Yesterday, it touched a new record - $1,050 - even as the dollar rose, oil slumped under $70 and stocks dipped very slightly.

Well, what do you expect? The United States added $1 trillion to its monetary base in the last year or so. The federal government is running a deficit of $1.7 trillion this year. And along comes Barack Obama with an idea to stimulate employment - spend more money! This time, Obama's plan is a kind of 'Cash for Workers' program...in which businesses get a tax credit for hiring new employees.

Gold investors must think the new program will be the straw they've been waiting for. Government has piled on bales of costly new initiatives on this poor camel's back. Still, he stands up straight.

So, is gold at $1000 a bargain...or a trap? Or both.

We begin by asking: where's the inflation? We don't see any inflation. What we do see is deflation.

Barclays Capital says gold could go to $1,500. We don't know where they got that number. It could go to $15,000 for all we know. Or it could go down, too.

Our guess is that it will go down enough scare the bejesus out of speculators. Then, it will soar.

But, hey, we're just guessing - along with everyone else.

Sooner or later gold is probably headed to the lunatic moon. We're sticking with the yellow metal. We don't want to miss that ride.

But when?

Ah...we're going to stick our necks out and say "eventually." We're sure we're right about this. Just don't ask us for more precision; we have none. And what bothers us is that between eventually and now there could be a lot of time and a lot of trouble. And one trouble that could come up pretty fast is another crash in the stock market.

If the stock markets of the world take another dive...like they did last year...gold will probably go down with them. Not as much, but down nonetheless. So, if we were speculating...we'd probably be short gold and short stocks too. We'd bet against bonds too - even though we think they will probably go up in the short run. The smart, long term money - in both stocks and bonds - is probably on the short side.

Here at The Daily Reckoning, however, we never speculate - except in print. As to ideas about how the world works we have plenty. We speculate daily. As to gold, stocks and commodities, we prefer to hold onto our long-term positions.

What seems fairly sure to us is that this recovery is a fraud. It's a mountebank and a flimflam.

And now approaches a moment of truth - earnings announcements. Stock market investors bid up shares on the theory that sales and profits would rise. Will they? We don't think so.

We think sales are going to be disappointing...and earnings will be even worse. If so, we'll see analysts begin to change their expectations...and announce that the results are "not as bad as expected."

If we get a few really bad announcements - with results much worse than expected - it could sink the rally. Then again, if we're surprised with exceptionally good reports...it could send the market in the other direction.

Good results will also cause us here at The Daily Reckoning to question our position. Maybe the economy is not sinking into a chronic depression, after all. Could we be wrong?

Ha ha...are you kidding, dear reader? Of course, we can be wrong. When we were younger we were uncertain about things. But now that we're older, we're not so sure.

Here is what we're pretty sure about:

1) The credit cycle has topped out.

Americans are saving - think of the poor boomers, 10 years older but not a penny richer than they were in 1999. Stocks have gone nowhere but down in real terms. Houses hit a high in 2006...now, they're off 30%...and still going down. Jobs? Forget it...there are already 15 million people who are unemployed and about 200,000 more every month. The job market is unlikely to recover for another 6-13 years - that is, after many of the boomers are retired! And if you are lucky enough to have a job, you're not likely to get a raise...not with so much spare capacity in the labor market.

Under those conditions, a consumer boom is very unlikely.

2) We know that a period of credit contraction is deflationary.

Prices go down as demand falls. Buyers disappear from the malls that once knew them, while the factories that produce stuff grow dusty and quiet.

But we know the feds hate falling prices. And we know they are taking extraordinary actions to get prices to go up. So far, their efforts have been a giant flop. Prices are falling in the United States at the fastest pace since the '50s.

Most of the feds' efforts have been directed towards keeping the bankers fat and happy...and getting themselves a bigger share of America's output. They took funds designed to relaunch the US economy, for example, and used them to buy themselves a big position in the auto industry, the financial industry and the insurance industry.

3) We know too, by the way they conducted themselves in those affairs, that the feds have become much more aggressive...throwing their weight around in the private sector as never before.

What we don't know is how this affects markets in the short term. So far, consumer prices are falling, but the stock market is enjoying a bounce. It is a real, new bull market? Or just a bear market bounce? It is probably a bear market bounce...but it has been going for long enough that we have to at least consider the idea that it is a genuine bull market. That's why the numbers from this quarter are important...they'll tell us if the companies themselves are expanding earnings fast enough to justify investors' optimism.

