There are some pretty big issues we left hanging with yesterday's DR. Are the Western Welfare States (the U.S., Japan, and EU nations) really going bankrupt? Things were headed that way before the credit crisis began. If Rogoff and Ferguson are right and the GFC is becoming a sovereign debt crisis, it will worsen an already bad situation.

How bad? We'll show you three of the charts we showed the folks in Canberra on Sunday. This is the condensed version of a forty-five minute presentation. So we'll have to leave out the colour commentary. And we're pleased to offer another contribution from Dr. Steve Kates on how government policy is destroying public wealth.

But first, check out the chart below from the 2008 annual budget audit by the U.S. Government Accountability Office. It shows that the U.S. government must roll over $3.4 trillion in debt over the next four years. This $3.4 trillion does not include any additional borrowing that may be required for other government programs (wars, healthcare, wars, school lunches).

What's the big deal? $3.4 trillion is a small number by today's standards, isn't it? Not exactly.

The chart shows how incredibly interest-rate sensitive U.S. government borrowing now is. Not only is it a big ask to ask the world's creditors to continue funding such large deficits (there are only so many savings available to borrow, after all), but the interest expense on that debt is likely to go up as the fiscal position of America deteriorates.

And if America can't find anyone willing to finance its deficits, what then? Well, the luxury of issuing debts in the currency you also print is that you can print money to pay for them. Technically, you can never become insolvent when you enjoy this privilege. The Fed, for example, can create new money to buy debt issued by the Treasury, funding deficits ad infinitum.

But this monetisation of the debt is another way of saying that international creditors are no longer willing to pick up America's spending tab. They will be betting against the American economy, not on it. Even if the Fed takes the unusual step of moving out further along on the yield curve to set interest rates (and keep the bond vigilantes from sending yields to the moon) this is a clear signal to owners of dollar-denominated assets and holders of dollar currency reserves to get out.

Another scenario to watch for is when creditors begin asking the U.S. to issue debts in currencies other than its own (Yuan, Euros). That would be something. In the meantime, they will look to lessen their dollar reserves.

That may not be such an orderly process. And the urgency to get out of the greenback and into something better will only pick up pace as it becomes clear the politicians in America (along with the Fed) are not likely to suddenly rediscover fiscal prudence.

You never know. The Fed may assert its independence and baulk at more quantitative easing. But we wouldn't count on it. And we reckon tangible assets and possibly emerging market equities would be the biggest beneficiaries of capital flows out of the dollar...and into anything else.

The next chart is for you, Paul Krugman. Krugman, among others, continues to insist that larger public sector deficits are necessary if the Western world is to avoid a Japanese-style deflationary "Lost Decade." He claims the government must increase spending as households and businesses deleverage and reduce debts.

Advocates of this idea claim that public sector deficits, as a percentage of GDP, have no real limits. And the example they cite is Japan. As you can see from the chart below, Japan's debt to GDP ratio is nearing 200%. America's isn't even half of that yet (it's about 98%, or $13 trillion). If Japan can finance a deficit at 200% of GDP, then why are we worried that U.S. deficits half that size would threaten interest rates or the dollar?

First off, it's worth pointing out that high public sector-debt-to GDP ratios haven't worked in Japan, if by work you mean pave the way to a stable recovery. Advocates might say-as advocates of the stimulus here in Australia often say-that the public spending made things less worse. But the opposite is true. It's made things more bad!

Or just worse, if you prefer. We mean that the public spending has done two things, neither of which is productive, and both of which, in fact, waste capital and resources. First, public sector spending to prop up financial firms with dodgy assets prevents the needed reckoning in asset prices that would produce market clearing prices for commercial and residential real estate. You get zombie banks and a zombie economy and zombie house prices.

Secondly, there's no indication that all the infrastructure spending in Japan has produced any kind of lasting growth for the economy. It may have built some great roads and bridges. But we wonder if it solved any of the underlying problems? What' more, the capital and resources that went into those projects was directed by political considerations and not available for the private sector, which could have put them to some use at least designed to produce a return on the capital.

The underlying problem which deficit spending does not solve is compounded by demographics. Japan's government is hoping that continued borrowing can be financed at low rates by pensioners who will be cashing out of their pensions but seeking safety. However, we suspect that Japanese pensioners will begin to consume their savings as they downsize their lives into their twilight years (which tend to last much longer in Japan, as the number of Japanese centenarians shows).

That means interest on Japanese bonds-which already one fifth of the Japanese budget-will consume even more of the nation's resources, if the older population clams up with its money. And like in the U.S., you'll see the government borrowing more and more of every new yen spent, with more of that borrowed yen going to pay a previous creditor. That's bordering on Ponzidom.

Japan has been able to run a higher-than-average public debt-to-GDP ratio because it has had such a high personal savings rates. This kept borrowing costs low for the government. But we'd expect that to change soon. A debt-to-GDP ratio of 200% will be very difficult to finance in the world as it is-much less in a world where those rates begin to rise and when Japanese savers begin to consume their savings.

Finally, what about Europe? Our argument here is simple: Europe's monetary union is going to come unstuck. Why? Europe has one interest rate for twelve different economies. That does not leave national governments with the flexibility to print money and inflate away political problems. This will be intolerable, the monetary union will break up.

The sign to watch for is a spike in the yields on euro-denominated debt. As the chart below (from Stratfor) shows, earlier this year bond yields did in fact begin to widen. Germany Bunds have the most stable rates, as Germany has traditionally the most stable fiscal and monetary policies in Europe (they did not go hog wild for stimulus).

But for Spain, Ireland, Greece, Portugal, Italy and Austria (whose banks lent large for real estate in Eastern Europe), another round of falling asset values really would show that the GFC has become a sovereign debt crisis. And will Germany bail out these nations? Can it afford to?

