Throughout history, no empire has managed to rule forever. Instead, empires rise to power, they prosper and spread their influence. Thereafter, they over-extend themselves and then break down in some fashion. In fact, all the glorious empires of history had one thing in common - a spectacular collapse.

Now, there can be no doubt that America ruled the economic world for the better part of the previous century. However, this powerful nation has now entered a terminal decline. The recent credit crisis and the failure of some of the largest American financial corporations is compelling evidence that the world's largest economy is well past its prime.

Today, America finds itself heavily in debt and to make matters worse, its demographics are also worsening. Unfortunately, the American leaders are attempting to postpone the day of reckoning by taking on even more debt! It is noteworthy that over the past year alone, America's federal debt increased by approximately US$2.1 trillion and its projected budget deficit over the next decade is now slated to be almost US$9 trillion! If this does not shock you, then consider the chart below which shows the total obligations of the US government.

As you can see, over the past six years, American unfunded obligations increased by almost 50% from US$79 trillion to US$114.7 trillion! Alarmingly, over the same period, American government revenue rose by only 12%! Now, you do not have to be a genius to realize that no entity can continue to increase its liabilities by more than four times the rate of its revenue. If this spending frenzy continues, commonsense dictates that at some point in the future, the solvency of the American government will come into question. When that happens, foreign capital will flee America, interest-rates will skyrocket and we will witness an epic currency crisis.

Furthermore, it is worth noting that apart from the American government, the Federal Deposit Insurance Corporation (FDIC) is also in serious trouble. In an ironic twist of fate, the FDIC's Deposit Insurance Fund has spent so much money covering bank failures over the past three months that it has completely run out of money! This implies that there is no capital available now to insure bank deposits held at American banks.

Given the horrendous deficits and ugly debt obligations, the American government is now left with the following options:

a. Raise taxes (not sufficient to meet obligations)
b. Cut back on spending (highly unlikely)
c. Default (unimaginable)
d. Print money (only viable option)

Remember, America is the largest debtor nation the world has ever seen and the only way it can repay its obligations is through a process known as quantitative easing (euphemism for printing money). In fact, this stealth confiscation of savings is already well underway. A recent report published by the Federal Reserve revealed that the American central bank purchased half of the newly issued US Treasuries in the second quarter of this year. Needless to say, the Federal Reserve financed these purchases by creating dollars out of thin air - a short- term fix but a long-term disaster.

Let us put it bluntly; the days of American hegemony are drawing to a close and within the next two decades, China will become the world's most dominant economy.

If you are sceptical about our claim, you may want to note that twenty years ago, China's economy was worth only US$342 billion and as of last year, its GDP had grown to US$4.4 trillion; representing an annual growth rate of 13.6%. Now, if China succeeds in growing its economy by roughly 8% per annum over the next two decades, its GDP will grow to US$20.5 trillion by 2029. At that point, China may well replace America as the world's largest economy.

It is worth keeping in mind that whereas American households are up to their eyeballs in debt, their Chinese counterparts have a savings rate of almost 40%! Furthermore, at a time when America and other nations in the West are struggling to stay afloat, China's foreign exchange reserves have surged to US$2.3 trillion!

Now, we are aware that many commentators are criticising China for the sheer size of the stimulus unleashed by its leaders. In our view, this ridicule is baseless because instead of spending printed or borrowed money, at least the Chinese are spending their savings.

In any event, the stimulus applied by the Chinese policymakers seems to be working. Over the past seven months, money-supply growth in China has risen by 26% and loans have surged by 32%. In turn, this inflationary orgy is creating a residential construction boom. All this economic activity is in stark contrast to America, where despite all the policy-actions, private-sector credit is contracting.

Look. The Chinese economy is roaring along...and you can be pretty certain that the country's rapid growth will cause domestic consumption to explode. Already, roughly 900,000 cars are sold each month in China and by the end of this year, the Asian powerhouse will replace America as the world's largest market for automobiles. Interestingly, similar trends of rising consumption can be observed in various household items such as refrigerators, motorbikes, mobile phones and so forth.

So it seems to us that in this low-growth world, investors would do well to take a good hard look at high-growth opportunities like China.

Regards,

Puru Saxena
for The Daily Reckoning Australia

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The quote comes from Ben Franklin. But it was recalled to us neither by America's president, nor Britain's Prime Minister. Instead, the Telegraph in London reported it from the mouth of Cheng Siwei, a "top member of the Communist hierarchy."

What goes around comes around. The Anglo-Saxons have forgotten what makes a successful economy. The Chinese have remembered.

Just look up Warren Harding on Wikipedia. The first entry you will find is not the 29th president of the United States of America, but a rock climber with the same name. But what do you expect? History is nothing but a long list of disasters in chronological order. Historians love calamity. And they reserve their highest accolades for those who cause them. The same is true in financial history. Those who make it big are those who make it worse.

It is safe to assume that no one working at the Federal Reserve or at the White House has a picture of Warren Gamaliel Harding over his desk. Yet, if American presidents were ranked on the basis of how well they faced up to financial disaster, Warren G. Harding might be somebody. His handsome face would be carved on Rushmore. His likeness would grace the $100 bill. Harding was the last American president to deal honestly with a major financial crisis. Every president since has tried to scam his way out of it.