4) We know too that there is a whole lot of 'flation going on.

We are just unable to tell you what kind of 'flation it is. The monetary base is way up - it increased by $1 trillion in the last 12 months. But the money-in-circulation has barely budged. The feds give the banks overnight loans at practically zero interest. Then, the banks lend it back to the feds at nearly 4% more.

What happens to it then? Well, what do you think...it is wasted on typical federal government scams and humbugs.

So, relatively little of the money actually ends up in the consumer economy. And so, we can't tell you whether the 'flation will have a 'in' prefix or a 'de' prefix. They're just two letters. But they will make a whole alphabet of difference to the economy and to your investments.

5) Most important, we are dead sure that the people running America's financial policies are jackasses.

We say that with all due respect, which is probably not much. They have only one idea - and it is a bad one. They think economies are improved by more consumer spending. They don't seem to care why consumers occasionally cut back on their spending. All that matters to them is finding ways to get the consumer shopping again. So they try tax cuts and government spending...bailouts and boondoggles...zero interest lending and federal takeovers...cash for clunkers, cash for houses, cash for employees....

..trillions worth of claptrap and folderol. But what a nuisance! The fool consumer still won't shop!

But they're determined to keep trying. That's why we can be pretty sure that, eventually, they'll get inflation rates up. One way or another. And then, gold at $1000 will seem like an outrageous bargain.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Is Gold Going Up Because People Fear Inflation?
• Gold is More Like a Religion or a Political Position
• Feds’ Plan is to Reflate the Economy
• Markets Rise While the Economy Sinks
• The Economy is Getting Worse Not Better

Harassing us!

Recall that last week, we reported the latest news on the SEC. Investigators wondered why the agency had let Madoff run billions in suspicious trades without ever checking them out. The SEC responded by saying it lacked sufficient resources. Then, New York Senator Schumer said he would propose a measure to increase the agency's spending power by 75% - by allowing it to shake down the financial industry directly, rather than going to Congress for a budget allocation.

Which still leaves open the question of what the SEC was doing when it should have been making Madoff do the perp walk. We have the answer: the SEC was harassing us.

Yes, hard to believe that they would target your poor, innocent editor. And they didn't, not directly anyway. Instead, they targeted one of our colleagues. This was a couple of years ago...when Bernie Madoff was at the top of his game.

We haven't mentioned it in this space...on the advice of our lawyer. Judges don't like it when you "try a case in public." And the case still isn't settled.

But we won't discuss the merits of the case...only the circumstances around it.

This will help us understand what the SEC is really up to...and why the hope of regulating fraud out of existence is as vain and futile as trying to clear out a bar by using foul language.

Here's what happened. One of our researchers discovered what he thought was a great investment opportunity. He called the target company and spoke to a VP in charge of public relations. What he heard convinced him that he was on to something, so he published a recommendation, sending a copy of it immediately to the company.

He got no response from the company. But a few months later, the SEC knocked on our door. What was their beef? That we had misled investors. How so? In our report, we told readers what the VP had told us. We carefully called it "insider" information...putting the word in quotes to let readers know it wasn't the same as the forbidden 'inside information.' Anyone could have found out the same thing if he had just called the company, read the published reports, and put two and two together.

Our caution was lost on the SEC. They didn't see the difference between "insider" information and inside information. What's more, the fellow at the target company denied he had said what he had said. Curiously, he made no objection when the report was published; the objection came after the SEC started snooping around.

The SEC wanted blood. They thought they could get an easy win against a little guy in Baltimore. They wanted us to turn on our own associate...to stop defending him and cop a plea. Obviously, we couldn't do that. We stood behind our man.

Then came a quirky turn of events. Both the researcher and your editor's company were charged with what was effectively a new crime - a federal case, no less. The SEC, remember, is supposed to be protecting investors from stock fraud, manipulation, and 'insider trading.' But there was never any allegation of manipulating a stock or insider trading. Instead, the agency charged us with NOT having inside information. We never traded in the stock at all...or manipulated it in any way. So the feds alleged that we did not have any inside information to trade on...and that therefore our representation - of having "insider" information (in quotes!) - was a kind of fraud.

