But we completely forgot about Dubai. It came up yesterday in conversation briefly with our colleague here in New Zealand under the topic: greatest misallocations of credit in history. We were talking about the wisdom of turning oil money into indoor ski slopes in the desert.

Today, however, we'll be talking about whether Dubai could default on its debt. German, French, and British stock markets were all down over three percent overnight. The worry in markets is that Dubai could delay its debt payments. It would, according to Bloomberg, be the biggest sovereign debt default since Argentina in 2001.

Dubai World - the group that built an island shaped like the world - has $59 billion in liabilities. It has sought a "standstill" agreement from creditors. That includes $3.52 billion in bonds due on December 14th, which according to our calendar is in a couple of weeks or so.

Dubai World has assets all over the world. It has casinos in Vegas and banks in London and luxury goods stores in New York. Presumably it has assets it could liquidate to pay some of the debt. But there's a lot of debt.

Bloomberg reports that Dubai borrowed nearly $80 billion over a four-year period. That borrowing - made possible in a way by the income stream from energy exports and rising energy prices - went straight into one of the worlds more impressive and outrageous property booms. But the bust has wiped nearly 50% of property values in Dubai and now this, the risk of sovereign debt default.

And suddenly the move into short-term U.S. Treasuries looks understandable, if not sensible. Emerging markets sold off on the Dubai news. And in the scheme of things, if you're going to own sovereign debt risk at the moment, perhaps 90-day U.S. paper will cause you the least anxiety. It's not a major commitment either (thirty years, for example).

How all this plays in Australia today will be interesting. We notice that Australian Small Cap Investigator editor Kris Sayce has trailing stops triggered on three positions over the last two days. Kris is taking profits on energy stocks mostly. The virtue of the trailing stop - other than turning a paper gain into a real profit - is that it makes the decision to sell a lot less emotional. If the stock hits your stop, you hit the sell button and take your money off the table.

However we're assuming the selling momentum in the market will pick up. Wall Street managed to buck Europe's negative lead. The Dow managed to close up for the day. And in the currency market, the greenback rallied against a whole basket of currencies, from the Vietnamese Dong to the Brazilian Real to the South African Rand.

That's the kind of move - paired with the flight to sovereign bonds on the Dubai news - that could produce the dollar short-covering rally we wrote about several weeks ago. When so many people are short (especially with leverage) a short-squeeze can see huge moves in markets as investors and traders are forced to sell leveraged positions (emerging market stocks and high yield currencies) and repay their dollar loans before the currency gets much stronger.

Mind you, as we believe Voltaire once said, all paper currencies eventually reach their intrinsic worth. But between now and then, you might want to buckle yourself up for a powerful U.S. dollar rally. It will defy the fiscal and monetary fundamentals in America. But this market is not trading on fundamentals at the moment.

This mean's the Aussie dollar's march to parity against the greenback may be on hold. Even oil dropped off the pace a bit. Another round of global deleveraging would not bode well for economic growth, which would not bode well for oil. For now, only gold seems to be holding the line - perhaps because the demand for gold is not economic but monetary. December gold futures traded up over five dollars to $1,193.80.

Meanwhile, ominous sounds are coming from the U.S. banking industry again. The Wall Street Journal reports that in the third quarter, loans by U.S. lenders fell by the largest amount since the government began tracking such things. Loan balances fell by $210.4 billion, or 3%, according to the Journal.

This confirms the suspicion that banks aren't lending...at least not to businesses and consumers. Banks are, instead, lending to the U.S. government via purchases of short-term U.S. bills and notes. We dispute the idea that it's "risk free." But it probably beats new mortgage lending by a good margin. And some banks - already struggling to stay solvent - wouldn't be keen to put any more money at risk.

The Journal reports that, "The FDIC's quarterly banking profile, which analyzed data from 8,099 federally insured banks, reported that 552 financial institutions, with combined assets of $345.9 billion, were on the government's problem list at the end of September, up from 416 with $299.8 billion of assets at the end of June. That means roughly 7% of all U.S. banks are on the list and face a higher probability of failure."

That is not a misprint.

It is, however, a warning. The GFC isn't over. The FDIC story is about a coming American banking crisis. But it will surely affect global liquidity, which makes it an Australian story too.

The Fed began inflating the bond market a year ago with its planned purchases of Treasury bonds and agency debt. By telegraphing its intention to support bond prices, it fed the bond bubble. This pushed U.S. interest rates even lower, which made borrowing dollars to buy other things all the rage.

And 2009 has been all about the rage. Borrowed dollars have bid up assets all over the planet yet again. The debt side of the balance sheet has not been appreciably shrunk, meanwhile. Asset quality at banks has not notably improved. And national governments have actually gone the other way, expanding their liabilities to try and plug the spending gap in the economy left by the departure of consumers from the field.

Here we are at the end of the November, with the whole leveraged financial economy seemingly at another Lehman - like moment. The cost of insuring sovereign debt against default is rising in the Middle East. Investors are tallying up the year's profits and deciding enough is enough. It's time to sell and buy some gold and government bonds.

Is this a case of post-Lehman jitters? Is it a minor aftershock to the major temblors of the last two years? Or is it a sign of the "big one" to come? It's hard to imagine financial events can get any bigger or worse than during the last few years. In fact, we can think of only one, the Great Depression. It's beginning to look awfully familiar.