We don't know the answer to those questions. But it is worth pointing out that by assuming or guaranteeing the liabilities of the financial sector, national governments have also assumed the risk. And the bond markets will be left to decide how to price this risk.

How it ends is anyone's guess. But our take is that the Super Cycle in fiat money is at its peak. And as it unwinds, it's going to take national governments and their financing model with it. They will be forced to adopt a new model and take a new form to survive.

This means a great deal of political and economic upheaval. It's no coincidence that the last time the world faced such monetary upheaval was when it went off the gold standard and straight into essentially thirty two years of military and economic conflict (1913-1945). If the world is about to become that disordered again, you'll need a plan to deal with it.

Dan Denning
for The Daily Reckoning Australia

• Japan and its Economy Did Not Have Secret to Everlasting Success
• Only Thing Rising Faster than Demand for Government Debt is Supply of It
• Investing in Japan…
• Government Debt
• Zero Percent Interest Rate Didn’t Work for the Japanese

We were thumbing through the transcript last night over some sashimi and a beer and highlighted this passage from Dr. Steve Keen: We are told that for example debt doesn't matter because if a company takes out a certain level of debt, say a very low level of say 10% debt to equity, that's irrelevant to the company's value because the person buying shares in that company can take out 90% debt to equity ratio."

"Therefore you're told the Modigliani-Miller proposition, after the two morons who got the Nobel prize for it, was that the level of debt that a company takes out does not affect its value. And those sorts of propositions are strewn through conventional economic theory, and of course people like Alan Greenspan and Ben Bernanke are experts in that very same theory."

See? Bernanke...Greenspan...morons, all of them! Debt does matter. And so do deficits. Just this morning we read that U.S. President Barack Obama will ask the Senate to lift America's statutory debt limit to $13 trillion. It's at $12.1 trillion at the moment.

The lower legislative body of the Congress, the U.S. House of Representatives, passed a measure lifting the debt ceiling earlier this year. But it used a parliamentary trick to do it in a manner which did not require a roll call vote. No jack asses had to go on the record.

The Senate is different. There are just 100 of the grumpy old men and women. And to increase the debt ceiling to accommodate annual deficits of over $1 trillion for the next ten years (it's $1.6 trillion this year) the Senator will have to go on record. Spending other people's money is generally easy (and probably kind of fun). But not when you have to publicly commit to it and "own" the debt. No one wants to own it, even though everyone wants to benefit politically from the spending (sound familiar?)

The investment fallout from the record U.S. debt and deficits is continued pressure on the dollar and $1,000 gold. Old yeller metal dragged itself up $2.50 in the futures markets to close over the $1k in New York trading last night. Gold has done this despite a 50% rally in stocks. We reckon once the punters catch a little gold fever - which they will if it can hold the line at $1,000 for a few days - higher highs will follow.

And let's not forget large owners of dollar-denominated assets like stocks and U.S. Treasury bonds. Do you reckon they're getting a touch nervous? Cheng Siwei, a Chinese official attending a conference at Lake Como in Italy, said he was worried about the Fed's indefinite policy of credit easing.

"If they keep printing money to buy bonds it will lead to inflation," Chen said. "And after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies... Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets."

In the meantime, why not try iron ore and uranium? Reuters reports that, "Chinese state-owned firms expanded their footprint in Australia's mining industry on Tuesday, agreeing to help fund two iron ore explorers in return for supply contracts and taking a controlling stake in a uranium prospector." The iron firms involved were FerrAus United Minerals both of which formed relationships with China Railways Materials Commercial Corporation. The uranium deal was between China Guangdong Nuclear Power Holding Co. Ltd and uranium prospector Energy Metals.

These deals are probably both operational and strategic. They're operational to the extent that in exchange for capital, Chinese firms get long-term supply contracts (price certainty) for key minerals and bulk commodities. They're strategic to the extent that State-owned firms can channel U.S. dollar reserves into tangible assets. This slightly reduces China's risk to the inevitable devaluation of U.S. debt securities through inflation.

Getting back to Cheng, he seems to understand exactly what happened over the last five years. Loose credit is the problem. "This is where Greenspan went wrong from 2000 to 2004," he said. "He thought everything was alright because inflation was low, but assets absorbed the liquidity." He's talking about real estate and stock markets.

He's also talking about the psychological and moral attitude in a country that's obsessively focuses on preserving its immediate lifestyle at the expense of future investment and growth. "The US spends tomorrow's money today...We Chinese spend today's money tomorrow. That's why we have this financial crisis."

Of course whether your Chinese, American, or Australian, it's everybody's crisis now. So what should you do?

Inflation has yet to really rip through the commodities sector. As Bill pointed out yesterday, the U.S. dollar has yet to really crash. It may do so only gradually. U.S. creditors are not exactly easy to cause a run on the dollar. They have a lot to lose. And we know the Fed and Tim Geithner and Barack Obama want a gradual devaluation, not a dollar crisis.

Will they get what they want? We don't know. But we reckon the Law of Perverse Outcomes applies here: people get not what they expect, but what they deserve.

For investors, we'd say again that markets are priced for earnings growth that we think won't materialise. It's wishful, almost nostalgic thinking. That means you should be on your guard for locking in paper gains since March with trailing stops. We're pleased that Gabriel Andre is just about ready to debut his new ASX 200 blue-chip timing service this week. The aim is to track the chart patterns and technical trends on the biggest Aussie stocks in order to avoid buying at the top.

But the big benefits - he hopes to prove - are the ability to take profits on long-term holdings and avoid the big declines we've seen over the last two years. Then, using the same analysis, Gabriel believes you can time your entry back into the same stocks. It's quite a proposition.

