There is a risk in holding cash in an environment of asset price inflation - a condition that usually occurs when governments create large fiscal deficits and inflate the money supply. The practice is endemic to banana republics and declining empires...and it is happening in the US at this very moment.

The global recession and financial crisis have refocused attention on government stimulus packages. These packages typically emphasize spending, predicated on the view that the expenditure 'multipliers' are greater than one - so that gross domestic product expands by more than government spending itself. Stimulus packages typically also feature tax reductions, designed partly to boost consumer demand (by raising disposable income) and partly to stimulate work effort, production and investment (by lowering rates).

The existing empirical evidence on the response of real gross domestic product to added government spending and tax changes is thin... But the evidence is quite strong that these policy responses usually trigger inflation.

I suppose that even someone without any common sense might understand that a "strong currency" over longer periods of time reflects a high degree of prosperity and economic success, whereas a chronically weak currency is symptomatic of economic imbalances, such as a lack of competitiveness or overconsumption, arising usually from excessive supply of money and credit.

I would also suppose that even if someone never travels overseas, he would understand that if the US dollar loses 50% of its value against all the other world currencies (everything else being equal), it means the US is 50% poorer relative to the rest of the world. (Now, this is not entirely correct, since the US has overseas assets that would appreciate in value in USD terms).

Moreover, stock price movements become extremely volatile and erratic in countries with a depreciating currency. In the long run, the depreciation of the currency will usually more than eliminate the gains in local currency terms. So, whereas in 2007 both the Dow Jones and the S&P 500 exceeded their previous highs reached in 2000 in US dollar terms, these indices failed to make new highs in Euro terms. In addition, whereas the US economy expanded in US dollar terms between 2001 and 2007, in Euro terms it actually contracted!

Even with the S&P 500 having shot up since the beginning of the year by over 25%, it has merely kept pace with the price of gold. And during the last 10 years, the S&P has lagged behind the official US inflation rate...while lagging VERY far behind both the euro and gold. Since the end of 1999, the S&P 500 has delivered a total return after inflation of about MINUS 25%.

Unfortunately, the US is not the only country that is busily debasing its currency. "Everyone" is doing it. Because of the current collective debasement of all paper currencies by central bankers, I believe that precious metals and mining companies will maintain their purchasing power.

In the 1980s the US dollar was a very strong paper currency compared to the Mexican Peso. Today, there is no paper currency that is as strong relative to the US dollar as the US dollar was relative to the Peso in the 1980s! The only "currencies" that have a chance of becoming as strong against the US dollar as the US dollar was against the Peso between 1979 and 1988 are precious metals such as gold, silver, platinum, and palladium.

Also, I should add that precious metals could appreciate even if the US dollar miraculously recovered strongly against foreign currencies for an extended period of time. Such dollar strength would probably be a symptom of some horrible economic or political problems around the world, which could be friendly to precious metals.

Central bankers and pundits seem to believe that they have averted the second Great Depression, while ignoring the fact that more and more debt produces less and less GDP and fewer and fewer jobs.

For now, though, the low ten-year bond yield is the lifeline from which all support flows. Much of the investment universe holds together because money can still be had for cheap - not by the volition of a cooperative private sector, rather induced by a US government that simply distributes money for free. Such an ill-conceived idea could only have been born in the test tube of a central banker.

Private lenders comprehend the difficulty of making profits when being forced to lend for nothing, so the government increasingly finds itself to be the interest-free lender of last resort.

Ultimately, if central bankers continue this process for long enough, it is the dollar, and any currency or economy still pegged to it, that could eventually crash. Therefore, we investors find ourselves in the precarious position of having to maintain sufficient liquidity, but not too much in case the real value of these liquid reserves is wiped out by politicians and central bankers gone mad.

Regards,

Dr. Marc Faber
for The Daily Reckoning Australia

• US Dollar As Reserve Currency Not Working Very Well
• 4 Ways to Protect Against a Falling Dollar
• Is Gold Money?
• Gold Falls for Four Straight Days but is the Low Price a Bad Thing?
• Transfer of Wealth

The financial crisis of '08-'09 was not a head cold. It didn't go away.

It was more like diabetes, a stroke, or cancer. It was serious. Life threatening. We may not recover. Our only hope is to change our habits, undergo some nasty treatments...and endure a long convalescence.

But that's not what most people think. They are convinced that the feds gave the economy a miracle drug. It cleared up the trouble lickety split. Now, our troubles are behind us.

The Dow moved up 17 points on Friday, leaving it above the 10,000 mark. Gold rose too - it is at a new record high, only $5 below $1,100.

According to the news reports, the US economy is 'growing' again. Yes, that's the official storyline.

But wait, what kind of growth is this? David Rosenberg:

"All we can say is that if the overwhelming consensus is correct that the recession is behind us, then what we have on our hands is the mother of all jobless recoveries and whatever economic growth is being squeezed into the system comes courtesy of the most dramatic intervention by the government in recorded history, including the New Deal 1930s era. President Obama is now running fiscal deficits that would have made FDR blush."

The quacks at the Fed and the Treasury department have delivered the biggest jolt of adrenaline in history. People in the private sector won't spend? Heck, the feds will spend for them!