By the time Harding took office in '21 the Panic of 1920 was taking the unemployment rate from 4% to nearly 12%. GDP fell 17%. Then, as now, the president's subordinates urged him to intervene. Secretary of Commerce Herbert Hoover wanted to meddle - as he would 10 years later. But Harding resisted. No bailouts. No stimulus. No monetary policy. No fiscal policy. Harding had a better approach; he cut government spending and went out to play poker:

"We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican capacity...it will be an example to stimulate thrift and economy in private life.

"Let us call...for a nationwide drive against extravagance and luxury, to a recommittal to simplicity of living, to that prudent and normal plan of life which is the health of the republic."

Within a decade, Harding's views were collectibles. But in 1921, he still saw the economic world as a moral world ordered not by man, but by God. This was not the result of long study or deep reflection on his part. He was probably the dummy everybody said he was. As Keynes pointed out, politicians are always in thrall of some dead economist. At least Harding was in thrall to the good ones.

"No statute enacted by man can repeal the inexorable laws of nature," he announced. "Our most dangerous tendency is to expect too much of government..."

Harding was not the first to see the economy as a 'natural' order...one that you disturbed at your peril. A Taoist named Zhuangzi, who lived about the same time as Alexander, observed: "Good order results spontaneously when things are let alone."

Later, economists of the Scottish enlightenment, notably Adam Smith and Adam Ferguson elaborated. Smith, like Harding, saw the economy ordered by the invisible hand of God. Ferguson saw markets as a 'spontaneous order,' which were the "result of human action, but not the execution of any human design".

The same basic insight led Irving Fisher - the greatest economist of the 1920s - to come up with his debt-deflation theory of depressions. After people had borrowed, they needed to pay back. Busts followed booms; there was no getting around it.

Warren Harding may never have been the brightest bulb on the White House porch, but intuitively he understood that proper macro-economic policies were more the product of virtue than of genius. Debt led to trouble; that's all he needed to know.

Keynes came along a few years later. Keynes was a genius; everybody said so. And he had an answer for everything. Nature? Government could do better. Debt? Don't worry about it, he said. Why not just let capitalism sort itself out? Without government intervention, it will only get worse, said Keynes.

But Harding had already proved him wrong. Harding did the very opposite of what Keynes recommended. Instead of increasing government spending, he reduced it. He cut the budget almost in half. He slashed taxes too...and cut the national debt by a third.

Japan at the time struggled with the same downturn. But it had no Harding at the helm. Instead, its masters prefigured Keynes, trying to stay the correction using price controls and other interventions. The result was a long-drawn-out affair that lasted until 1927 and ended in a bank crisis. In America, meanwhile, by 1922 unemployment was back down to 6.7%. By 1923 it was down further - to 2.4%.

This lesson was entirely lost on the world's economists. When the next crisis hit a decade later, they turned to Keynes. Of course, it turned out to be a moral world after all. They got what they deserved.

Regards,

Bill Bonner,
for The Daily Reckoning Australia

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The challenge of today's Daily Reckoning is to separate the short-term trends in financial markets from the long-term trends in geopolitical history. It's a big challenge. But let's break it down and see where we go. And let's begin with U.S. Bank Wells Fargo.

The Dow Jones slipped under 10,000 at the end of the day Wednesday largely because analyst Dick Bove changed his call on Wells Fargo from "neutral" to "sell." Bove said the quality of the company's third quarter earnings was, "pretty poor." "If you take a close look at the earnings, what you can see is that the improvement is due to a hedging profit made on the mortgage service portfolio, about $3.6 billion...You can also see that they cut their tax rate," he told Dow Jones news wires.

Imagine that; a major bank boosting earnings with one-off events. This is why we said last week that quarterly earnings (and whether they are above or below analyst expectations) don't always tell you what you need to know about a business. Granted, Bove is still bullish on Goldman, Morgan Stanley, and Bank of America. But his comment set off a small chain reaction on the Street.

It was a weird reaction too. Stocks fell and the Aussie dollar briefly faltered against the greenback. But commodities like oil and gold continued to power ahead. Oil is at a 12-month high and trading over US$81. Gold futures again traded above $1,060. And the U.S. dollar kept falling against commodities and other currencies.

So does this disprove our trading idea that the dollar index is due for a rally? Nope. The index could make a new low below 70. And that would certainly confirm what we already know: the rest of the world is on to America's habit of living way above its means. The dollar index could plumb a new low until there is an improvement in America's trade deficit or its fiscal deficit. However...

Don't discount the rally! "We should be prepared for a counter trend rally," wrote Slipstreamer Murray Dawes earlier this week. "RSI are entering long term oversold levels (although in a downtrend they can remain oversold for long periods of time of course and so are not a good trading signal against the trend) and market news is constantly bearish the US dollar so trader positions may be getting a bit full up on the short side."

"A short squeeze would not be out of the question, but I would not be trading a squeeze unless it breached the 81 level to confirm the re-entry into the last year's range," Murray concluded. A short squeeze in the greenback would see oil and gold correct, along with the Aussie dollar and stocks. Mind you this is a trading trend, not a long-term investment call. But we're tracking it and will keep you posted.

For a top-down view of just what's happened to the dollar this year and what it means for your investments, have a read of David Einhorn's speech at the Value Investor's Conference in New York City. It's a real page turner. And it's only eight pages!