Of course, anything that looks or sounds like market timing probably makes a buy-and-hold investor really nervous. But it's time to question the conventional wisdom that buying and holding blue chip stocks is a guaranteed retirement strategy. It's not.

If we've learned one thing in the last two years, it's that the stock market is not a retirement machine. The name of the game is to generate gains. And we are at least open to the idea that it may be possible to make better gains as a medium-term trader of ASX 200 stocks than simply buying and holding for grim death.

On the other hand, there are some very exciting disruptive energy technologies that have a huge upside if you can stomach the risk. Woodside Petroleum Don Voelte took a swipe at those technologies in a recent article published locally. And for good reason. He's got a bit to worry about. More on disruptive energy technologies tomorrow...

Dan Denning
for The Daily Reckoning Australia

• American Family’s Share of Government Debt Now Over Half a Million Dollars
• The Very Large Bubble of Government Debt
• Ratings Agencies Put Spain on Negative Debt Watch
• Uranium: A Carbon-friendly Substitute for Coal
• In a Bear Market Most Stocks Go Down, So What Do You Do?

The evidence shows that the Chinese...and other Asians...are already trying to lighten up on their US debt holdings. This from The New York Times:

"Figures released by the Treasury Department this week indicated that China reduced its holdings of Treasury securities by $25 billion in June, the most China had ever sold in a month.

"Monthly figures can be volatile, and can be revised, so it is risky to draw conclusions from one month's data. In May, China increased its holdings by $38 billion, according to the Treasury figures.

"Nonetheless, the decline highlighted a fact...Asia's appetite for Treasury securities is not growing as fast as it once did. That means the United States will have to turn to other buyers, including American citizens, who are now saving as they did not do during the boom years, to finance the deficits... In the first half of 2009, China and Hong Kong acquired only 9 percent of the more than $800 billion worth of Treasuries that were sold.

"Japan, which was replaced by China as the largest foreign holder of Treasuries last year, has been a larger buyer this year, taking up 11 percent of the new supply of Treasuries.

"Ownership of US Treasuries by China, Hong Kong, Japan, South Korea, Singapore, Taiwan and Thailand - since 1994 - rose to 25 percent, from less than 8 percent. Since then, as budget deficits in the United States grew, the share has fluctuated within a narrow range. In June, it was 24.7 percent."

If Asians don't finance US debts, who will? We don't know... But the fewer bonds Asians buy...the more they are bought with funny money by the Fed. And the more the Fed buys with funny money the fewer Asians want to buy with real money.

How will this end? Badly...we keep saying. There is no way out. Either the feds cease spending more than they can raise honestly, by taxation and reasonable borrowing. Or, the system runs into chronic, mega deficits...like the chronic deficits in the private sector during the bubble years. Then, it blows up.

That is why we caution readers against the dollar and against Treasuries. Most likely, they will both go up this autumn...as investors flee to safety from the next market downturn. But the chances of them blowing up completely are too great. That's why we stick with gold - even though we would not at all be surprised by a period of weakness in the gold market.

Bill Bonner
for The Daily Reckoning Australia

• The Story Behind China Dumping its US Treasury Debt
• China Using Holdings of U.S. Treasury Bonds as Cudgel to Bludgeon United States
• China Stepping Up Purchases of U.S. Treasury Debt
• The Chinese and the Fed Both Buying U.S. Treasury Bonds
• The Case for Higher Treasury Yields…and Lower REIT Prices

So far, not a single major university has asked us to make the commencement address. Nor a minor college. Not even a school of cosmetology or taxidermy. But here at the Daily Reckoning headquarters in London, protected by a broad ocean and a narrow reading of the First Amendment, we will give them - and UK graduates too - advice no one asked for.

"Plastics," was the advice given to college graduates in Mike Nichols' '67 film. But that was when there was still hope for America's manufacturing sector. Even then, it was too late. The percentage of GDP from the manufacturing sector fell for the next four decades, from over 20% in the last '60s to barely 12% last year. Better advice would have been 'derivatives.' They stank just as bad, but they were much more profitable. While only 8% of GDP, finance accounted for 40% of corporate profits in 2007. And derivatives grew from nothing to a face value of 16 times the GDP of the entire planet.

But your elders are always giving you bum advice.

"You cannot decline the burdens of empire and still expect to share its honors," said Pericles to the class of 430BC. He lived during a time not unlike your parents' era in the USA - when Athens was on top of the world. But vanity got the better of him. He launched an attack on Sparta that backfired badly. He soon died of plague and Athens was not only ruined, but enslaved. Athens' 'golden age' turned to lead. Young Athenians should have shrugged off the burden rather than accept it. You should do the same.

When you were born 20-some years ago, the nation's total debt per person was less than $90,000 - adjusted to '09 dollars, of course. While that was a lot of money, it was nothing compared to what was coming. Now it's $186,717 per person - more than twice as much, in real terms. Fortunately, private debt is not inheritable. But it comes to you as a lien against property. Instead of paying off their mortgages and leaving you a house, free and clear, the baby boomer generation spent the 'equity' in their houses even faster than they got it. House prices rose. But mortgage debt rose faster. While your grandparents owned 80% of their houses, by 2007, the typical homeowner only really owned 4 rooms of an 8-room house. And then, when house prices fell, so did his remaining equity...to the point where one out of six homeowners in America is now underwater. You could still eventually inherit a house, but you may have to scrape the barnacles off the front porch.

But that's not even the half of it. While your parents had control of the US government they allowed themselves a little larceny. Add the unfunded retirement and healthcare benefits they voted for themselves to the official national debt, and together they are scheduled to cost your generation 4 times the total annual output of the US. This is over and above the private debt they accumulated.