It took the Fed nearly one hundred years to grow its balance sheet - which is the foundation of the US money supply - to $800 billion. Then, after Lehman Bros. went broke, it doubled its balance sheet...to more than $1.8 trillion.

Early last week, the Fed announced that it would keep the firehose- sized IV in place. Then, by the end of the week, the G-20 meeting of finance ministers confirmed said they were all sticking with their stimulus programs.

You can't put that much cash into a financial system without getting some kind of reaction. Goldman is making record profits, for example. How does Goldman make money? It is finance business. It profits by offering credit. When credit expands, the moneylenders and speculators at Goldman make money.

The private sector isn't borrowing. Every day brings more proof.

Consumer credit contracted again in September - the 8th month this year.

Unemployment just passed the 10% mark, reports The New York Times.

"Small Businesses Hunker Down to Survive," says another headline story.

Another big bank went bust in California.

But while the private sector de-leverages, the public sector expands. Now, it's the feds who are doing the borrowing - about $1.7 trillion this year.

This is great for the people who help the feds finance their spending. But all it does is add more debt to the system. And debt is the real problem.

If former OMB director David Stockman is right, we'll see deficits over $2 trillion for a decade.

What people once took for absurd they now take for granted. Such as trillion-dollar deficits. For even with a hole in public finances equal to 13% of GDP the US House of Representatives passed a law overhauling the health care system, at a cost of more than $1 trillion.

What were they thinking?

Well, they were probably thinking that 'deficits don't matter.' And they were probably justifying the expense on the grounds that it was 'countercyclical spending' that would help pull the US out of its slump.

Whatever they were thinking, they weren't remembering what happened 20 years ago. It was 20 years ago today that the Berlin Wall fell, bringing to an end a 40-year demonstration project. The East Germans/Soviets wanted to show the world how well economists working for the government could run an economy.

And we found out!

Bill Bonner
for The Daily Reckoning Australia

• Government Debt
• Bankers Take Money From the Government and Use it to Speculate
• Feds Have Used the Correction to Increase Their Power and Add to Their Wealth
• Why Weren’t Economists On Top of This Thing?
• Where Do the Feds Get Any Money?

"The dollar looks awfully like sterling after the First World War," said David Bloom, the bank's currency chief.

"The whole picture of risk-reward for emerging market currencies has changed. It is not so much that they have risen to our standards, it is that we have fallen to theirs. It used to be that sovereign risk was mainly an emerging market issue but the events of the last year have shown that this is no longer the case. Look at the UK - debt is racing up to 100pc of GDP," he said

The Telegraph reports:

"Crucially, China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles. Asia's 'mercantilist mindset' of recent decades is about to be broken by the spectre of an inflation spiral.

"The policy headache was already becoming clear in the final phase of the global credit boom but the financial crisis temporarily masked the effect. The pressures will return with a vengeance as these countries roar back to life, leaving the US and other laggards of the old world far behind.

"A monetary policy of near zero rates - further juiced by quantitative easing - is completely incompatible with circumstances in most of Asia, the Middle East, Latin America, and Africa. Divorce is inevitable. The US is expected to hold rates near zero through 2010 to tackle its own crisis.

"What is occurring is an epochal loss in the relative wealth and economic power of the old G10 bloc of rich countries compared to rising regions of the world. The euro, yen, sterling, Swiss franc and other mature currencies will be relegated along with the dollar in this great process of rebalancing, but the Greenback will bear the brunt."

That said, we repeat a headline from Seeking Alpha:

"Dollar shorts should look out."

We agree with HSBC and the Telegraph: the dollar will probably slide - especially against Asian currencies - for the next few decades.

But that's the long term. In the relatively short term we still face the shock of another leg down of the credit contraction crisis. Risk is likely to make a comeback. When that happens - and it could happen in a 'Red October' - the dollar will seem like a relatively solid refuge. This is what happened last year. We wouldn't be surprised by a replay of that 'flight to safety' we saw at the end of last year.

But we know what you're thinking: what? When did the dollar become a 'safe currency?' Of course, it's not safe. But when the end of the world approaches, it will seem safe.

For a while.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• The Dollar Left Behind
• Will Synchronized Rate Cuts Solve International Financial System Problems?
• Where Do the Feds Get Any Money?
• Fed Vice Donald Kohn Urges Emerging Markets to Drop the Dollar Peg
• Prices of Gold in the Top 10 World Currencies

We spent Sunday with the publisher of International Living magazine.

"Prices have fallen so much in Florida that you really get more for your money there than practically anywhere else," she continued.

"I think Florida may be cheaper than Buenos Aires," added son Will, who's been living in Argentina for the last three years.

Housing is cheap in the United States. In Texas and Arkansas, housing is probably the best bargain on the planet. Food prices are going up; still food in the US is much cheaper than it is in Europe. And cars? We have a friend in Paris who goes back to the US to buy his Mercedes. Even with the cost of shipping the car back to France...and the cost of refitting the car to European standards...he still saves about $10,000.

"I was just in Paris," Will continued. "You pay $10 for a cup of coffee and a croissant. In Florida, I can get the 'Breakfast Special' for $5.95...and it has everything. Pancakes. Bacon... Everything."