And the whole case turned on a telephone conversation between a stock market analyst and a public relations guy in a company. One said one thing; the other said another thing. Reporters make mistakes all the time; so do their sources. But this was the first time the government made a federal case out of it.

We believe our analyst. The SEC believed the other guy and spent millions trying to prove that our fellow lied. No one who bought the research report on the stock complained, let alone threatened a lawsuit. Prior to any SEC probe, refunds were issued to anyone who asked (most did not). Yet the SEC, protector of the public interest, spent years...and millions...on the case - while Bernie Madoff was stealing billions from his clients.

Case against your editor's company: judges ruled that we were innocent.

Case against our colleague: still undecided at the appeals court.

Case against SEC: guilty of negligence, dereliction and humbug.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Madoff Astonished SEC Didn’t Verify His Claims
• Rising in Defense of Goldman Sachs
• Social Security a Bigger Scam Than What Bernard Madoff Schemed
• Real Estate Brokers: The Latest Victims of the Housing Crunch
• Bernie Madoff and the SEC

The "old normal" is the way things were before they fall apart. Nearly everyone would like to believe that nothing has changed all that much since September of 2007. Sure, there was a massive stock market crash and a serious blow to confidence in the global financial system. But all of that is ancient history!

In the "old normal" view - preached by politicians left and right and amplified by a compliant media and a smarting financial industry - you should go back to doing what you were doing before. Have a short memory. Buy stocks automatically because they always go up. Get a mortgage and buy a house, perhaps even a second one. Spend money. The government will make more.

There are some key problems with the old normal. These problems were exposed in the last two years. But they are being swept under the proverbial rug of rising stock prices. Those problems include too much household debt, unaffordable house prices, and an entire economy geared to consumption over production.

But all that is changing, says Bill Gross of PIMCO. In his latest note to clients, Gross says we have entered a world of slower growth. This makes sense to us, given what we said earlier this week. The growth in the world's GDP over the last twenty years has been boosted by cheap credit and cheap energy.

Those two forces accelerated the depletion of natural resources. And with cheap credit anyway, you saw the birth of securitisation and dervitisation, in which bundles of debts became tradeable assets, sold to investors by Wall Street firms (which then loaded up on these assets relative to equity with leverage, sowing the seeds of their own share price demise).

Gross says we are entering the era of DDR - deleveraging, deglobalisation, and re-regulation. He writes that, "All of those three in combination, to us at PIMCO, means that if you are a child of the bull market, it's time to grow up and become a chastened adult; it's time to recognize that things have changed and that they will continue to change for the next - yes, the next 10 years and maybe even the next 20 years."

"We are heading into what we call the New Normal, which is a period of time in which economies grow very slowly as opposed to growing like weeds, the way children do; in which profits are relatively static; in which the government plays a significant role in terms of deficits and reregulation and control of the economy; in which the consumer stops shopping until he drops and begins, as they do in Japan (to be a little ghoulish), starts saving to the grave."

If Gross is right, what does this mean for Australians? For starters, there is the danger that growing government deficits could push up interest rates. If Gross is right, larger government deficits could become a staple feature of the economy. If the Australian government insists on maintaining its stimulus measures, we're pretty sure it will push interest rates up.

Treasury Secretary Ken Henry disagrees, probably. In a recent speech, Henry said that even though global capital flows between developing and industrialised countries were rebalancing in favour of the developing world, Australia might see a net increase in capital flows because it's such a nice place to invest in. If that were the case, interest rates would remain low as global capital poured into Aussie assets, including the dollar and all that debt being sold by the Australian Office of Financial Management.

Maybe the Secretary is right. But yesterday's trade figures would give us a bit of fright. Australia reported a$1.55 billion goods and services deficit in July. It was the highest deficit in the last 14 months and nearly three times the size of the June figure. But what does it really mean?

Well, it means the government stimulus kept people spending, whether it was good for them or not. This led to a 4% increase in imports and a decline in exports (in both volumes and dollar figures). There were two interesting nuggets in the data one big takeaway.

The first nugget is that capital goods imports were up by 5%. This isn't a bad thing. If you can turn new capital goods into new production and profits and employment, it's actually pretty good, although it does contribute to the deficit. The second nugget is that petroleum products imports were up by 21%.