Some of this debt can be carried. Some will have to paid down. But as it stands, as much as $77 trillion of post-'09 earnings must be stolen from the future in order to pay for the liquor your parents drank...the bombs they dropped on god-forsaken foreigners...and the interest on their debts. So, forget about saving for a European vacation or a house of your own. Even if every penny of your savings - and every other American's savings - are put to the task you will still be paying for your parents' expenses all your life.

But wait, there's more! The burden is getting heavier. Federal budget projections show an additional $7 trillion in deficits over the next 10 years. Described as the cost of fighting recession, the present generation buries its own mistakes under cash that the next generation hasn't even earned yet. Today's bankers, businessmen and speculators are being bankrolled by you - tomorrow's bankers, businessmen and speculators. Today's homeowners get a helping hand...from whom? Tomorrow's homeowners - you. Today's employees get a boost too. Same story. Where do you think the money came from to pay Wall Street bonuses this year? How do you think GM stays in business...and Fannie Mae...and AIG... Who pays those salaries? Who pays to keep troops all over the world and keep old people supplied with new drugs? Who pays for hundreds of billions' worth of 'shovel ready' boondoggles? You will. At least, that's the plan.

The luck of one generation is the curse of the next. Like Pericles, your parents inherited a dollar; they leave you a peso. They took over the strongest, richest, most competitive nation in the world. And like Pericles they minded everyone's business but their own. Now, not only does the US owe money all over town, its government puts out trillions more in IOUs every year - each one with your name on it. You're not even out in the real world yet, and you're getting the bill for 50 cents of every dollar the feds spend - almost none of it earmarked for you. But that is the thing about the real world your teachers probably forgot to tell you about. It is more unreal and fantastical than anything you studied.

Here's what's real: You've been dealt a bad hand. From the bottom of the deck...your parents have slipped you some nasty cards. Our advice? Fold 'em. Get up from the table before they clean you out.

Bill Bonner
for The Daily Reckoning Australia

• Deal With Bondholders Cleared the Way for GM Bankruptcy
• A Degree from an Elite College is No Guarantee of Higher Wages
• A Long Time Before Investors Will Gamble on Housing Debt
• Boomers Made a Mess of the United States of America
• Painting for Good Money

The place NOT to be is choking on debt, trapped in the tar baby that is the unfolding Anglo-Saxon bond crisis. The bid by the U.S. and the U.K. to auction off hundreds of billions of dollars and pounds worth of bonds this year is already forcing interest rates up in those countries.

Bear with us, if you would. We know. There are few things in the world more arcane and less interesting than interest rates. But right now, we believe the action in the bond market is the key to understanding the move in commodity and stock prices. What you see in the charts below is the widest spread between ten-year and two-year notes since 2003.

Ten-year yields spike as the short-end of the curve gets trendy

Source: Wall Street Journal

The yield curve is getting steeper. Ten-year yields closed above 3.5% while two-year yields look pretty range bound. Investors are charging the U.S. more to loan to it long-term while they seem to be happy to park cash in shorter-term maturities, even if the real yield (adjusted for inflation) is negligible (or negative).

The current spread between ten-years and two-years is 263 basis points (2.63%). It blew out to 274 basis points in 2003. That was about the same time that Alan Greenspan's Fed slashed rates to one percent and kept them there to kick off the leveraged bull market in all asset classes across the globe. Global synchronised boom.

The Fed doesn't have that flexibility today, of course. U.S. short-term rates (the Fed funds rate) are already being held in a range between zero and 0.25%. If the central bank wants to try and bring ten-year rates down, it's going to have to buy more bonds directly. And if it does so by creating more money, we reckon it puts more bullish pressure under gold, oil, and copper prices. We'll get to that in a minute too.

By the way, keep an eye on the auction of US$35 billion in five-year notes tomorrow and US$20 billion in seven-year notes later in the week. If we're right and non-U.S. investors are suspicious of the value of U.S. long-term bonds, these auctions will be a lot more difficult than the US$40 billion two-year note auction this week, which showed plenty of strong demand from non-U.S. buyers.

If the Fed loses control of ten-year and thirty-year U.S. interest rates, look for the ratings agencies to put the U.S. in the same company as the U.K. when it comes to credit quality. If you finance deficits and borrowing with outright monetisation, it kicks of a crisis of confidence in your currency and your outstanding debt. In the U.S., foreigners hold some $6.35 trillion in debt. They'd be very worried indeed the more the Fed monetises new debt issues.

Either way, the Anglo-Saxon bond crisis is here. Higher interest rates retard economic growth, make credit more expensive, and debt more costly to service. They will also drive investors further into tangible assets. Why? Well, investors may simply turn their back on sovereign debt and invest in exchange traded commodity funds or publicly listed resource producers.

Dan Denning
for The Daily Reckoning Australia

• U.S. Bonds Better than Greek or Other Sovereign Bonds
• Look out! It’s The Bond Vigilantes!
• Between What Bond Investors Stand to Gain in Yield and What They Stand to Lose from Inflation
• If Unemployment Numbers Get Better So Will the Economy
• Central Bankers Encourage Debt Booms That Become Debt Bombs

Meanwhile all sorts of mischief is afoot in financial markets and the Australian energy market. U.S. stocks fell over 1.5% in Thursday trading. The minutes of the Federal Reserve's April meeting were published. The notes said there were "significant downside risks" to the U.S. economy and that the global financial system remains "vulnerable to further shocks."

You don't say?

The minutes also showed the Fed is willing to print more money to buy more bonds in order to keep U.S. interest (and mortgage rates) low. This, by the way, is spurring the trade out of financial assets and into real assets. The Fed has already purchased $450 billion in mortgage backed securities to keep the flow of credit going to the U.S. housing market. It's also purchased $79 billion in bonds issued by government sponsored enterprises Fannie Mae and Freddie Mac.