Dan Denning
for The Daily Reckoning Australia

• Dubai, Built on Debt and Sand
• Dubai Debt Story More Like Bear Stearns Less Like Lehman Brothers
• A Sovereign Debt Crisis Bullish for U.S. Dollar and Bearish for Gold
• It All Comes Down to Debt Again for NAB
• U.S. Bonds Better than Greek or Other Sovereign Bonds

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

• Renting Apartments in Paris
• 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

"Huh?" We looked around to try and spot the little green devil. He's been in our ear before. But he was nowhere to be found. We could still hear his voice.

"Think about you fool. It is now safe to be dogmatically bearish on the front page of the newspapers. The hedge funds have been forced to liquidate. The mob followed on the fund industry's heels, sold everything, and headed for the hills. The hills are full! Can't you see what this means?"

"No."

"The selling has exhausted itself for the year you moron! Roubini recommends a $400 million stimulus package. It's a sign. The liquidation of the long commodities/short dollar and yen trades has got to be nearly over. The moves in the currency markets have been massive. It can't go on. And if it does...well if it does then this is the second Great Depression and you'll have other things to worry about."

But what if you're wrong?

"Then I'm wrong. If you're going to be in the equity markets at all for the next year, you should own the world's best businesses. You're not going to see them this cheap again for awhile. If you don't want to own theses businesses, why bother being in the market at all?"

God may not whisper in everyone's ear. But we find daemons more than willing to have a chat, usually when our judgement is most in doubt. Still, we couldn't help following through the thoughts of our little green devil to their logical conclusion. And in his own way, he makes perfect sense.

Bob Prechter and the Elliott Wave theorists (if we're not mistaken) believe that 'social mood' is what determines the direction of the stock market. And the market then leads the economy. But what leads the social mood?

Well, that's a tough one. At the Border's on Chapel Street this weekend, we noticed that Bill Bonner and Lila Rajiva's book, Mobs, Messiahs, and Markets had moved up to number seven on the hardback best seller list. People are trying to understand why investors act like a flock of birds or a school of fish, all seeming to move in the same direction at once, without cause or explanation.

People are wacky. The great mistake of market analysts (and most socialists) is to assume that people are rational and make economic decisions after calm, rational calculation. This is a figment of the rational imagination.

People often take leave of their senses. And these days, it's hard to say just why some people are selling and no one is buying. As we've said here, we think it's the massive unwinding in leverage that's forcing stocks to be sold. There are simply not enough buyers to sop up all the selling (at least not until last night in New York, when some of that cash got back in the game).

It doesn't help that you have a slowing global economy and a credit crunch. When you combine all that, the social mood turns decidedly sour. The beer goes flat. The smoke, rather than being a pleasant cloud in the lungs and making everyone look sophisticated and cool, just burns the eyes.

What our little daemon told us yesterday, we think, is that the social mood couldn't possibly get any more sour. "Consumer confidence drops to record low," reports Bloomberg this morning. There was dust and tumbleweeds blowing through the markets this week. It was fast becoming a barren wasteland.

But yesterday in New York, the first intrepid investors popped their head out from above their fallout shelters. Squinting in the sun, they found that perfectly healthy world-class businesses were lying around in the street for the taking. They were taken. The Dow was up double digits.

Don't get us wrong. This still feels like the beginning of the 50% rally the Dow experienced in late 1929 and early 1930. But a man can take only so much depression in one quarter.

It is not hard to see a simultaneous round of global interest rate cuts, a massive stimulus package in the U.S., and the election of Obama in the States (did somebody say Messiahs?) as just the things to turn the social mood around. And that's what makes for a rally.

An improvement in the social mood won't do much to improve the structural causes of the mess we're in. FedEx CEO Fred Smith was recently interviewed in the Wall Street Journal. He made some fantastic points about why we are where we are...and how to get out of it.

"Things became so flipped upside down," in the financial economy. "The assets at these banks became the liabilities and the liabilities became the assets. These people were making these fantastic returns at places like Fannie Mae and Freddie Mac but in reality they weren't adding a lot of value. I have said time and again that there is a fundamental tendency in good times in the financial sector to over-leverage. Our national policies actively encouraged all this debt."

Smith points out that Anglo-Saxon capitalism favours speculation over actual capital accumulation and production. It does this through a tax policy and monetary policy. The corporate tax rate in the U.S. is 38%, compared to 25% in Germany. When you throw in loose monetary policy-money available at cheap rates to borrow and speculate with-you see how a company like GE went from being a company that made things to a company that made loans.

If the regulators failed to restrict the amount of leveraging possible in the financial system, then corporate boards and CEOs equally failed. They took the easy way up, banking quick financial profits with borrowed money. They did not realise-or more likely ignored the fact-that leveraging financial returns with borrowed money is not a long-term business strategy. Leverage is the root of all our cotemporary financial evil.

The last two months have seen the collapse of leverage and the deflating of the credit bubble as money drains from the global financial system (faster than the Feds can pump it back in). The hedge funds are delivering. The banks, despite infusions of new capital, probably still have too much leverage. What's Paulson going to do about that? Hmmn.

In the meantime, you can be sure that there will be more corporate dirty laundry aired in the coming months. Unwinding that bank leverage may involve more selling of assets, perhaps to the government at an artificially high price (or to sovereign wealth funds and private equity if market prices prevail). The credit crisis, though improved, is not entirely over. More bad debts from mortgages loom on the horizon. And Europe faces trouble from emerging market debt.

But for now, the social mood seems to have lightened. How long will it last? We'll ask our green devil if he shows up again. We'll see if we can get him to tell us what he's buying, between drinks of champagne.

Dan Denning
for The Daily Reckoning Australia

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