Australia is well on its way to becoming a chronic net importer of refined fuels. When you couple this with declining domestic oil production, you get a country that is highly dependent on oil imports, which is not a good place to be. Here's a thought: why not convert Aussie cars to LPG and use some of that massive new gas from Gorgon to power Aussie cars for the next 50 years?

The big takeaway is that the economy is achieving growth in the same "old normal" way, with consumer spending on imports exceeding the volume and value of Australia's mineral and metal exports. It's astounding. The "old normal" way of thinking is still firmly in place.

Gross says that, "Our world, and the world's world, is changing significantly, leading to slower growth accompanied by a redefined public/private partnership." But he points out that the slower growth might be better for some countries than others. Gross reached five "strategic conclusions" which you'll find below.

1. Global policy rates will remain low for extended periods of time.
2. The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.
3. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.
4. Asia and Asian-connected economies (Australia, Brazil) will dominate future global growth.
5. The [U.S.] dollar is vulnerable on a long-term basis.

There is some good news and some bad news in those conclusions for Australia. The good news? Gross reckons Asia-connected commodity producers are going to benefit from "future growth." And the bad news?

We reckon there will be an interval between the old normal and the new normal. Call it the "new bad," after the first bad of the last eighteen months. This "new bad" will see a second round of falling asset prices and lower growth as government stimulus plans falter and companies and households are forced to engage in more re-balancing of the balance sheet. And frankly, it looks like it's starting this month.

Gold moved back up near US$1,000 overnight. This is one indication that risk-averse assets might start getting a bid again in the "new bad." And we might even see another strange period of U.S. dollar strength on deep pessimism about global growth. But that is far too complicated to explain in the little space that's left this Friday. So we'll leave it to Monday! Until then...

Dan Denning
for The Daily Reckoning Australia

• We Do Not Live in Normal Times
• New Trend in the Market: Sell Bonds and Buy Commodities
• US Dollar is Getting Trashed
• Keynesian Economists Bluff in Global Economic Gamble
• Unemployment Rate at a Five Year High

The prevailing opinion is that quick action by the feds avoided a more serious meltdown. Ben Bernanke says he was working to prevent a "second Great Depression."

And now that the crisis is past, the economy is slowly climbing out of its hole. The second quarter showed GDP falling at 1% per year in the United States...rather than the 6.4% rate recorded earlier in the year. Housing sales have perked up. Oil is trading above $71 - a sign of renewed economic activity. And gold seems to be getting ready for another assault on the $1,000 mark - a sign of growing inflation pressures.

At least...that's the way the world sees it.

Here at The Daily Reckoning, we look...we squint...we wipe the fog off our glasses and try to tear the scales off our eyes. What do we see? We see a financial world gone mad.

Or, perhaps we should say...a financial world that has still not recovered from the Bubble Madness of 2002-2007.

One bubble begat another. We have previously reported that the Bubble Era was over. Because the machinery that made it possible - the bubblelized financial industry - was broken. Well, we were only half right. The finance sector has exploded. Bear Stearns was sold for peanuts. Lehman Bros. went broke. Merrill was forced into a shotgun wedding with the Bank of America; with Hank Paulson holding the firearm. JPMorgan is still in business. So is Goldman. But now we know that even Goldman might have gone under if Paulson - ex-Goldman man - had not engineered a stealth bailout. He brought the feds in to save AIG, and in the process he saved his old alma mater too...AIG's biggest trading partner, Goldman Sachs.

And now Goldman is in the news almost every day. It reported spectacular trading results for the quarter, lifting the entire world stock market. What's good for Goldman must be good for the whole world economy, investors reasoned.

Then it was reported that Goldman made its money in a variety of ways - none of which had anything to do with providing genuine service to the economy. Goldman made a fortune on the feds' own money raising, it came out. And then it came out ...Goldman was making billions by trading at lightning speed - clipping investors for fractions of pennies each time a transaction passed through the markets.

Goldman... Goldman... Goldman... The Italians think Goldman runs their country. They've got the top three posts in Rome...Premier Romano Prodi is an ex-Goldman guy. So is the headman at the Treasury. And the chief of the central bank, too.

They think Goldman is like a cult...a semi-secret society of insiders with the power to rule the country - surreptitiously. Like the free masons...the Jesuits...or the Illuminati.