Einhorn made a few great points worth considering. The first is that Australians should watch out for a second period of slower growth (maybe even recession) once the effects of the stimulus exhaust themselves. It wouldn't be the first time something like this happened. The attempts to stimulate America out of the Depression boosted GDP for a few years, but didn't solve any of the problems which really ailed the economy.

"An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fallout. Our [America's] choice may be to maintain large annual deficits until our creditors refuse to refinance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline."

Einhorn is writing about the U.S. In Australia, the government is hoping the removal of the fiscal stimulus won't result in "significant economic fallout." It must be hoping that capacity expansion by the mining industry is enough to support employment and consumer spending...and that house prices (and home building) keep the rest of consumer spending buoyant...and that businesses begin to reinvest.

That's a lot of hope. But hope has been pretty easy to sell these days.

The other factor which makes Australia's situation slightly different than Americas is that funding Australia's comparatively small deficits shouldn't be too hard, given the strength of the Aussie dollar. Not that racking up long-term debts to China or other foreign creditors is good, especially when the borrowed money is just going to your mates in the building industry or to prop up select retailers.

But it's probably true that Australia's creditors won't squeeze the government until much later, after the current government has been replaced. That will happen years down the track, when tax payers will still be paying off today's debts. Perhaps they will be wondering why no one [today] thought it was immoral to steal money from the future in order to maintain over-leveraged lifestyles today.

But that is the future's problem. So we'll let them deal with it. Einhorn is right to point out that policy makers tend to favour short-term benefits over long-term prudence because it's easier to get elected that way. And news organisations always spin the policy in terms of who the narrow groups that benefit rather than the unknown parties in the future that don't. But maybe this is just too abstract a point for people to understand these days. In any event, years down the track when Australia is paying off its debt to foreigners, the question may come up again.

Today, there are other more critical events that could rock financial markets. "As we sit here today, the Federal Reserve is propping up the bond market, buying-long dated assets with printed money. It cannot turn around and sell what it has just bought," Einhorn says.

The Fed has no exit strategy! The U.S. bond market has become a quagmire from which Geithner/Westmoreland and Obama/Johnson cannot escape! But hyperbole aside, what does that really mean?

It means that TARP and TALF and CAP may eventually wind down. But the Fed is subsidising mortgage rates and short-term Treasury rates in the U.S . This is what's going to drive the next down move in the dollar and the dollar index (it will make new lows). The Fed will continue "monetising the debt" and there will be fewer and fewer foreign takers (willing to finance U.S. deficits by buying bonds and notes).

This quantitative easing is incredibly bullish for gold. And it's a liquidity trap for the Fed.

"There is a basic rule of liquidity," Einhorn says. "It isn't the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because both the size of my position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up."

We'd argue there already IS inflation, but it's in assets...stocks, bonds, commodities, and real estates. The Fed's nightmare is that it is unable to shrink the monetary base without collapsing the Treasury market (sending yields to the stratosphere). You'd get a collapse in asset values and devaluation in the dollar, which, in the real economy, would lead to rising prices. A loss of net worth coupled with a rising cost of living...is not a good formula for getting re-elected.

And one more point on the U.S. debt. It is now extremely interest rate sensitive, as we wrote here in April. Einhorn writes that, "The Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach a point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort."

Besides taking U.S. monetary policy into the land of the absurd, you would also want to buy long-dated calls on U.S. interest rates if Einhorn is right. You can trade it two ways actually. You can be short U.S. bond prices through exchange traded funds like TLT and IEF, or long U.S. bond yields by buying call options on U.S. Treasury yields.

And what about the other dodgy currencies like the Euro and the Japanese Yen? They are doing well against the Greenback now. But at a fundamental level, both have the same genetic defects as the U.S. dollar. "I believe there is a real possibility that the collapse of the major currencies could have...a domino effect on re-assessing the credit risk of other fiat currencies run by countries with large structural deficits and large, unfunded commitments to ageing populations."

The "domino effect" Einhorn is referring to is the collapse of Lehman Brothers. For at time, until it was clear the government would not allow the other investment banks to fail, it was clear to investors that if Lehman's leveraged model was dead, so was Goldman's and Morgan Stanley's and Merrrill Lynch's.

In a world where credit was not so ready and the unwinding of leveraged assets threatened to wipe out equity capital, those major levered up firms faced an existential threat. The government stepped in at that point and bailed them out, preventing the free market from doing what it was about to do: punishing the firms, their creditors, and their shareholders for incredibly bad risk taking.

Now you have the goofy situation where a government pay Czar is intervening to cut executive salaries at those firms by 90%. If the government hadn't intervened in the first place, the salaries would have been cut by 100% and the bad bets by the firms would have been written off and the economy would be closer to recovery. But that is neither here nor there.

Einhorn's warning is that currency devaluations force investors to revalue the idea that sovereign bonds are risk free. This is another way of saying that the nation state as a fiscal enterprise is every bit the failed model that investment banking is today. Investment banks borrowed money to bid up assets. Governments borrow money, securitised by tax revenues, to "invest" in policy objectives.

But as we are finding out now, those "investments" have not been self-sustaining in an economic sense. Einhorn, if we read him right, is reaching the conclusion that the nation state financial model (the fiscal warfare/welfare state) is in deep, deep trouble. It is the next institution that is "too big to fail." And it's going to fail because its funding model is based on the fraud of an idea that we can all live at one another's expense and that you can get something for nothing.