"But what is amazing," continued our International Living colleague, "is that interest in moving overseas is going up. It's not about money. Apparently, a lot of Americans are just fed up...or afraid. They want to get out. They see taxes going up or they see the society going down the tubes. I don't know. But many say they just don't like the way things are going.

"One thing I hear is that they think American society has become meaner...ruder...less civil. You can't have a polite discussion of politics anymore. People get really upset and nasty. I mean, someone yelled out and called Obama a liar in the middle of a joint session of Congress. And a substantial part of the US population regards the guy - the guy who called him a liar - as a hero. They think Obama is a traitor...

"I think this is really a result of the financial downturn. People feel betrayed. Let down. They think something is very wrong. That the nation is in decline. So they look for someone to blame. And they tend to blame each other. Conservatives blame liberals. Liberals blame conservatives. They blame the bankers. They blame the capitalists. They blame the government.

"I guess that's what happens when you get a major correction or a big financial crisis."

We recalled what happened in Germany in the '20s and '30s:

"Germany was probably the most civilized country in the world - before WWI. Artists, philosophers, scientists, mathematicians, musicians... Germany had the best in the world. The war shook the public's faith in its leaders. But then, according to people who lived through the period, the financial crises of the '20s and '30s were worse. Hyperinflation...depression...strikes...a decade of financial chaos and disruptions led to a breakdown in social order. By the early thirties, groups of communists and fascists were battling in the streets. People seemed to leave the center and move to extreme positions. Soon, the Nazis had the upper hand and Hitler was voted into the government."

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Lending Rates Will Go Up With Inflation
• Does This Mean You Should Sell Your Gold?
• A Financial World Not Yet Recovered From the Bubble Madness of 2002-2007
• Baby Bush: The Worst President in History?
• The Crime of Central Banking

"Since the global financial system started unraveling in dramatic fashion two years ago, distinguished economists have suffered a crisis of their own," starts the article. "Ivy League professors who had trumpeted the dawn of a new era of stability have scrambled to explain how, exactly, the worst financial crisis since the Great Depression had ambushed their entire profession.

"Amid the hand-wringing and the self-flagellation, a few more cerebral commentators started to speak about the arrival of a 'Minsky moment,' and a growing number of insiders began to warn of a coming 'Minsky meltdown.'

"'Minsky' was shorthand for Hyman Minsky, a hitherto obscure macroeconomist who died over a decade ago. Many economists had never heard of him when the crisis struck, and he remains a shadowy figure in the profession. But lately he has begun emerging as perhaps the most prescient big-picture thinker about what, exactly, we are going through.

"A contrarian amid the conformity of postwar America, an expert in the then-unfashionable subfields of finance and crisis, Minsky was one economist who saw what was coming. He predicted, decades ago, almost exactly the kind of meltdown that recently hammered the global economy."

Economists went off their heads in the last few decades. They thought capitalism would make us all rich. And they thought capitalism automatically tended toward beneficent equilibrium.

Here at The Daily Reckoning, intuitively, we guessed the contrary. The system produces a kind of orderly chaos...in which the rich are frequently impoverished, the proud are humbled...and the goofballs who think capitalism fails inevitably make things worse.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Nobody Appreciates Laissez-Faire Capitalism
• Depression: A Natural and Recurring Feature of Capitalism
• Gold Price Should Continue Going Up as the Dollar Accelerates its Terminal Decline
• Nobama rally… Nobama bounce… Nobama bull market… Nobama nuthin’…
• Capitalism and Capitalists

But first, what the stock market and the economy are doing...

In the past two days, the price of gold has shot up more than $40. It's now near $1,000 an ounce.

Why? We don't know. Rumors, talk, noise...there's plenty of that. But as for why investors are suddenly putting so much money into gold, we'll have to wait to find out.

But should you buy gold now? The answer is simple: yes and no.

The Trade of the Decade is still buy gold/sell stocks. And the decade isn't over. If you have US stocks, this is a good time to sell. The Dow went up 63 points yesterday - a weak bounce after several days of losses.

This is no time to hold stocks - for the reasons we outlined yesterday.

But gold? Should you buy gold and hope to get rich when gold shoots up to $3,000 an ounce? A bad idea, in our opinion. You should buy gold to protect your assets. The risk is in the paper money...because they can create as much of it as they please. And they're under pressure now to create a lot. You buy gold as insurance against inflation, a dollar bust, a bear market in stocks and bonds, or a financial crisis. Gold is nature's money. It is better than manmade money. Because, with gold, what you have it what you've got. They can't artificially depreciate it or easily increase the quantity of it. That's why the feds don't like it. It won't support their cause du jour - whether it is a war, a bailout, stimulus, health care, or whatever. Gold doesn't cooperate with the financial engineers. That's why it's a good thing to hold when you think the financial engineers are making a mistake.

But our view at The Daily Reckoning headquarters is that while the engineers are making a mistake, they not very good at it even when they're making a mistake they're good at. Typically, they're pretty good at causing inflation. But now the credit bubble is deflating, not inflating. It will take them a few years before they become reckless enough to move prices up again. And then, they'll probably overshoot their objectives considerably.

