital goods, stocks and bonds.
• Once expectation sets in, it becomes a self-feeding phenomenon, taking years and a severe recession to work itself out.

Just like a shot of adrenalin administered to a sick patient generates an apparent revival, only to have the patient collapse as soon as the injection wears off, the artificial monetary injections by the Fed will do the same. Paraphrasing former Fed chairman Paul Volcker, "Once you have a little [monetary] inflation, you need a little more". As with any medicine, its effects wear off and become less potent the more "injections" are received.

At this stage, your primary goal should be asset protection. Once that is in place, you will be in a better position to hunt for the opportunistic profits one can only find in times of crisis.

Regards,

Olivier Garrett
for The Daily Reckoning Australia

• Fannie and Freddie Say Goodbye to Veto
• Freddie Mac’s Main Man is in the News
• The Greatness of a Depression is Commensurate to the Government’s Efforts to Prevent It
• How Much it Really Cost to Bailout Fannie Mae and Freddie Mac
• Irving Fisher Remains Immensely Important in the History of Economic Thought

"The World Bank met on Sunday faced with a mounting food price crisis that has sparked deadly unrest in developing countries, underscoring the urgency of fighting hunger and poverty," reports Channel News Asia.

How urgent, you ask? The Prime Minister of Haiti was sent packing this weekend by crowds protesting soaring food and fuel prices. We don't even know who the man is but reckon he won't be the last public official to be ridden out of town on a rail before this current crisis is over (and it may not be any time soon).

As usual, it's the people at the margin (whether lending or with food) that are affected first when surplus turns to scarcity. Despite all the daily signs of abundance here in Australia, let us not forget that there are about four and half billion people on the planet who have little margin for error in their daily lives. If food prices go up, many of these people go hungry.

World Bank President Robert Zoellick, doing his best impersonation of Franklin Delano Roosevelt, wants a "new deal" for global food programs. He's asked richer nations to contribute US$500 million immediately to help get food to poorer nations.

IMF President Dominique Strauss-Kahn was less pragmatic but more rhetorical. Wrapping up his organisation's annual spring meeting, he said that, "Food prices, if they go on like they are doing today ... the consequences will be terrible…Hundreds of thousands of people will be starving…As we know, learning from the past, those kinds of questions sometimes end in war."

People often talk about resource wars being a common feature of the coming century (or decade). But it's usually oil and energy they're talking about, not rice and wheat. Food is fuel for the body (we've been watching the Biggest Loser). If you don't have access to cheap calories, what good is cheap fuel?

It's our contention here at the Daily Reckoning that both food and fuel are getting more expensive. The scary thought is that artificially low interest rates and cheap energy have, for many years now, sent bogus signals to the world about how much and how fast the population can grow. Agricultural abundance is only a very recent (and perhaps temporary) historical phenomenon. It's no coincidence that it occurred alongside the energy boom from cheap oil.

Not that it's any consolation to starving people stranded in long petrol lines, but businesses in the agricultural sector are going to boom (provided they aren't nationalised). Farm equipment, fertilizer, and large producers should all see earnings rise this year. And next year. And the year after that.

The second "f" crisis is in finance. It's been with us so long now it doesn't seem like it's new. But some people are slow on the uptake. The nerve endings of large institutions like the IMF and World Bank are few and far removed from the tiny central brains that direct the movements of these mammoths. Brontosaurus Banks.

Like a bunch of dinosaurs standing under a meteor shower, the G-7 meeting this weekend produced lots of talk and no action. The ministers agreed that concrete steps need to be taken in the global financial system to improve transparency and the way the banks value certain assets. The G-7 statement also paid lip service to issue of credit ratings and how to make sure in the future that garbage debt doesn't get a Triple A investment grade rating.

Here's the trouble though…American policymakers are worried about recession and plunging house values. Everyone else-especially the increasingly sweaty Wayne Swan-is worried about inflation. Because of the different concerns, no one can agree on any policy solutions.