Here's a question, though: who bails out a failed nation state? Will the IMF bailout America? Will the World Bank lend to Japan? Will China establish a line of credit for Europe?

Speculators who like what Einhorn is saying would consider buying long-term put options on the Euro and the Yen too, not just the U.S. dollar. But what do you do if you're not George Soros? Why not try gold?

"I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible."

Sounds pretty sensible.

Dan Denning
for The Daily Reckoning Australia

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Investors must be pondering the future.

What will the future look like? No one knows. But investors thought they saw things they liked.

For one thing, there was the Federal Reserve governor from New York, who told the world that there was no risk of a rate hike anytime soon. Bill Dudley knows which way the wind is blowing. He said the Fed would hold money policy loose "indefinitely."

Indefinitely is otherwise known as "as long as it takes."

But as long as it takes for what? Ah...as long as it takes until the economy appears strong again.

How long will that be? Ah...maybe longer than anyone realizes.

Yesterday, we were calculating how long it would take to get the jobless number back down to '90s levels...that is, around 5%. There are now about 131 million jobs in the United States...and about 15 million people who would like a job but can't find one. Meanwhile, population growth adds about 1.5 million new workers every year. That means the economy has to grow at 1% (in real terms) just to stay even with population growth. Currently, the economy is going in the wrong direction - backwards. It's losing jobs...maybe 3 million this year...and maybe another 2 million or so before it finally stabilizes (who knows?)...for a total of 20 million jobs down (about 13% unemployment) by the time unemployment bottoms out.

Let's suppose, by some miracle, the economy turns around...and begins growing at 3% per year. That should be about 3 million new jobs per year. Half of those, remember, are just to keep up with population growth. So the other half - 1.5 million - gradually reduce unemployment. Now, let's get out the calculator...20 million divided by 1.5 million equals a little more than 13. By these numbers you can expect full employment again in 2022!

But what if the economy doesn't grow at 3% per year? Ooooh...that's the problem, isn't it? All the feds - and practically all other economists too - are projecting a return to normal. They expect a 'recovery.' But what if there never is a recovery?

Heck, yesterday, the central bank of Australia said it was so sure that everything was going well it raised its key lending rate by 25 basis points.

"Canberra says risk of serious retraction over," The Financial Times reports.

But they get a lot of sunshine down under. Possibly, the heads of the Reserve Bank of Australia got a little too much of it yesterday. Australia is also a supplier of natural resources to China; possibly, the sun burnt bankers failed to notice that China is a bubble.

Or maybe they failed to notice that China's biggest customer is broke.

Right under The Financial Times' article about Australia is the following headline:

"No sign of credit revival for US households."

"The latest data from the Federal Reserve show consumer credit declined at an annual rate of 10.4% in July - the fastest rate since the crisis began two years ago."

Yes, dear reader, Americans are shedding debt. They are cutting back. They are saving.

Another headline in The Financial Times tells us, "Holiday sales [are] set to fall."

Hold on. Who makes all that junk that Americans buy for Christmas? And how can China buy more raw materials from Australia when it is selling fewer finished products to Americans?

Perhaps China is focusing more sales on the domestic market; we don't doubt it. But you don't refocus the world's second or third largest economy in 12 months. It takes years. And you don't get this kind of rebirth without some kind of suffering. The big, old oak tree has to fall down before the sapling can take its place. And when the oak falls - it makes one helluva mess.

Bill Bonner
for The Daily Reckoning Australia

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On the latter, here's what Addison had to say:

"'Deflation now, inflation later' is a mantra we've adopted at The Daily Reckoning. The Federal Reserve, through it's program of quantitative easing, is busting the seams of its own balance sheet in order to fight a deflationary trend in the West. At some point, the tide will shift. Mr. Bernanke assures the world he's watching inflationary indicators like a hawk. We have our doubts whether those indicators will do him any good. As Paul Volcker, the great inflation slayer of the early 1980s, said when we interviewed him for I.O.U.S.A. 'Once inflation gets started, it's very hard to stop. And there's a strong flavor of that at the moment.'

To read Addison's full interview, see here.

"Global trade rose at its fastest rate in more than five years in July," The Financial Times reports, "suggesting the economic recovery is feeding through into commerce."

"I've been worried about the effects of protectionism in shutting off different markets and making a weak economy even worse off," says colleague Chris Mayer. "Commodity markets especially need open markets to function well. The EU, for example, just put a 40% tariff on Chinese made steel pipe. That's not good for steel pipe demand and hence, the steel makers and the commodities that go into steel. If we see widespread adoption of such measures, we'd have to re-think some things.

"But so far, it looks like we've got a recovery of some kind in global trade. When I look at the global economy, many of the bright spots stem from surging trade along old trade routes (such as China and Arab world)."

Racehorse prices are in freefall, says a report out yesterday. But collectible cars are still doing well.

Yesterday, we saw someone drive by in a huge, gaudy pink Cadillac from the 1960s. It had magnificent fins and enough chrome to stagger a blind man. In it were a middle-aged man and woman, looking very comfortable and proud. They were traveling in style...in a rolling sculpture.

Old cars are not only holding their values, they're still going up. But not all old cars. Detroit's muscle cars have been falling in price for the last three years. Not very green?

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

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The importance is dependent on your perspective. Those people who are not borrowing money to spend are thus suffering the pangs of a lowering of their lifestyle, which depended on borrowing money to spend; and then they come around, whining about stupid things like, "Daddy, things have gone up so much in price that I need more money, which you would give me if you loved me. Don't you love me? I love you! Won't you please love me, daddy?"