In the meantime, there's no inflation to speak of...no dollar crisis...no bond bust. So we wouldn't expect the price of gold to soar...not just yet. That's the big surprise - that this period of deflation will last longer than expected. Then, when it begins to seem permanent, inflation will suddenly come roaring back.

By then, most investors will have given up on gold...especially those who were speculating on it going to $3,000. It will go to $3,000, but only after speculators have dropped their positions.

So far, everything is happening just as we expected. After more than half a century of boom, we are now in a bust. People need to downsize...cut back...and live a little less large than they had in the boom years. That means...well...just what you'd expect.

Wasn't it just yesterday that we reported that Florida was losing population? People just aren't retiring like used to. Here's comes the evidence:

From The New York Times comes this headline: "Older US Workers Put Retirement on Hold."

The Times tells us that older people are continuing to work because they don't have a choice. They can't afford to retire. So they hold onto jobs, which is another reason it's so hard for the unemployed to find a job. Those who have them aren't giving them up. A Bloomberg report today, for example, tells us that more people are applying for job benefits than expected. Another tells us that millions of people are running out of benefits before they find a job.

Just what you'd expect, in other words. Here are some of the other things we expected:

1. Unemployment is still rising.

"Investors discouraged by US jobs report," says a headline at the International Herald Tribune. To make a long story short, August was a disappointment. More jobs were lost than expected.

We don't know how many jobs we should expect to lose. But we're in the downhill part of the credit cycle; we're bound to lose a lot of them.

2. Sales are falling.

That's another thing we would expect. People have to cut back. So...they do cut back. Sales go down. That means fewer sales and fewer jobs. No point in making things, shipping them and retailing them if no one is buying them, right?

3. What else would you expect? Lower house prices? Check. Higher savings rates? Check. More bankruptcies? Check. Falling prices? Check.

Isn't it nice when things work out "as they should?' Check.

Bill Bonner
for The Daily Reckoning Australia

• Should You Buy Stocks Now to Take Advantage of Bull Market?
• Economy Has to Grow at 1% to Stay Even With Population Growth
• The Bailout is Approve So Now It’s Time to Buy Gold
• We Expect No Recovery from the Economy
• Last Decade: Buy Gold, This Decade: Buy Energy

How did Australia get caught up losing money in commercial U.S. real estate? In yesterday's Age, Bwembya Chikolwa, a lecturer in the School of Urban Development at Queensland University of Technology, says Aussie super funds had money to burn and listed property trusts, with their large portfolios of U.S. assets, were liquid enough to do the trick.

"Unfortunately they were caught up in circumstances to do with the financial crisis," she says. "Moving into the US wasn't a problem because it had more or less the same settings...It was driven by large investment inflows into the super funds...The super funds needed new investment avenues and the trusts were a good avenue. So they invested through the listed property trusts. They had the funds and had no choice but to move offshore and the US market because of its size."

No choice? A portfolio manager always has a choice. It's the retail investor who is forced into compulsory super that has less choice. But this does highlight the obvious fact that fund managers are not paid to put clients into cash. Self managed super investors can do this easily enough, and many did (whether by design or indifference), thus avoiding the share market wipeout. But big fund managers have to buy big stocks. They are too big to buy small stocks, by the way, which creates a niche for Kris Sayce at the Australian Small Cap Investigator.

But now we have yet another seemingly external threat to your cozy domestic retirement: U.S. commercial real estate. Yesterday's Wall Street Journal reports that the $700 billion U.S. commercial mortgage backed securities market saw a delinquency rate of 3.14% in July. That was up six times from the year before.

The Journal reckons that over $153 billion in loans need to be refinanced by 2012. Of that amount, at least $100 billion could be in trouble. Why? The underwriting on the original commercial real estate loans was dodgy (as it always is in a credit bubble). But more importantly, with property values on commercial real estate down by 50% in some areas, refinancing at the same loan to value ratio as before just isn't going to happen.

Cash flows are fine for debt service and principal repayment now, according to the Journal story. It's the write down in property values that will scupper the refinancing. What's more, because the loans were securitised, it's often hard to figure out who you should be renegotiating with. This is reminiscent of the residential mortgage backed securities market where Deutsche Bank couldn't proved it owned the properties it wanted to foreclose on.

Mortgage servicers, banks, and investors would all prefer the problem to go away so no one has to take a write down on their asset values or a loss on their securities. But Aussie firms already know better. The only question now is if a pear-shaped U.S. commercial real estate market will do as much (or more) damage to the global financial system as the residential housing market. Stay tuned....

Dan Denning
for The Daily Reckoning Australia

• Property Sector Has Seen the Value of its Assets Wiped Out
• Commercial Mortgage Backed Securities Are Back
• A Look at Debt and Super
• Paying Attention to the Risk from Deleveraging in Commercial Real Estate
• Your Average Australian Super Fund

In the meantime, the chart below shows that the since peaking in the third quarter of 2007-global financial crisis eve-S&P 500 earnings adjusted for inflation have fallen 98%. In fact, according to the chart providers, "real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative."

This wipeout of S&P profits is the largest of any S&P profit cycle since anyone's been gathering earnings data on the index. That includes all financial panics and wars of the last one hundred years. What we have here is a profits depression (to go along with the Credit Depression). But it makes sense once you suss it all out.