What would you expect to happen if the central bank of the world's largest economy reduces its growth forecast and says it is willing to step into the bond market to "support the recovery" by keeping yields low? Check out the chart below.

Fed Buying Sends Yields Down...For Awhile

Source: Wall Street Journal

When the Fed first announced its intention to buy mortgage backed bonds and Treasuries in November of last year, it sent yields on ten-year U.S. notes and 30-year bonds tumbling. Traders and banks front-ran the Fed and got in ahead of the Fed buying, which they expected to push up prices. But by the time 2009 began, the Fed buying (or threat of buying) was no longer enough to keep yields low. They've been climbing ever since.

And Thursday, even after the meeting notes revealed the Fed might go beyond spending $1.75 trillion on Treasuries and mortgage-backed securities, ten-year and 30-year yields moved up. So, by the way, did the gold price ($953.90) and crude oil ($61.21). The Fed is losing control of bond yields. It's going to have to wade in with trillions more. That will push up commodity prices.

There's something happening here. What it is, well that's not exactly clear. But it sure looks to us like the Fed's indication that it's willing to ramp up purchases of U.S. assets to keep rates low is actually causing investors to sell U.S. assets. Investors are beginning to wonder what the inflationary effects of such a large money-printing campaign might be, and what it would do to the value of their existing bonds and notes.

This is one reason why the largest holder of publicly traded U.S. debt (China) has shifted its purchasing of U.S. debt to the short-end of the yield curve. The good news for the big spending American government is that its creditors are willing to finance its deficits. The bad news is that those deficits are now a lot more interest rate sensitive. If shorter-term yields start trending up along with the longer-term yields, it's going to get really expensive for America to borrow.

Do you sense a theme here? Deficits DO matter.

The other big news on the day was that Standard and Poor's announced it could cut Britain's credit rating from Triple A on account of that nation's massive deficits. It moved Britain's rating from "stable" to "negative." Ireland, Greece, Portugal, and Spain have already lost their Triple A ratings because of massive fiscal deficits. But Britain is beginning to cause a lot anxiety in global bond and currency markets.

The U.K. is going to run a £175 billion fiscal deficit this year alone. That's 12.5% of GDP. It will need to sell £220 billion in bonds to cover the gap. And mind you, it's a big gap. The nation's total debt is nearing 100% of GDP.

The government deficit was £8.5 billion in April alone. That was the highest monthly deficit since 1993. And it speaks to a point we made earlier this week that once a government debt-to-GDP ratio reaches 10% and beyond, it begins to drag on GDP growth and lead to even higher deficits (lower tax takings, higher debt-servicing costs). Pimco's Bill Gross went on Bloomberg television and said markets are, "beginning to anticipate the possibility" that the U.S. will face a similar credit downgrading.

Let's recap. Stocks are down. British gilts are down. U.S. bonds are down. And both the pound and the U.S. dollar were weaker against other currencies.

Who says deficits don't matter?

Dan Denning
for The Daily Reckoning Australia

• New Trend in the Market: Sell Bonds and Buy Commodities
• U.S. Bonds Better than Greek or Other Sovereign Bonds
• U.S. Bond Prices Rose and Yields Fell
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis

There's so much bad news about in the land that stocks moving up in such a climate is noteworthy. It means everyone's talking about how bad things are, but there aren't any sellers left. So are there any sellers left?

Well, over in New York there are. The Dow Jones made a new bear-market low at 7,465. It's a six-year low for the index, in fact.

Here in Australia things are more range bound. Kris Sayce produced the following chart in his weekly e-mail update to subscribers of the Australian Small Cap Investigator. The market is clearly trading in a range. You might even call it a range within a range.

As Swarm Trader Gabriel Andre says, these sorts of patterns don't last forever. Range-bound indices break out. But in which direction? If it's up, this is good news for the small-caps Kris tracks. Many of them have been absolutely battered in the last year. But if it's down...it means lower highs and lower lows. It is possible.

Take this for the complete psychological speculation that it is, but this "feels" a little like the moment last year when the oil price peaked. On June 27th of last year, when oil traded at $139.69, we wrote: "Our intuition is that you could see oil put a top in sometime in the next week, if it hasn't already happened."

That call was a few weeks early. But the idea at the time is one you should consider today. "Not that you want to step in front of a moving truck," we wrote." Markets can remain irrational longer that you can remain solvent, the old saying goes. We're not suggesting you bet against oil. But we are suggesting you take note of the sentiment. The bears have almost totally capitulated. The bulls are being whipped into froth. When any little thing drives the price higher, you have a very dangerous market."

Feelings are not very scientific. But maybe a sense of crisis-fatigue has set in and sellers are exhausted. That might make room for some profit-taking in gold and rebound/relief rally. Might. We'll see. But if we had to compare the market's selling exhaustion to a YouTube video, it would be this one.

If you wander over to YouTube, you might want to check out this video from CSPAN over in America. On the video , U.S. Congressman Paul Kanjorski explains what Ben Bernanke and Henry Paulson told Congress behind closed doors on September 15th, 2008, the day Lehman Brothers died.

Pay special attention to what he says between 2:14 and 3:44 of the clip. For those of you who can't watch it, Kanjorski says that the by 11 am that day, over US$500 billion had been liquidated from money market accounts. He describes it as, "an electronic run on the banks." He says the Fed told Congress that if action wasn't taken immediately, over $5 trillion would disappear from the markets by 2pm.

That's pretty precise forecasting isn't it? Whether the Fed was exaggerating, guessing, or in total panic mode isn't the point though. Kanjorski says the whole day threatened, "The end of our economic and political system as we know it."