And so I ask, "Can't you love me if I don't give you any money?" and they say, "No. You could borrow the money, and then we would love you", and I reply, "I have been borrowing money and now I can't pay them back" and so the kids say, "Then borrow some more!"

And, in a terrifying revelation, I realized that it is not only my children, but all the rest of the economy that is totally dependent on everybody else borrowing money to spend, too.

So now you see how Chaos Theory was right, and that all things are connected to all things? If not, then pay attention to how they will now commence to all drag each other down into the Nightmarish Hell Of Inflationary Insolvency (NHOII).

And it doesn't take a real genius to see why, but the point is not that the American people were stupid enough to think they could get a perpetual free lunch by borrowing money to pay for it, or even that a smaller subset of those who are suffering the pangs of a lowering of their lifestyle is composed of those who also think that they can call me on the phone and either 1.) Ask to borrow some money from me, or 2.) Ask me to pay them back the money I borrowed from them.

My response is the same, in that I give neither one of them any money because I don't have any money; so to one I laugh in scorn, and to the other I say that I have just put a check in the mail to them, and that they will get their money soon, and if it hasn't arrived in a few months, call me back and I'll write you a new check and get it right into the mail.

The point is that a much larger subset of those who are suffering the pangs of a lowering of their lifestyle is composed of those people who think that they can elect government representatives who legislate all problems out of existence, that will tax me and then give the money to them, or the Federal Reserve will create more money to loan to investors with which to buy government debt so that the government can spend, spend, spend us into blessed Utopia. Either way, it's Bad, Bad News (BBN).

And, alas, one way or the other, they are right. Unfortunately. And that is one reason that I weep, alone, in the Mogambo Bunker Of Bunkers (MBOB), doors locked, radio blaring, machine guns cocked and loaded, mostly drunk or nearly so, soon to be blissfully comatose.

Another reason that I cry so piteously and drink so abusively is that all this new government borrowing will create so much new money that it will destroy the dollar's buying power, taking my own country down with it.

The only reason that I stop bawling like a little crybaby is the knowledge that the people who own gold, silver and oil will get rich, rich, rich, and since I own gold, then people will want me to loan them a few bucks out of my huge stacks of money because they are starving, and their children are starving, and I will say, "No!" and it will be thin gruel indeed for them to hear my mocking voice again echoing in their heads, "Buy gold, silver and oil, you morons, because your stupid government is letting a private bank (that misleadingly calls itself the Federal Reserve when it is, in fact, neither) to create so damned much fiat money that it will produce catastrophic inflation in consumer prices that will destroy the country, just like it has done to every other stupid country in the last 4,000 years that let its stupid government increase a fiat money supply at its whim! Hahahaha! Now you see why I always said you were freaking doomed! Hahaha!"

But I feel terrible, as this constant infliction of inflationary pain by heedless expansion of the money supply is so unnecessary, and that is why I was pleasantly surprised to read in The Wall Street Journal the headline "Central Banks Consider Gold" in its Commodities Reports column.

The reason is easy to see if you read the article backwards, in that there was a question about central bank buying "last week, when gold saw a record single-day gain", especially Chinese central bank buying of gold, which is already the ninth-largest holder of gold in the world but which holds only 1% of its foreign-exchange reserves in gold, although it actually said it would like to hold more. And Mark O'Byrne at Gold & Silver Investments says that he would "be surprised if the Chinese hadn't been nibbling at the gold market," which leads to the news that Asian banks "are seen as keen buyers" of gold, which leads to the news that "other central banks are now far more likely to be holders of gold", which leads us back to the second paragraph that "Turbulence in the financial markets and recent US dollar weakness are helping the precious metal claw back its reputation as the central monetary anchor within the international monetary framework", which leads to the opening paragraph of "Central banks may be starting to turn one of the few assets in which they can invest; gold."

In short, those crafty Chinese, a fifth of the world's population, may be getting ready to issue a gold-standard money, which will instantly make their currency the strongest in the world, which is just what a country needs if it wants to import a lot of things cheaply so as to respond to demand for internal economic growth without stoking inflation in prices!

And, fortunately for those of us who both love to have large profits handed to us and who also own gold, a Chinese gold-standard may soon make a dream come true as gold would skyrocket when priced in suddenly depreciated dollars.

Whee! This investing stuff is easy!

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

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• The Return of the Cattle Market

One of the reasons for my bullishness and bullheadedness about silver is the large short position, which is the number of ounces already sold (opening the short position) but which have not been bought yet (closing out the position), which means these shorts are going to get clobbered if they have to cover their short position by buying silver at a higher price than they sold it.

So I was very interested when Ed Steer's Gold and Silver Daily reports says that the commodity futures market report shows that bullion banks' "silver net short position now stands at 213.6 million ounces...about a third of world silver mining production...all held by 'four or less' bullion banks."

He characterizes this as "grotesque beyond description", which I guess it is, since it is hard to even imagine such a thing, which implies that these "four or less" banks are so stupid that they would be short silver when the fundamentals are so compelling that my throat is bloody and raw from screaming, "The fundamentals of silver are compelling!"

And this is even ignoring the headline "Gold & Silver Market Alert - Buy before the Breakout!" from Julian Phillips at Goldforescaster.com, which reflects my sentiments exactly.