If the profit cycle is determined by business investment, and business investment is goosed by credit bubbles, then we'd be coming off the biggest increase in S&P profits in history-followed by the biggest bust. Having boomed with the bull, profits are going bust with the bear.

But isn't that all backward looking? Shouldn't we be focused on the future? And isn't that what stocks are doing now? Doesn't the rally show that the past is not really prologue at all, but simply past?

In one aspect, the stock market's current behavior isn't all that remarkable. It is the nature of markets-and probably human beings-to be forward looking. Investors look at the profit crash on the S&P 500 and assume it can't get any worse. Thus, the index is being priced for a profits recovery.

This also shows that investor psychology may have recovered from capitalism's near-death experience in the last eighteen months. When things get really bad in markets, stocks are not priced on a forward looking basis. The future is so murky, dark, and uncertain at these despairing moments that investors price stocks as if yesterday's business conditions will be tomorrow's enduring reality. This is traditionally-but not always-a buying opportunity.

Once you get over the fear that the body of capitalism is on its death bad, there's a flush of optimism about future earnings. After all, they have to recover sometime. And coming off extreme lows, the recovery could be powerful, swift, and for shares-extremely bullish. Right?

All of that may be true up to point. And we think that explains why so much cash that's been on the sidelines is now getting back in the game and bidding up shares. But in the rush to conclude that stocks are cheap based on a future earnings recovery, we'd pause to consider the fact the contribution of credit growth to corporate profits and cash flows over the last fifty years-and the last ten especially.

And after we consider the impact of the credit boom on S&P 500 earnings we'd say that corporate earnings are never going to be the same again. They may revert to the mean. But it will not be nearly as high as it was at the highs of the credit boom. It's undeniable that the expansion of the credit bubble and the advent of securitisation and derivatives led to a huge and unsustainable increase in the profits of financial firms-especially as a percentage of S&P 500 earnings.

Writing over at Hussman Funds in December of 2007, CFA William Hester showed that, "It's clear that without the contribution of the financial sector's wide profit margins, overall margins for the index [the S&P 500] wouldn't be nearly as stretched as they currently are."

"Over the past 25 years," he continues financial companies have earned a growing share of the total earnings in the U.S. economy, and the wide profit margins of the past few years has exaggerated that effect. At the bottom of the 1982 bear market, profits from the financial industry made up about 10 percent of GDP, while manufacturing earnings contributed more than 40 percent. The most recent data show that manufacturing's contribution has fallen by half, while the percent of financial profits contributed to GDP has tripled."

Hester also shows that, "The contribution from financial earnings to the overall S&P's margin quickened over the last few quarters, up until the most recent quarter... Margins in the S&P 500 Ex-Financials had already begun to flatten out in recent quarters, while margins for the financial group continued to increase. With a flat yield curve since 2005 and a U.S. housing market in decline since 2006, it was difficult to explain the level of financial profit margins earlier this year."

Of course the next four quarters after Hestor wrote that, the entire financial sector experienced an earnings collapse. That showed up in the shocking earnings performance of the S&P 500. Now, investors think that collapse must inevitably be followed by some sort of recovery. And maybe they're right.

But we'd suggest that financial stocks, along with insurance and real estate-related stocks, are not going to be reborn from the ashes of the credit bust to fly high again. The survivors in these particular industries (Goldman Sachs, for example) will recover and capture more market share. However, we reckon that the composition of S&P earnings is going to change in the next few years. And we reckon what investors are willing to pay for those earnings will return to trend as well.

It's possible that the S&P rally is the resurrection of the equity premium in stocks. But don't count on it just yet. The equity premium in stocks is based on an unsustainable expectation of corporate earnings and profits. People are staking a claim on national and corporate income that may never materialise.

The expectation of a 2007-level equity premium is unsustainable because there is still heap of deleveraging and asset write downs to go in the global financial system. The banks have fought these tooth and nail, aided by liquidity measures from their servants in the central banks of the world. Of course we're wrong about this we're going to miss some of this reality (although Gabriel is busy trading it).

However, we're not keen to buy the banks and financial stocks just yet. We reckon the bottom line is that corporate profit margins in the financial sector will never again be as good as they were in the last twenty years. Liquidity can't make up for a decade of bad investments.

If regulators introduce higher capital requirements and there is a reduction on the use of leverage in the financial system, it will simply mean lower average corporate profits for financial firms. That's clearly bad news for Wall Street. But it's not necessarily bad news for everyone else.

In the bigger picture, a restricting of national income and profits means that finance will be less important to the American and Australian economies and less profitable for the companies in those industries. But national income has to come from somewhere, unless national income itself experiences a net decline, which is also possible in a hyper-competitive world.

But assuming national income in English-speaking economies doesn't just disappear but is restructured to more productive enterprises that use capital more efficiently, the obvious question is: where will national income and profits come from, if not from the finance sector? Well that's a very good question!

Here in Australia, the national income is balanced between the financial industry (banks, insurance, real estate, funds management) and natural resources (capital intensive extractive industries). Both are experiencing some tough times. But one of the things we like about Australia is that the country has a meal ticket in the future. National income WILL be generated from the resource industry.