You can't make this stuff up.

But then, Australia's own Central Banker has told Australian politicians that September 15th is a day that will forever live in financial infamy. He didn't use those words exactly. But in prepared remarks to be delivered to Australia's House of Representatives today, Glenn Stevens fingers the 15th as the day the world changed.

Shortly after the Committee last met" he begins, "the global financial system took a serious turn for the worse. On 15 September 2008, the American firm Lehman Brothers filed for bankruptcy. It was the biggest actual failure of a major American financial institution for many years. While it had been widely known that Lehmans was under immense pressure, when it came the event was still a shock. It triggered a massive re-appraisal of risk, and ushered in a period of the most intense financial turmoil seen in decades.

"The worst of the turmoil was actually fairly short-lived - a matter of weeks. But in that time a number of events occurred that have had a significant bearing on the outlook for the global economy. These included the incipient failure and/or public support of a number of major financial institutions in the United States, the United Kingdom and continental Europe, effective closure of many important capital markets and a worldwide decline in equity values of a quarter, leaving them around 50 per cent lower than their peak."

We'll leave any further discussion of September 15th's significance until next week. There are two other dates, though, that are critical to the story you now find yourself a part of. The first is February 4th, 1965.

That's the day French President Charles De Gaulle gave a press conference. It was a press conference that would begin undermining the post-war Bretton Woods international currency system. Why? It's what DeGaulle said about gold.

"The time has come," he said, "to establish the international monetary system on an unquestionable basis that does not bear the stamp of any country in particular. On what basis? Truly, it is hard to imagine that it could be any standard other than gold. Yes, gold whose nature does not alter, which may be formed equally well into ingots, bars or coins; which has no nationality and which has, eternally and universally, been regarded as the unalterable currency par excellence."

Over the next five years, French banks would begin redeeming American dollars for gold. The French could see America's war debt from Vietnam stacking up. Lyndon Johnson's Great Society program promised infinite butter along with a multitude of guns for the war in South East Asia. Government deficits soared.

Just over six years later, somewhere between August 13th and August 15th, Richard Nixon met with his economic Politburo at Camp David in Maryland outside Washington, DC. Against the advice of Federal Reserve Chairman Arthur Burns, Nixon decided to institute wage and price controls and, more importantly, close America's gold window.

We've been living with the world of free-floating fiat currencies and expansion of deficits and credit ever since. Lehman's collapse was one nail in the coffin of the modern financial system. De Gaulle built the casket in February of 1965. So what's the third date that changed the world? More on that next week...

Dan Denning
for The Daily Reckoning Australia

• French Model of Economy Allows Meddling from the State
• The French are Feeling Pretty Smug
• Marking the Beginning of the End
• Gold and Silver!
• U.S. Recession: Is the End Nigh?

First, the U.S. stock market did nothing yesterday. The Dow ended down 9 measly points. The Dow is about 10% above its November low; have we seen the rebound already?

Oil slipped slightly - down to $39. And gold lost $21. While some may see the drop in the gold price as disheartening, we see it as an opportunity to grab some more of the precious metal while the price is relatively low.

The Banque de France says the country's GDP is falling. It's expected to walk backwards by about 1% this year.

The Sarkozy government announced a $12 billion program to support France's auto industry. "We'll give you money," he said, "but you've got to promise not to cut salaries or close down."

Nissan, 40% owned by Renault, announced it was cutting 20,000 jobs worldwide - 9% of its workforce.

Japan is facing an "unimaginable" contraction, its central bank's chief economist warned yesterday. Orders are drying up...production is falling off...and consumers can't seem to find anything they want to buy. Industrial production in Japan fell a record 9.6% in December. The country is looking at an annual GDP decline of 1.7%.

Growth is collapsing throughout all of Asia. Singapore, for example, went from healthy 5.3% growth last year to minus 2.4% this year. India and China are still projecting decent rates of growth - though significantly below their highs. We'll see how long that growth continues...

And poor Latvia. Its economy is not just walking backward...it's running. Today's Financial Times tells us that output is falling there too at a depression rate of more than 10% per year.

But the big news yesterday was the sell-off in the bond market.

"All eyes on sudden spike in US Treasury yields," says the headline in the Financial Times.

The yield on the U.S. 10-year note rose above 3% for the first time in three months. The two-year note, meanwhile, moved above 1% yield. What does it mean?

We are bearish on U.S. government paper - in all its forms. And here's why. The latest estimate from Goldman Sachs puts US government borrowing for this fiscal year at $2.5 trillion. Meanwhile, foreigners are showing less and less interest in U.S. debt. They're switching to short term paper - bills and notes, which are less vulnerable to inflation and currency declines. And they're pulling out of U.S. Treasury market generally. The total percentage of U.S. debt owned by foreigners is falling from 60% down to about 40%...a huge drop.

Either one of two things will happen. If the government funds its deficits honestly - by borrowing from willing lenders - this huge extra demand for credit will force up yields...thereby lowering bond prices. Or, if the government resorts to "monetizing the debt" - that is, funding its debt with printing press money - investors will flee bonds, in fear of higher inflation.

Either way, it will be bad news for bond prices.

Remember, we are only in the Boondoggle Stage of the crisis. Using the collapsing economy as an excuse to waste money, the pols are having the time of their lives. Does your community need a bridge? A new drainage system? A shooting range for blind people? A study of the mating habits of fire ants (how do they get together without getting burnt?) Even in the best of times, politicians have trouble saying 'no.' Now, 'yes' is the answer to every request.

What strange madness is this? Why would anyone think the economy will be made better off by squandering money now on projects that were deemed unworthy or unaffordable only a few months ago? The country got into trouble because people squandered too much money; now they think they will get out of trouble by letting the government squander money. But we'll have to wonder about that later. Now, we're just trying to keep up with the torrent of boondoggles, bailouts and bunkum.