In gold, the situation is similar, in that Mr. Steer says, "The bullion banks' net short position now stands at 211,342 contracts... 21.1 million ounces. This is well over 25% of world gold production. This is also grotesque beyond description".

Suddenly I see an opportunity to hide my rising excitement and get a quick laugh! So I said, "This means it is NOT 'beyond description' when it is perfectly described by silver, which is also 'grotesque beyond description' and which can be described as 'like gold'! Hahahaha!"

Well, I am laughing at my own joke and having a wonderful time when I looked around and noticed that nobody else appreciated my little joke about circular reasoning, which, upon reflection, I admit is pretty bad, and I am pretty embarrassed about it.

I don't know why I thought it was funny, except for maybe it's these new pills that are supposed to keep me from screaming my guts out in fear about the coming collapse of the dollar and the attendant horrific rise in consumer prices that destroys America and plunges us into a post-Apocalyptic nightmare. And, parenthetically, they work pretty well, too, except for the catatonia and the, you know, drooling.

Mr. Steer sees my embarrassment and starts talking about how many of the owners of futures contracts in gold and silver said, "We want our metals!"

People with inquiring minds want to know, "How much gold and silver was delivered so that we can maybe see if the Mogambo Who Thinks He's So Hot (MWTHSH) is actually turning out to be right about gold and silver going so much higher in price because the despicable Federal Reserve is creating so much money and credit that inflation in consumer prices is guaranteed, which would be indicated by a rising price for silver!"

Well, it turn out that "The final totals for August are as follows... gold 5,728 contracts [572,800 ounces] and silver 91 contracts [455,000 ounces]", which doesn't seem like a lot, but what in the hell do I know?

So, I report these things without knowing what they mean because I am pretty stupid and I am just in it for the money, so all I can ever see is the obvious, especially when it is pointed out to me, which he apparently does when he says it means, "August was a big month for gold deliveries...but not for silver. September is a big month for silver deliveries...but not for gold."

I still don't know what it means, but a big buying of gold and silver every other month is plenty enough to keep their prices rising and demand growing, which is Another Good Reason (AGR) to buy gold and silver beyond the obvious good reason that they always soar in value and price when the government is acting so irresponsibly, or when the Federal Reserve is acting so irresponsibly, but especially when both of them are acting irresponsibly, like now!

It's enough to make you squeal with delight, "Whee! This investing stuff is easy!"

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

• Bullish On Silver
• Gold and Silver Demand Unprecedented
• Price of Silver Climbing to All Time High of US $1,012
• Silver Stats That Will Make You Salivate
• Gold and Silver!

Your editor scratched his chin over this question while thumbing through a copy of the Financial Times over the weekend in the shadow of the le Grand Arche de la Defense west of Paris. You know the one. It's a modern, shiny, gleaming version of the Arch de la Triomphe.

Just why we chose to stay in the business district of Paris rather than down in the middle of the city...well it had to be a cost saving decision. It certainly wasn't aesthetic. This is Paris without the charm, pretty trees, and rich smelling coffee. In fact, with all the glass buildings and paved pathways, it could be any city anywhere during any credit boom. It's just another example of finance dominating the global economy.

And that returns us to the big question as we open the week. The financial markets have clearly rallied. If it's true that markets lead economies, markets are telling us that things are going to get much better. The FTSE index of emerging markets is up 99% from its March lows. The S&P 500 is up nearly 60%. And gold itself is up 25%, with much of that move coming in the last few weeks. This is what happened in 2003, all asset classes went up simultaneously, riding the global money tide.

David Rosenberg, who used to work at Merrill Lynch but is now the chief economist and strategist at Gluskin Sheff, says that something is fishy about this rally. It's come, at least in the U.S., as the economy lost another 2.5 million jobs. "Typically, by the time we are up 60%, the economy is well into the third year of recovery; we are not usually engaged in a debate as to what month the recession ended."

Fine, you may be thinking. Employment is a lagging indicator. It will be the last thing that picks up. But it will pick up. In the meantime, how can you ignore what the markets are saying?

One answer might be that the markets are rigged. Or, if that is too indelicate, you could say that the surge of liquidity provided by central banks has allowed banks to load up on assets again, producing paper gains which boosted earnings and justified-in the minds of some insane people-higher valuations for stocks. The bull is back baby! The economy should quite being such a party pooper and get with the program.

For example, during the same time that the U.S. economy has shrunk by about $400 billion in terms of GDP, the balance sheet of the Federal Reserve has grown by over $1 trillion. Japan has the same problem, a shrinking real economy and an expanding central bank balance sheet. GDP has fallen by £16 billion in the UK, but according the FT's Lex Column, the Bank of England has injected ten times that amount into the economy.

What does it all add up to? Why isn't an increase in credit leading to growth in the real economy? All that new money is not leading to a lending boom with renewed business investment that creates jobs and a recovery. Instead, it's leading to forced speculation in the stock market which is driving asset prices higher. This is the famous problem Alan Greenspan had with low interest rates. You can turn the credit spigot on, but you just never know where the money is going to flow.

Right now, it's flowing into stocks. Lex says that since Lehman collapsed, "US banks have increased their assets by 10 percent to $14.2 trillion." Rather than shrinking their balance sheets, the banks seem to have escaped the push for regulatory reform and actually loaded up again on free money for a credit-fuelled bender. Leverage is in vogue again, as are risk assets.