Goldman has its boys in important posts in the United States too - but not at the same level as in Italy. Tim Geithner is not a Goldman graduate. Neither is Ben Bernanke. But both have plenty of input from ex-Goldman associates, colleagues and handlers.

We confess an interest - we have relatives working at Goldman. But we doubt that Goldman rules the world. Just look what they said and did over the last couple of years; they had no more idea of what was going on than anyone else. No, they don't rule the world...but they do manage to persuade it in their direction from time to time...

During the bubble years, they urged consumers, bankers, and investors to borrow...to speculate...and to ruin themselves. Naturally, Goldman made out like...well...like a bandit.

And now Goldman guys urge the government to ruin itself too. Yes, dear reader, the Bubble Era is not quite over. Now, there's a bubble in government debt. Here as well, Goldman makes money...like a bandit. The more the feds borrow...the more debt there is to buy and sell. And the more the feds stimulate...the more acts of reckless speculation there are to finance.

And the more money Goldman makes...the more politicians the firm is able to buy. Of course, they welcome campaign contributions.

And of course, Wall Street is spending record amounts in lobbying. But the real appeal is the lure of being able to join Goldman itself...of being able to spend some time in Washington...pushing business Goldman's way...and then cash in big by joining the firm and getting a piece of the action...

There are two big bubbles now. There is the familiar one in federal government debt. The other is the Peoples' Republic of China.

Andy Xie says China is a 'giant Ponzi scheme' fed by new investors hoping to get rich. Of course, the China story is an attractive one. China's growth rate is spectacular. Even in a worldwide financial meltdown...and the biggest depression since the '30s...China is still growing at greater than 8% per year - or so the figures tell us. New cities are still being built...at a breathtaking pace. Stocks on the Shanghai exchange are up 80% so far this year. China has the biggest pile of cash on the planet - $2 trillion worth. And it has more bright, well-educated engineers, accountants and economists than anywhere else... In fact, it has so many economists trained at Western universities, it is almost sure to blow itself up...

Maybe this is the Chinese Century. Maybe it is not. Either way, it seems inevitable to us that the Chinese bubble economy is going to pop. Banks are lending three times as much as they lent last year. You can't increase lending at that rate and still maintain credit quality - if there was any in the first place. A lot of buildings are going up that won't find tenants. A lot of factories are expanding that won't find customers. A lot of speculations are going on that investors will later regret. That's just how a bubble works!

Mr. Xie says, for example, that the cost of property in China is about the same as in the United States. But wait, the average income in China is only 1/7th what it is in the USA. How can the Chinese afford American prices? Well, they can't. They're all betting on the 'greater fool theory' - that they can pay any price, because some greater fool will come along and pay more. Trouble with that is that the Greatest Fool of All finally shows up...and then the whole structure collapses.

Barron's says that "The Greenback is Broken." True, the dollar has been losing ground as the stock market gains it. Yesterday, it took $1.44 to buy a euro.

"I was amazed at how expensive everything is in Paris," said son Will. "You go into a shop to buy a few groceries... You expect to pay about $12. Instead, the bill comes to $40. Or, you stop to have a cup of coffee and a croissant. It costs you $10. I don't know how you can afford to live in Paris."

Will lives in Buenos Aires...with frequent visits to in-laws in Florida...

"You know, it used to be so much cheaper to live in Buenos Aires than just about anywhere. But now, I think the prices are about the same as in Florida. Everything seems so cheap in Florida. And you can make some very good deals on property...

"Remember that house that I bought in 2006? You warned me not to do it. But right after I bought it people were coming to my door asking if they could buy it. One guy offered to write a check for $600,000. Then another guy offered $675,000. I began to think I really had something hot.

"Of course, then the market crashed. Now, I'm thinking of selling it for $300,000 - if I could find a buyer.

"But that's in South Florida...only about an hour up the coast from Miami. There are places in the US where things are really, really cheap. In Iowa, maybe, or Arkansas...or Michigan. You can get a nice house for less than you'd pay for a garage in Paris. From that standpoint...the US seems like the place to be. You can live so cheaply. And fairly well, but quality of life is another thing..."

The dollar is low...America is cheap. Barron's is probably wrong about the buck. It's not broken - not yet. Our guess is that it will rise when stocks crash this fall.

We've thought a lot about quality of life. It is not a constant, fixed thing we conclude....