The big challenge for investors is to figure out who's going to claim the largest share of that income. You hope it will be the individual firms you put in your self-managed super or buy for your portfolio. But maybe it will be the Chinese. Who knows?

These are the issues we grapple with everyday at Diggers and Drillers (where lately we're on to lithium and tight gas) and that Kris Sayce grapples with at the Australian Small Cap Investigator (where he's on the unconventional LNG story in Queensland).

Of course we can't guarantee we're going to get the stock pick winners right. But as far as asset classes go-we'd much rather be looking at Australian resource stocks than U.S. government bonds. Resources are scarce. American government bonds, on the other hand, are multiplying faster than cockroaches.

The U.S. government is auctioning off another US$200 billion in debt this week, according to Min Zeng at Bloomberg. That's a lot of borrowing. We picture the future where Treasury Secretaries stand in expensive suits waiting in long lines, hoping for a meagre helping of capital from the world's savers.

"Please China, may I have some more," asked Timothy Twist.

Min reports that, "This week's auctions include a record $109 billion supply in two-year, five-year and seven-year notes, up from $104 billion in June and $101 billion in May. The government is also selling $90 billion in three-month, six-month and 52-week bills and $6 billion in 20-year inflation-linked securities, topping up an existing issue."

Strangely, Bloomberg is also reporting that real yields on U.S. Treasuries are at their highest inflation-adjusted level in fifteen years. We find this strange because the article suggests that Treasuries are helping investors beat inflation with great yields, even as the supply of Treasuries explodes on the U.S. borrowing binge. Bloomberg reports that the spread between yields on ten-year U.S. notes and the rate of consumer price inflation is 5.10%, whereas historically (for the last twenty years) it's been 2.74%.

Ah, now it makes sense. Because the government is lying about the rate of consumer price inflation, bonds appear to promise an attractive yield.

Australia, of course, is ramping up its own borrowing on the global capital markets. The Australian Office of Financial Management will hawk another $1.4 billion in government securities this week. Will this crowd out private borrowing? Does it threaten Australia's sovereignty by transferring power to foreign creditors?

These are some of the questions we plan to take up at this Friday's Debt Summit. We promise to report back. And tomorrow, as promised, more on Australia's rising net debt position.

Dan Denning
for The Daily Reckoning Australia

• England Sinks Deeper into Depression in Decade of Pain
• Macquarie Group (ASX:MQG) Profits Fall By 43%
• JPMorgan and Goldman Sachs Making Billions in Profits
• Crash, Depression, Hyperinflation – the Triple Crown of Financial Catastrophes
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year

A recent example from the British press: One of the first lottery millionaires punched a plumber and ended up in court, says The Telegraph. Michael Antonucci won 2.8 million pounds in 1995. But he "blew his entire fortune," reported the paper last month. Now he's reduced to stiffing tradesmen. The amount in dispute was just 400 pounds, what he was billed for a "gigantic ceiling mirror fitted above a whirlpool Jacuzzi." He had the mirror installed when he was still flush. Now that he's broke, he can't pay...hence the altercation.

The phenomenon is little different when it happens on a national or even imperial scale. Any money that you don't earn is stimulus. Without the sweat of honest toil on it, money seems to play a pernicious role in history. There are no examples - none - where it produced genuine prosperity. Instead, when a nation suddenly runs into some easy cash, it is soon spending more than it can afford...and getting into trouble.

The Roman Empire is in some measure a stimulus story. It conquered. It grew. Each conquest brought more booty...gold, silver, land and slaves. And each led to more conquests, which brought forth more booty. But the stimulus of this booty stimulated only the need for more stimulus. It did not stimulate real prosperity. Instead, it undermined it. First, slaves bought by rich landowners destroyed the free labor market and ruined small farmers. And then, imported wheat from the provinces - paid as tribute - put the large-scale farmers out of business too. Italy was then dependent on foreigners for its food.

In the first century AD, Roman conquests reached the point of diminishing returns; the stimulus came to an end. But borders still had to be protected. And Roman mobs, made up of displaced small landowners and out-of-work laborers, needed bread and circuses which drained the Treasury.

The first financial crisis of the imperial period came early. Caesar Augustus tried to solve it...with more stimulus. Neither paper money nor the printing press had yet been invented. So, Augustus increased the money supply in the only way he could; he ordered slaves in the silver mines in Spain and France to work around the clock! This extra money did not bring prosperity; it caused price inflation. In a period of about three decades, Rome's consumer price index almost doubled. Then, when output from the mines could be increased no further, Augustus's great nephew, Nero, found a new source of stimulus; he reduced the silver content of the coins. This source of stimulus proved ineffective, but enduring. By the time barbarians took over, the silver denarius contained almost no silver at all. Of course, Rome itself was played out too.

Another early and dramatic example of stimulus-in-action came in Spain in the 16th century. The conquistadors increased their supply of money in the time-honored fashion - by stealing it. Galleons brought treasure from the Americas; increasing the Spanish money supply substantially and fatally. The Spaniards had so much stimulus that they laid down their tools. Why should they work? They could buy things.