But we have no reason to believe this is going to end any differently than the last leveraged boom. We know how those end. We've seen bubbles popping steadily since 2000. First it was Internet and telecom stocks. Then emerging markets. Then common stocks. Then the commodities sector got pounded. And don't even get us started on how bad an investment sovereign government bonds issued by debtor countries are going to be.

All of that might sound unnecessarily grim for an Australian-based investor wandering the streets of Paris in late September. Can't we manage to say anything positive? Well....yes, we can! For example, last night's dinner of simple farm-style chicken in the shadow of the Sorbonne was...well it was excellent.

But what about investing? If you're going to have a plan for the next five years that takes into account this attempt to reflate the financial economy, there are a few things worth keeping in mind. First, it's going to fail, and probably spectacularly so. That failure will be accompanied by an even greater expansion of government debt.

For example, the Times of London is reporting that Britain's net debt is growing at a rate of nearly six thousand pounds per second. Tax receipts are plunging. And politicians, jack asses that they are, are actually making even more promises to deliver things they can't begin to pay for now.

We think they key idea in all of this is that you're going to witness a transfer of ownership in the underlying capital assets of the global economy. The big question is will you profit from it or be victimised by it? We reckon that if we're right-and if you can anticipate the general progression of events-you can stay one step ahead of the curve.

Easier said than done, right? So for the remainder of the week, we're going to go back and review our proposal for a "Permanent Portfolio." It will be based on a forecast of more debt deflation...and then rapid inflation.

Yes, it sounds tricky. But this isn't the first time this sort of thing has happened. Tomorrow, we'll take you back to one of the first "Great Inflations" Europe experienced and show you how it literally capitalised a new entrepreneurial class for the next three hundred years. Until then!

Dan Denning
for The Daily Reckoning Australia

• If Unemployment Numbers Get Better So Will the Economy
• The More Money in a Financial System the Less Each Unit is Worth
• Financial World Has Every Reason to Encourage Government Stimulus
• A Recovery of Some Kind in Global Trade
• Possible Second Round of Panic Hitting Financial Markets

"If they [the Fed] keep printing money to buy bonds," said Mr. Cheng, "it will lead to inflation, and after a year or two, the dollar will fall hard. Most of our [Chinese] 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." Mr. Cheng was referring to over $2 trillion of Chinese foreign reserves, the world's largest holding.

"Gold is definitely an alternative," said Mr. Cheng, "but when we buy, the price goes up. We have to do it carefully so as not to stimulate the market."

From Mr. Cheng's lips to God's ears - and now to ours. We have direct testimony from a high-level cadre that China, while cautious, is a key driving force in the gold market. China is buying.

We already knew that the Chinese are buying gold - and hoarding it. For example, China is the world's largest gold-mining nation. China mines more gold each year than the US or South Africa. Yet what are the net gold exports from China? Umm...zero. That is, China doesn't export gold (unless you buy a Panda coin or something.) Overall, in fact, China is a net importer of gold.

Sure, the Chinese use gold in industry, such as for electronics, jewelry and the like. But much of the rest of Chinese gold purchases go into state coffers, or into "off-books" storage. I'll bet that there's a lot of gold in "industrial stockpiles" in China, which are really just strategic monetary reserves for China's Central Bank.

The implication from Mr. Cheng is that the Chinese will not overbuy gold, which may be why the yellow metal has hovered just below the $1,000 mark per ounce in recent weeks. At the same time, it's more than likely that China will buy gold whenever there's a price dip.

The significance is that the Chinese seem to be prepared to establish a floor under any correction in gold prices. This limits the downside for well-positioned gold miners such as we hold in the Energy & Scarcity Investor portfolio.

Is there an upper limit to gold prices? Well, I expect to see the gold price rise, but slowly and in a long series of plateaus. I also expect to see pullbacks, usually based on world monetary and political events.

So we'll surely have some roller-coaster rides with the prices for the mining shares. How it all unfolds for us as investors will depend on when, and to what degree, monetary-driven inflation begins to bite into the economy. When it becomes totally obvious, it'll probably be too late to protect and preserve your wealth and purchasing power.

The problem for us in the West is that most of the politicians and major media just DO NOT GET IT. Or at least, the ones that do "get it" generally don't report things honestly to the citizens. They're probably afraid of what might happen when the citizens really figure out how much the political classes have screwed up the world.

So you see these rosy-sounding headlines about how the economy is "improving" and things are "getting better." Huh? What planet are these guys on?

The tide of inflation is rolling in. It'll lift the boats of the gold miners.

Byron W. King
for The Daily Reckoning Australia

• Gold Outlives Paper Money, Empires and Governments
• India Beats China to Walk Away With 200 Tonnes of IMF Gold
• The Chinese and the Fed Both Buying U.S. Treasury Bonds
• Stock Prices Down Signals Bears to Hold onto Cash, Treasuries and Gold
• Admonishment from China and the Decline of U.S. Credibility

From a mainstream economic perspective, it should be renamed Leisure Day, as unemployment is interpreted as an individual choice of leisure over paid labor effort. Of course, only a tenured professor could be expected to come up with such a conclusion. As it stands, it is currently estimated there is one job opening for every six people looking for work.