Let's see, Bloomberg reports that about $3 trillion has been spent fighting the downturn in the last two years by the United States of America. We pass over the issue of whether this has done any good, and stick to our figures... Another $5.7 trillion has been pledged. Plus, this latest Obama Bailout will cost about a trillion more.

Hmmm...a trillion here...a trillion there...pretty soon you're talking about real money.

"US Taxpayers Risk $9.7 Trillion on Bailout Programs," Bloomberg figures, or about two-thirds the entire national GDP.

Hmmm...that's about as much as the total burden of household mortgages. In other words, instead of all these boondoggles, bailouts and bunkum, Congress could have just paid off everyone's mortgage.

*** Inflation is now only a problem because there isn't any. In the United States, the consumer price index crested at nearly 6% last year. Now, it appears to be headed down to zero...and perhaps below. That is what the feds are desperate to avoid. When consumer prices fall, consumers become obsessively frugal. They know that if they just wait, they'll be able to get what they want at a lower price. And then, why not wait a little longer...and get the item even cheaper still? This "propensity to save," as economists call it, becomes self-reinforcing. As consumers stop spending, lower demand causes prices to fall further...which incites consumers to dilly dally even more...which causes prices to sink again.

That is the Japanese-style 'deflationary cycle' that gives Ben Bernanke a nightmare.

But we explained yesterday, there's not much he can do about it - at least nothing honest. Rupert Murdoch says the financial crisis has caused $50 trillion in wealth to vanish. The feds have put back only $3 trillion (arguably) so far. Just looking at the numbers, it doesn't seem as though prices will be rising anytime soon. For every dollar the feds put into the system, $17 disappears.

What's a fellow to do? The only way out, as near as we can see, is the road taken by Gideon Gono. "Monetizing the debt"..."quantitative easing"..."printing press money" - it will no doubt go by a number of different euphemisms and code words. It's what happens when the Fed buys U.S. Treasury debt directly. For this purpose, it simply creates a ledger transaction...effectively adding to the money supply.

But even printing money does not automatically and immediately cause consumer price inflation. According to classical economic theory, the shelves must be cleared and the excess capacity must be re-absorbed before prices will rise. That could take a very long time. But we're not sure it works like that. If money were suddenly dropped from helicopters, as Ben Bernanke once pledged to do, merchants probably wouldn't wait for their inventory to disappear before raising prices. They'd be concerned that there were giving away something that was valuable in exchange for something that was not.

When this kind of inflation happens - perhaps worthy of the adjectival modifier 'hyper' - it can happen very suddenly, and very violently. That is why we suggest selling U.S. paper now...even if it turns out to be very early.

*** Drought...fires... plagues...

The poor Australians are battling blazes all over Victoria province. The total cost is climbing up towards 200 dead...and half a billion Australian dollars worth of property damage.

There's a terrible drought in China too...the worst in 50 years. Peking has put up 10 million euros to help the peasants.

Chris Mayer sends this note:

"China is in the midst of its worst drought since 1951. Beijing has gone 100 days without rain. Nearly one-fifth of China's wheat harvest is at risk and over 1.8 million head of livestock are short of water. Over 3.7 million people face water shortages, as do nearly 23 million acres of farmland. Rivers and lakes are drying up and farmers are drilling deeper than ever to reach falling water tables.

"As is the way with these things, it couldn't happen at a worse time. The economy is clearly slumping along with the rest of the world. Unemployment is on the rise. And now food prices may also climb. Not a good combination for a country that already has a fair amount of unrest bubbling just below the surface.

"Water mismanagement has long been a problem in China. Wasteful irrigation is one problem. So is pollution and mass urbanization to the cities, particularly in the more industrialized - but water-parched - areas in the north.

"The government knows this and has swung into action with a number of emergency measures, including financial aid for farmers. One of these measures also increases the subsidies to pay for irrigation projects.

"Over the next several years, I think irrigation equipment is going to play an ever-larger role in helping reduce water use. Water problems will get only worse before they get better. The companies that make the tools and have the expertise to solve those problems will be very valuable. And so will their shares."

*** And from Argentina comes bad news. Not only is the country parched, the drought seems to be centered on your editor's farm.

"It's dry...very dry..." says the farm manager. "We got almost no rain this season. The reservoirs are empty. There's no way to keep the cattle. There's nothing for them to eat. We just have sell as many of them as we can."

So far, the cattle business has not been a big winner for us.

"When the grass is too dry and too short," the farm manager explained, "the cattle pick up a lot of dirt and sand when they eat. The sand wears down their teeth, so even if they had good grass, they wouldn't be able to put on much weight. And since they can't find much to eat and can't eat it very well, they don't have the energy to go very far looking for better grass. It's a vicious circle. But that's what we've got up here...a difficult place to raise cattle."

Meanwhile, here in Europe, there's water everywhere. Fields are flooded in England. In France, it's been raining for days.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Cattle Prices Have Risen Only 1% This Year
• Our Cattle in Argentina
• Investors Now Treating Bad News for the Dollar as Bad News
• Bad News if You Are Afraid of Inflation in Consumer Prices
• A Chilly Trip to Argentina

One of these positives, he says, is that the current recession is now 13 months old, whereas the worst recessions since the Great Depression only lasted 16 months (and there were two of them: 1973-75 and 1981-82).

Well, this is just the kind of technical-analysis thing that drives me crazy, and I was just getting ready to try and grab a little of the limelight and ream this guy out for using such technical-trading crap, when he obviously sees me coming down towards the podium.