The discovery of a whole mountain of silver - Potosi - in the middle of the 16th century insured a supply of stimulus that would last for nearly a century. Results? Predictable. Inflation. In the "price revolution" from 1540 to 1640 the cost of living went up throughout Europe. In England, for which we have the most reliable data, prices went up 700%. And Spain, though it covered 40% of its state budget with this easy cash, still defaulted on its debts about once every 15-20 years, from 1557 for the next 10 decades. Spain, like Rome, welcomed stimulus; it never recovered from it.

Now we turn to the biggest misadventure in stimulus ever - the period after the United States 'closed the gold window' in 1971. In the 150 years before then, nations could stimulate their own economies with cash and credit, but only to a point. They could overspend; but they had to settle up in gold. After 1971, on the other hand, the sky was the limit - especially in the United States of America. The US could settle its bills in paper, which was then used by foreign central banks as monetary reserves. Since foreign banks were eager to add to their supplies of reserves, there was no effective limit on the amount of stimulus available. The Fed's adjusted monetary base grew 900% since 1985, and more than doubled this year alone. Total US debt tripled - as percent of GDP.

As it did with Rome and Spain, more and more stimulus stimulated spending and speculation, but not real output. During the 2001-2007 period, for example, credit in the United States increased by $22 trillion. The nation's GDP increased only by $4 trillion. For every extra dollar of output, Americans took on $5.50 of debt.

But now the bubble has blown up; the feds are on the case. What do they offer? More stimulus! Cometh a report this week that $23 trillion has already been put at risk in the various bailouts and credit guarantees. As for the US public debt, it is expected to increase until the country goes broke.

Future economic historians will look at these staggering efforts with awe and wonder; they will wonder what the Hell we were thinking.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

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Let's first set the record straight on Herbert Hoover's fiscal policies. Contrary to what you have heard and read over the last year, Hoover behaved as a textbook Keynesian after the stock market crash. He immediately cut income tax rates by one percentage point (applicable to the 1929 tax year) and began ratcheting up federal spending, increasing it 42 percent from fiscal year (FY) 1930 to FY 1932.

But to truly appreciate Hoover's Keynesian bona fides, we must realize that this enormous jump in spending occurred amidst a collapse in tax receipts, due both to the decline in economic activity as well as the price deflation of the early 1930s. This combination led to unprecedented peacetime deficits under the Hoover Administration-something FDR railed against during the 1932 campaign!

How big were Hoover's deficits? Well, his predecessor Calvin Coolidge had run a budget surplus every single year of his own presidency, and he held the federal budget roughly constant despite the roaring prosperity (and surging tax receipts) of the 1920s. In contrast to Coolidge-who was a true small-government president-Herbert Hoover managed to turn his initial $700 million surplus into a $2.6 billion deficit by 1932.

It's true, that doesn't sound like a big number today; Henry Paulson handed out more to bankers by breakfast. But keep in mind that Hoover's $2.6 billion deficit occurred because he spent $4.6 billion while only taking in $2 billion in tax receipts. Thus, as a percentage of the overall budget, the 1932 deficit was astounding-it would translate into a $3.3 trillion deficit in 2007 (instead of the actual deficit of $162 billion that year). For another angle, I note that Hoover's 1932 deficit was 4 percent of GDP, hardly the record of a Neanderthal budget cutter.

The real reason unemployment soared throughout Hoover's term was not his aversion to deficits, or his infatuation with the gold standard. No, the one thing that set Hoover apart from all previous US presidents was his insistence to big business that they not cut wage rates in response to the economic collapse. Hoover held a faulty notion that workers' purchasing power was the source of an economy's strength, and so it seemed to him that it would set in motion a vicious cycle if businesses began laying off workers and slashing paychecks because of slackening demand.

The results speak for themselves. During the heartless "liquidationist" era before Hoover, depressions (or "panics") were typically over within two years. Yes, it was surely no fun for workers to see their paychecks shrink quite rapidly, but it ensured a quick recovery and in any event the blow was cushioned because prices in general would fall too.

So what was the fate of the worker during the allegedly compassionate Hoover era, when "enlightened" business leaders maintained wage rates amidst falling prices and profits? Well, Econ 101 tells us that higher prices lead to a smaller amount purchased. Because workers' "real wages" (i.e. nominal pay adjusted for price deflation) rose more quickly in the early 1930s than they had even during the Roaring Twenties, businesses couldn't afford to hire as many workers. That's why unemployment rates shot up to an inconceivable 28 percent by March 1933.

"This is all very interesting," the skeptical reader might say, "but it's undeniable that the huge spending of World War II pulled America out of the Depression. So it's clear Herbert Hoover didn't spend enough money."

Ah, here we come to one of the greatest myths in economic history, the alleged "fact" that US military spending fixed the economy. In my book I relied very heavily on the pioneering revisionist work of Bob Higgs, who has shown in several articles and books that the US economy was mired in depression until 1946, when the federal government finally relaxed its grip on the country's resources and workers.

Sure, unemployment rates dropped sharply after the US began drafting men into the armed forces. Is that so surprising? By the same token, if Obama wanted to reduce unemployment today, he could take two million laid-off workers, equip them with arm floaties, and send them to fight pirates. Voila! The unemployment rate would fall.

The official government measures of rising GDP during the war years is also misleading. GDP figures include government spending, and so the massive military outlays were lumped into the numbers, even though $1 million spent on tanks is hardly the same indication of true economic output as $1 million spent by households on cars.