Since employment is a lagging indicator of economic activity, we learned over the years to dig deeper than the headline figure to get a read on where labor market conditions may be going. One of the more useful, but often ignored, parts of the employment report tells us about the percent of private industries that are net offering jobs. Even when payrolls are shrinking in total, some industries are still net hiring - and, indeed, this is part of how markets facilitate the reallocation of productive resources during a recession, which, as the Austrian approach reminds us, is crucial to long term-growth prospects.

This measure is called a diffusion index, and we prefer to look at the average in this series over the past three months to avoid too many miscues. As it stands, the breadth of private industries net hiring, though still at a lower level than the last recession, has consistently climbed from the March lows. The pace of broadening is even a bit stronger than what we observed in the last exit from a recession, which, as you may recall, was followed by a jobless recovery. If the slower pace of layoffs is all a sugar high from extreme policy measures, or if a double dip is about to open up before investor eyes, this is one of the places it should show up first. So far, this diffusion index is more consistent with an unemployment rate that peaks near year-end around 10% and begins to show some improvement in Q1 2010. We would also note while survey results still report perceptions of a very difficult job market, these measures have stabilized in recent months.

When firms start shedding labor more aggressively than their production activity is contracting, labor productivity (output produced per hour of work) tends to reaccelerate as the pressure on the remaining work force intensifies. In fact, productivity growth has begun to rebound, and we believe it has a good shot at pushing through 4% year-over-year growth by year-end, from the current 2% pace in the nonfarm sector. At the same time, businesses struggling to stay alive have pressured labor compensation growth. Hourly compensation (wages and benefits) growth has been on a disinflation (that is, decelerating inflation) path through the entire recession. We suspect it will be flirting with deflation near year-end, which is something we have not seen since Q4 in 1949.

If we put these two developments together - labor compensation growth approaching deflation, while labor productivity growth reaccelerates - we get deflation in unit labor costs. Companies that can hold the line on pricing while unit labor costs are falling will tend to experience rising profit margins, and rising profit margins are generally a signal to expand production. Improving cost conditions are one benefit of recessions, and if final demand can stabilize or improve from sources other than the household sector - say, fiscal policy or an improvement in the trade balance or the onset of some replacement capital spending - then this can be a route back to economic recovery. We will have more to say about this in the next monthly letter, but for the moment, it does look like firms are successfully compressing cost conditions.

This matters because with the release of Q3 S&P 500 earnings in October, we suspect strong operating leverage will become apparent to equity investors. Earnings improvement through Q2 has been all cost cutting related in a flat or falling revenue environment for most companies. If Q3 begins to show top-line revenue improvement, as we suspect it will, then earnings will be fed by both revenue and profit margin gains. After the seasonal September jitters, the exposure of the operating leverage available to firms that have cut to the bone could very well capture the imagination of investors, leading to the next leg in the advance of US equity indexes since early March.

According to supply managers in the manufacturing sector, goods sector production has been on the rise since June, and new orders are through the roof. By way of reference, the new orders index was scraping a new historical low back in December, rivaled only by the 1980 lows following Fed credit controls. Never before in the six decades of Institute for Supply Management (ISM) records have new orders surged so dramatically in any eight-month span. Never before has the ISM new order and production indexes recorded these levels without marking an escape from recession. No doubt the "cash for clunkers" sugar high has something to do with this, but we doubt it explains away all of the dramatic reversal in supply manager perceptions, as the export indicator in this report has also improved remarkably since the December 2008 lows.

These ISM results are usually good for a three-four month lead time on government reports for industrial production, shipments and new orders. We can anticipate the rebound depicted above will now reverberate in the monthly reports from here to year-end, at a minimum. In particular, the ISM production index has provided a reasonably good guide to year- over-year momentum in manufacturing production.

The sharpest monthly contractions in industrial production began in September of last year as the credit markets went into cardiac arrest, and all parts of the economy went into a cash grab/cash conservation mode so that prior cash commitments could be met. This included dramatically reducing production and liquidating existing inventory stocks. In other words, the comparisons against year ago are about to get ridiculously easy, and a healthy 5% year-over-year manufacturing production growth rate is certainly within reach by year-end 2009.

As summer slips away into the flaming leaf show of fall, we conclude the labor market is still a mess, but we can find some broadening of hiring activity even though total payrolls are still contracting. That means the necessary reallocation of productive resources, which is part of the function of recessions, is under way. More importantly, unit labor costs are falling as the pace of layoffs has overshot the contraction in output, and labor productivity is improving as a consequence, which is a second growth encouraging outcome of recessions.

The question remains what lies ahead after the massive quantitative easing operations of the Federal Reserve have lapsed and the bulk of the fiscal stimulus is behind us. In the very near term, we can surely expect auto sales to wilt following the end of the cash for clunkers program, but we remain impressed by what supply managers in the most cyclical part of the economy, namely manufacturing, have to say about new orders, production and export conditions. Policymakers panicked and adopted a "whatever it takes" stance, one that has proven to be the most radical outside of major wartime conditions. Looks like something took - and not surprisingly, gold is taking out the $1,000 per ounce mark at the same time.

Regards,

Rob Parenteau
for The Daily Reckoning Australia

• “Deflation” Remains the Watchword for 2009
• The Challenge of a Balance Sheet Recession
• The More Money in a Financial System the Less Each Unit is Worth
• Suspicion the Service Sector Consumer Spending Series is Overstated
• June Producer Price Index Indicates Slower Inflation in Australia