There are only three main decisions you make in life - what you do; who you do it with; and where you do it. Typically, these decisions are made without much real thinking - which is probably the best way. They are not things that lend themselves to thought...but to feeling. Pity the more man who marries a woman after a prolonged and logical thought process. The poor sap is doomed. His head may be in the game, but his heart will drop the ball. The next thing you know, he will be in divorce court or therapy. Likewise, the decision about where you live is not one that is readily subject to logical analysis. You like a place because you like it... And you may like it for a variety of reasons that defy analysis. There's no accounting for taste, as they say.

Living in rural Iowa probably wouldn't suit us. We don't have the stomach for it. We couldn't draw enough nourishment out of such lean meat. We need more stimulation.

We like Paris for the street scenes. Everywhere we look, we see something we like to look at - people, buildings, shop windows, streets, bridges, and river boats. Same thing out here at our summer place. We work in an octagonal office that sits in the park. No matter what window we look out of, we see something that pleases us. A stone barn with a red barrel tile roof. Those big limousine cattle grazing in the field. And there's the house itself...a conglomeration of a fortified farm house from the middle ages with a Renaissance-style faux-chateau cobbled onto it in the 19th century. And there is our grandson...16 months old...playing in the gravel...

Wait - what's he doing? Uh-oh...he's eating the gravel.

Gotta run...

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Cheapest Place in the World to Live is the US
• Rising in Defense of Goldman Sachs
• JPMorgan and Goldman Sachs Making Billions in Profits
• Americans Have No Money to Spend Because They Already Spent It!
• Meredith Whitney and the Buy Recommendation on Goldman Sachs

Last November, Wachovia Bank of the Tar Heel State was worth more than $100 billion. Two weeks ago, it was worth $20 billion - after confessing a loss of more than $8 billion in the second quarter. Buy yo ho...last week it was back up to $37 billion.

What's going on? Well, many people will tell you that the banks are coming back. Don't believe it. The boom in finance is over, as the vast majority of our speakers at last week's Agora Financial Investment Symposium pointed out. Two more banks failed over the weekend - First Heritage of California and First National of Nevada.

In his speech at the Symposium last Tuesday, The Rude Awakening's Eric Fry quoted Charlie Munger, vice-chairman of Berkshire Hathaway:

"Include me out. A lot of rot has crept into the financial system...we've got plenty of scandals coming."

Even the survivors will never recover to the glory-days levels they had a year or two ago. That doesn't mean they won't have some spectacular bounces. As they say on Wall Street, even dead cats bounce. But it will be a very long time before the big banks enjoy the kind of profits they made back in 2003-2007 - when they made billions by lending to people who couldn't afford to pay it back.

Let us explain how the financial industry worked. A guy borrowed some money from some other guy who borrowed the money from some other guy who borrowed the money from the Fed at a lower rate than the going rate of consumer price inflation. Then, the lender booked a profit on the transaction and paid himself a bonus...while selling the loan on to someone else, whereupon both of them booked a profit and paid more bonuses. Then, the loan was packaged up with similarly infected credits, rated AAA by Moody's, and then sold on again - and again, everyone involved in the transaction, including the cleaning lady, booked a profit and got a bonus.

"The leveraged stupidity of the last few years was perpetuated by the ratings agencies," Eric explained to the 800+ attendees, "They wanted to quantify things that are unquantifiable. People did not really know what they were getting themselves into."

In the four years leading up to the credit crunch Wall Street's big banks paid themselves $250 billion in bonuses. It didn't seem to matter to anyone that the source of the wealth was largely a swindle...and that real profits would never be realized. Now, the banks are writing off the bad loans...and turning to the taxpayer for a handout. But no one has offered to return a bonus, as far as we know.

Of course, this is just the genius of modern Anglo-Saxon capitalism - the most capitalist institutions pay out their capital in bonuses. Then, when they get in a jamb, they turn to the taxpayer for relief. Of course, the taxpayer spent all his money too. He's lucky to be able to fill his gas tank - with a credit card! Which is why Hank Paulson is so eager to deceive the world. He knows that if the foreigners ever catch on to what a scam the United States is running, they'll stop lending it money. And then, Wall Street, Washington, and the lumpenconsumer himself are all up the creek.

"The common thinking among Americans is comparable to wearing a string bikini on a polar ice fishing expedition," quipped Eric, "look good until you perish."