The conclusion? There is no one solution to the credit crisis. That is bad news for people who think of the economy like a machine. It's not just a matter of changing the oil or checking the fuel pump. The engine is sputtering, the drive train is wrecked, the tires are flat, and someone seems to have cut the brake lines. There are no air bags.

As they say in the used car business, it's not the years, it's the miles. You wonder if this globalisation jalopy is going to make it.

As for the dollar, Europe would like it to be stronger in order to revive its exports. Dollar-pegging countries in the Persian Gulf would like the dollar to be stronger too, so they don't import inflation and the political instability that goes with it. Even Japan and China would like the dollar to be stronger. Dollar strength maintains the basic economic model of the last 50 years: manufacture cheap and sell to America.

But the dollar is not strong. And the things that would make it stronger-a lower trade deficit, higher interest rates, lower government spending-are not going to happen. In fact, the opposite will happen. While officials talk up a "strong dollar," everything they actually do weakens the dollar.

This is why the day-to-day movements in the dollar index and in gold don't tell you much. The most important fact about the gold price is that that the official policy of the U.S. government is to cheapen its currency. Rates are being lowered. The government is spending money. It's also giving away money, hoping Americans can spend the country out of recession.

Do you know of any person or any nation that ever spent its way to prosperity? Neither do we.

The fuel crisis hasn't reached the same acute stage as global food markets. But in time, it will. There were two developments in the clean coal front this that caught our eye this week. First, "Australia is now investing $63 million in developing clean-coal technology in China, our biggest coal buyer," according to Dennis Shanahan in today's Australian.

Making the last stop in his first world tour, Aussie PM Kevin Rudd told reporters made the case for an Australian Chinese partnership on coal, "The fact that Australia is the world's largest coal-exporting country, and that China is the world's largest coal-consuming country, presents both of us with a fundamental responsibility to act in this area of critical technology," he said.

You say "responsibility" we say "opportunity." Now that we are moving into a world of energy "haves" and "have nots," coal is a realistic source of transportation fuels for oil-poor, coal-rich nations. What coal-rich nations lack is the technology and capital to turn coal into liquid transportation fuel. Australia has several public companies that can help them do it. That's the opportunity.

The trouble with above ground coal-to-liquids (CTL) technology is that it produces nearly double the carbon dioxide emissions that you get from burning coal to make electricity. In the U.S., green politicians have actually prohibited U.S. government agencies from buying coal-based fuel with tax payer money.

The U.S. has plenty of coal. The Air Force would like private enterprise to turn that coal into fuel for U.S. planes. But California Congressman Henry Waxman introduced a provision into last year's U.S. Energy bill (section 526) that prohibits government agencies from buying fuels from "unconventional" sources.

Those "unconventional" sources are oil shale (the Pieceance Basin in Colorado), coal (the Powder River Basin Wyoming), and heavy oil sands (found in Alberta in Canada). Two U.S. Congressman are looking to repeal Section 526 from last year's U.S. Energy Bill and unlock the future fuel from those unconventional hydrocarbons.

Will the section be repealed? It depends on what you think about global warming. We won't weigh in here. Our main interest is in how governments respond to the dueling crisis of Peak Oil and Global warming.

The old "real politik" answer is to use your domestic resources to achieve energy security. This way you don't exchange your currency reserves for oil and outsource your supply of a vital industrial commodity to foreign interests. If you have lots of coal but no oil, you turn your coal into fuel.

But hey, if the planet is warming and coal is the culprit, burning more coal doesn't exactly make things better, does it? What do you do? Go nuclear? Conserve? Go renewable?

All of these options are on the economic table and an intelligent and prompt response is becoming increasingly urgent. You can bet that the government will do something, and probably the wrong thing. Meanwhile, our money is on the firms doing something with coal, wind, waves, and solar.

These three crises-food, fuel, and finance-are a formidable triply whammy for the global economy. It's bad news for the indexes, which already have plenty of bad economic news to consider. But for a certain class of agricultural and alternative energy firms, this could be the bull market of a lifetime.

Dan Denning
The Daily Reckoning Australia

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