So, instead of letting his presentation degenerate into a pointless argument with a loud and obnoxious lunatic like me, he quickly defuses the situation by saying, "Just because every recession since the 1930s ended in 16 months or less doesn't mean this one has to as well," which certainly takes the wind out of my sails!

Having failed to get the attention that I so desperately crave for some weird reason, I resorted to making rude farting noises as I went back to my seat, and in doing so I almost missed it when he continued, "historical precedent plus the massive amount of government-minted stimulus equals reason for some optimism that we're closer to the end of this slowdown than to the beginning."

Man, he said a mouthful there! Trillions of dollars are appearing everywhere as the loathsome Congress deficit-spends the money and credit that the Federal Reserve creates with every breath!

Apparently seeing me working myself into a screaming hissy-fit, he calmly says, "The Federal Reserve began cutting interest rates in September 2007, and historically interest rate changes impact the economy with roughly a six- to 12-month lag. This increase in money supply is a very positive development for both the economy and market" which he seems to prove by charting the eye-catching similarity of the percentage change in the money supply (lagged 6 months) with the year-over-year percentage change in consumer spending since 1982, and it is certainly impressive to see.

Then he shows a graph of the percentage change in the U.S. money supply and the percentage change in "nominal" GDP, going back to 1960, and that's pretty impressive, too, particularly since the money supply right now is zooming so far that it is, literally "off-the-charts"!

This is certainly going to look like good news to a lot of people, as Harper's Index reports that 47% of Americans say they live "paycheck to paycheck", and 21% of those making over $100,000 live that way, too!

It is also kind of weird to me that while there are 306 million American men, women and children, a full 47% of them report living paycheck-to-paycheck at the same time as only 47% of the population has a job (the government says that 143 million are employed)! So everybody with a job is living paycheck to paycheck? Hahaha! We are so freaking doomed!

But regardless of how much money the stupid government and the morons at the Federal Reserve create and spend, it will - regardless of all the charts and graphs and historical comparisons - not be good news for people, as such massive, irresponsible inflation in the money supply caused by the massive government deficit-spending will cause catastrophic inflation, which may have something to do with why Scotty is calling up from the Engineering Section, "Captain! The di-lithium crystals canna take the strain!" and out through the window of the bridge you see Spock flying off to safety in one of the Shuttlecraft.

With the gold, in case you were looking to Star Trek for a moral to the story!

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

• Australian GDP is Doing Better Than the U.S.
• The U.S. Dollar is Not the Euro
• Federal Reserve to Buy $300 Billion In U.S. Treasury Bonds
• Mainstream Financial Press is Finally Catching on to Hedge Funds
• U.S. Home Sales Up Because of Congress Tax Credit

"When Dick Cheney told Paul O'Neill deficits don't matter," we found ourselves explaining to the audience after Saturday night's screening of I.O.U.S.A. at the Maryland Film Festival "he didn't mean that they don't matter economically. Of course, deficits matter in economics. What he meant is politically, politicians don't get punished by voters for running deficits."

In the movie, former Treasury Secretary Paul O'Neill tells the story about the day Cheney said, "deficits don't matter" to him in a cabinet meeting. He also talks about the day he was fired from the Bush Administration for "a difference of opinion."

"Well," said a gentleman in the second row "let me explain things from the policy makers point of view..."

"Uh ho," Patrick, the director of the film said. He was standing next to me at the front of the theatre. "Are we in trouble?"

The gentleman went on at some length about the "political coalescence" that had taken shape in the 1990s, whereby both parties agreed, that despite their differences, keeping the nation's finances sound should be a priority for everyone.

But that all flew out the window in 2002 when you had the third of the three consecutive tax cuts go into effect at the exact same time that self-imposed "pay as you go" spending laws expired. The nation's revenues dried up. But spending exploded. For the first time this year, we've seen a $3 trillion dollar budget proposal. The deficit is expected to reach beyond $500 billion.

The gentleman, it turned out, was Paul Sarbanes, the former Senator from Maryland whose name gives the willies to corporate legal and accounting firms across the civilized world. Sarbanes co-authored the much-rued Sarbanes-Oxley corporate transparency law. And, now retired, had some extra time on his hands to come and instruct us on the subject of our own movie.

Patrick, a Chicago born, recovering Union supporter was impressed and took the time to raise the issue of disparity of wealth in the country. We were a little more subdued. This is exactly the crux of the problem with I.O.U.S.A. – the film, the project and the nation. Once you get down to brass tacks and start talking about specific solutions you run into two sides of an economic argument that are equally entrenched.

On the one hand you have the Arthur Laffer, supply-side zealots, of which the current president is one. On the other you have the died-in the wool New New Dealers who see government programs – most notably social security and medicare – as the bedrock of their parties' existence. Their current arguments sound like this:

Neo Lafferites: "Let's keep the tax cuts permanent"
New New Dealers: "The nation needs universal health care."

Neither the twain shall meet. If we're successful in getting I.O.U.S.A. into theatres this August and as part of the "national conversation" in time for the political conventions...this is the crux of the problem. With these two sides entrenched, Washington and the political system is broken. And you are the victim. "If we do nothing," David Walker likes to point out "the national debt alone rises by $3-$4 trillion a year. That's if we do nothing."

Which is exactly what we're doing now. Nothing.

Unfortunately, it won't be the Paul Sarbanes or the Arthur Laffers of the world who have to pay the price. It will be you and your family.

*** Tomorrow...more on the coming revolution (yes...you heard that right)...

Bill Bonner
The Daily Reckoning Australia

• Maryland Film Festival This Weekend
• I.O.U.S.A. the Movie Opens in 358 Theatres Across the Nation
• Actor’s Life is Misery: Giving Up on London and Going to L.A.
• “This is England” Review
• Social Security a Bigger Scam Than What Bernard Madoff Schemed