"It's time to sell risk and buy caution."

The average lumpenhouseholder is getting whacked coming and going. Inflation smacks him on one side...and a deflationary slump wallops him on the other.

Page 3 of the weekend Financial Times presented two headlines:

"EDF raises electricity prices 17%" said one.

"Economy now contracting, analysts say," reported another.

How can a giant utilities company raise prices during a slump? Foreclosures are running at twice the rate of a year ago. And homeowners are finding it harder and harder to refinance. With mortgage rates rising and house prices falling, only 3% of homeowners qualify for refinancing, according to one estimate, as compared to 30% a year ago. House prices have fallen 10 months in a row. They're down 18%, according to Case/Shiller. And they're only about half the way to where they're going. That's Nouriel Roubini's guess. He says that ultimately, credit-related losses will swell to between $1 and $2 trillion, and that a recession will last at least a year.

The big market news last week was the fall of the price of oil. It fell to $122 by Friday. Has the black goo topped out? Maybe. But as we explained, the bubble in oil is not like the bubble in tulip bulbs or dot.coms. Oil is probably the most essential commodity in the modern world. And as near as we can tell, the number of people who want it is going up, while the amount of it readily available for sale is going down. It might go up. It might go down. But it's not going away. And when all is said and done, the real price for oil is likely to stay higher than it was before 2003. Which is why utilities are raising rates...and airlines are losing money. They were hoping oil prices would quickly abate. They haven't. And they probably won't go down too far - even if the peak has come and gone for this cycle.

The whole world bobs on a frothy sea of cash - which makes it hard to know what anything is really worth. The dollar rose a little last week - but at $1.56 to the euro, it is hardly what you'd call a "strong" currency.

Still, Treasury Secretary Hank Paulson says a strong buck is "very important" to the United States. The top man at Treasury understands how dependent the United States is on the kindness of strangers with familiar money in their pockets. There's some $13 trillion outside the U.S., says Jim Rogers. And the Gulf States alone are adding to their pile of cash at the rate of $1 billion per day. If these foreigners ever decided to dump the dollar...there would be pandemonium in the currency markets. The dollar would collapse...and the United States would be unable to borrow the money it desperately needs in order to continue living beyond its means.

Bill Bonner
for The Daily Reckoning Australia

• I Love Coming to Rome
• Crude Oil Becoming Much Harder to Find
• Investors Rushed to Bid Up the Shares of WFC
• The Percentage of the U.S. Economy Devoted to Consumer Spending Went Up and Up
• Reserve Bank of Australia Tolerating Inflation

The world economy is slowing down. The global financial system is falling apart.

The whole situation is a mess...a disaster for investors...a catastrophe for homeowners...a Waterloo for the financial industry. But it is God’s gift to us.

What fun it is to read the paper! So much nonsense! So many clowns! Such drivel...such claptrap...everything is working out just as we expected.

We had to put down our copy of the Financial Times this morning. We were afraid of internal hemorrhage. Besides, our eyes were watering so much we could barely see...

First...there is Ben Bernanke on the cover, looking rather serious, as he appeared before the U.S. Congress yesterday. The poor man was expected to explain what was going on. What could he say, but that the economy was beset by “numerous difficulties?” He had to play the politician, in other words – the cunning dumbbell...avoiding at all costs saying anything useful or true. Of course, it is true enough to say that the economy faces troubles, but that description of it hides so many absurdities...and so many errors...and so many vanities and hallucinations.

Why didn’t he just come right out and explain that Americans have been living beyond their means...and now they’re being forced to cut back? That’s what yesterday’s retail sales figures showed – that consumer weren’t spending so much. What’s surprising about that? Nothing at all...we’ve been talking about it for months...even years.

But the news struck economists and financial reporters like a UFO sighting – they didn’t know what to make of it.

There’s also a photo of a long line in front of IndyMac’s door – waiting to get their money back. Mr. Bernanke might have also explained what was happening in the financial industry. Wall Street banks...Fannie Mae...Freddie Mac...IndyMac...Bear Stearns and the whole lot...made their money by peddling debt to people who already had too much. What did you think...that they could do that forever?

The headman at the Fed would have done us all a service, in our opinion, if he leveled with the nation.