On top of that distortion, Higgs reminds us that the government instituted price controls during the war. Normally, if the Fed prints up a bunch of money to allow the government to buy massive quantities of goods (such as munitions and bombers, in this case), the CPI would go through the roof. Then when the economic statisticians tabulated the nominal GDP figures, they would adjust them downward because of the hike in the cost of living, so that "inflation adjusted" (real) GDP would not look as impressive. But this adjustment couldn't occur, because the government made it illegal for the CPI to go through the roof. So those official measures showing "real GDP" rising during World War II are as phony as the Soviet Union's announcements of industrial achievements.

If the Keynesians rely on bad economic theory, and misleading history, to justify their calls for huge government deficits, the Chicago School monetarists are hardly better when they call for interest rates at zero percent (or even negative!) and blame the Depression on the Fed's lack of willpower.

In doing research for the book, what I noticed is that from the time it opened its doors in November, 1914, all the way through 1931, the New York Fed charged its record-low rates at the very end of this period. The "discount rate" was the interest rate the Fed banks would charge on collateralized loans made to member banks. For the New York Fed, rates had bounced around since its founding, but they were never higher than 7 percent and never lower than 3 percent, going into 1929.

This changed after the stock market crash. On November 1, just a few days following Black Monday and Black Tuesday-when the market dropped almost 13 percent and then almost 12 percent back-to-back-the New York Fed began cutting its rate. It had been charging banks 6 percent going into the Crash, and then a few days later it slashed by a full percentage point. Then, over the next few years, the New York periodically cut rates down to a record-low of 1_ percent by May 1931. It held the rate there until October 1931, when it began hiking to stem a gold outflow caused by Great Britain's abandonment of the gold standard the month before. (Worldwide investors feared the US would follow suit, so they started dumping their dollars while the American gold window was still open.)

So far my story doesn't sound unusual. "Everybody knows" that the Fed is supposed to slash rates to ease liquidity crunches during a financial panic. It helps to ease the crisis, and provides a softer landing than if the supply of credit were fixed.

But guess what? Throughout the period we are considering, the highest the New York Fed ever charged banks was 7 percent. And the only time it did that was smack dab in the middle of the 1920-1921 depression.

Although you've probably never heard of it, this earlier depression was quite severe, with unemployment averaging 11.7 percent in 1921. Fortunately it was over fairly quickly; unemployment was down to 6.7 percent in 1922, and then an incredibly low 2.4 percent by 1923.

After working on these issues for my book, it suddenly became obvious to me: The high rates of the 1920-1921 depression had certainly been painful, but they had cleaned the rot out of the structure of production very thoroughly. The US money supply and prices had roughly doubled during World War I, and the record-high discount rate starting in June 1920 was a pressure washer on the malinvestments that had festered during the war boom.

Going into 1923, the capital structure in the United States was a lean, mean, producing machine. In conjunction with Andrew Mellon's incredible tax cuts, the Roaring '20s were arguably the most prosperous period in American history. It wasn't merely that the average person got richer. No, his life changed in the 1920s. Many families acquired electricity and cars for the first time during this decade.

In contrast, during the early 1930s, the Fed's rate cuts "for some reason" didn't seem to do the trick. In fact, they sowed the seeds for the worst decade in US economic history.

It's actually easier to see what's going on if you forget about a central bank, and just pretend that we were living in the good old days when banks would compete with each other and there was no cartelizing overseer. Now in this environment, when a panic hits and most people realize that they haven't been saving enough-that they wish they were holding more liquid funds right this moment than their earlier plans had provided them-what should the sellers of liquid funds do?

The answer is obvious: They should raise their prices. The scarcity of liquid funds really has increased after the bubble pops, and its price ought to reflect that new information. People need to know how to change their behavior, after all, and market prices mean something.

But in more modern times, thanks not just to Keynes but more important to Milton Friedman, central bankers now think that during the sudden liquidity crunch, they are supposed to shovel their product out the door. But in order to do that, of course, they have to water down its potency. It's as if a wine dealer suddenly has a rush of customers for a rare vintage of which he only has 3 bottles, and his response is to put the vintage on sale but then dilute it with 9 parts water to 1 part wine. That way he can sell to all the eager customers and not pick their pocket at the same time.

Let's try a different example: If the owner of a trucking company experiences a huge rush for his services, he might decide to postpone essential maintenance on his fleet, to take advantage of the unprecedented demand. But during this period he will be charging record shipping prices to make it worth his while to deviate from the normal, "safe" way of running his business. He will only be willing to bear the extra risk (either to the safety of his drivers or just the long-term operation of the trucks) if he is being compensated for it.

The same is true for the banks. Just as every other business during a recession wants to bolster its cash reserves, so too with the business that rents out cash reserves. If there's a hurricane, the stores selling flashlights and generators should raise the prices on those essential items, to make sure they are rationed correctly. The same is true for liquidity, the moment after the community realizes they are in desperate need of it.

Regards,

Robert P. Murphy
for The Daily Reckoning Australia

• Herbert Hoover Watched the Depression Unfold
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• Great Depression Survival Guide, Part II