“Look,” he might have said, “the prosperity we have enjoyed for the last few years has been largely an illusion; it was based on debt, leverage, and speculation. We all know you can’t get rich by spending more than you earn. And you can create real prosperity by borrowing money and spending it on consumer items. We’re now paying the price for those mistakes. Let’s just get it over with.”

Those words may or may not have been on call for him. He might have doodled something like that on the back of an envelope on the way to Capitol Hill. Maybe they came to him in a dream.

But when he got in front of the microphone, he realized that the truth is the last thing anyone wants to hear. He wisely avoided it, sticking with the stock phrases and standard wording of economic obfuscation.

Meanwhile, down the street, the U.S. president shifted from soporific twaddle to breathtaking imbecility.

“To the extent that we find weaknesses [in the financial system] we’ll move,” said the president of all the Americans, George W. Bush.

Mr. Bush has a weakness himself – for movement. He has presided over the most fidgety administration since Franklin Roosevelt. Not content to sit still, he spent more, borrowed more, and stirred up more dust than any previous administration. Now, he proposes a vast new expansion of the war against Free Enterprise.

Bailing out Bear Stearns, providing tax refund checks, and nationalizing Fannie and Freddie “signal a weakening of the administration’s ideological commitment to free-market principles,” says the Financial Times.

At this moment, we had to put down the paper. Where has the FT been? This administration has no commitment to any principles, as near as we can see. All it took was a terrorist attack in New York, and it threw over its entire conservative foreign policy in favor of reckless interventionism. And now we have a crisis in the financial industry. Of course, the big lenders, spenders and speculators are only getting what they deserve. Still, the Bush Administration is mounting an invasion.

We predict that it will have roughly the same results. Sweden, of all places, faced a major financial meltdown in 1991. The government hastened to intervene with a bailout. The cost – if translated to an American-scale economy – was more than $1 trillion. Mr. Bush’s intervention will cost that much – we predict. Or more.

Bill Bonner
for The Daily Reckoning Australia

• Fannie and Freddie Say Goodbye to Veto
• Irving Fisher Remains Immensely Important in the History of Economic Thought
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• The Percentage of the U.S. Economy Devoted to Consumer Spending Went Up and Up
• Freddie Mac’s Main Man is in the News

We are speaking about the entire financial industry, in general, and hedge funds in particular. Picking at the innards of the deceased, we find their plumbing so twisted, it's a wonder they lived as long as they did.

Of course, every mother wanted her babies to grow up and work on Wall Street or the City. Why? Because the money was so good. No sector was more profitable; no employees were better paid. But that was the basic problem too. People who worked in the financial industry were encouraged to take outsize gambles in the hopes of outsized bonuses. And as long as the credit cycle was on the upswing, the wagers paid off.

"Until the recent tempest," says Fortune magazine, "Wall Street firms looked like just about the world's best businesses. Year after year they boasted sumptuous profitability, ever-rising share prices, and, if you believed their claims, a new generation of chief executives who had mastered the art and science of risk management."

In the period, 2002 to 2006, the sun never shined more brightly for the five big independent firms - Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Bros., and Bear Stearns. Their earnings rose 200%, to more than $30 billion, with an average return on equity of 22%. Too bad they didn't hold onto the money. But when the money was on the counter, the clerks at financial firms didn't put it in the till. They took it home.

Fortune continues with the numbers: In 2006, the top six employees at Lehman pocketed $150 million, and James Cayne, who was at the time Bear Stearns's CEO, paid himself $40 million. Employee compensation at Wall Street's big five investment banks included restricted stock and options equal to 26% of the companies' outstanding shares.

As long as the weather was good, no one complained. But in 2007, the monsoons began. Since the middle of the year, just three firms alone - Bear, Merrill Lynch and Morgan Stanley - have taken more than $40 billion in writedowns. Bear drowned...while managers at other firms looked for ways to stay afloat. Shareholders, meanwhile, raced to the cupboard to look for the companies' rainy-day reserves. Alas, employees had stripped the company of capital.

As for hedge funds, we have nothing against them. Au contraire, we value them as we value influenza and Russian roulette....they help carry off the weak and eliminate the stupid.

It was a bad week for hedge funds. Poor John Meriwether, for example, was back in the news; we get to laugh at him twice. He was the captain of LongTerm Capital Management which sailed along beautifully - thanks to the aid and comfort provided by two Nobel Prize-winning economists, Myron Scholes and Robert Merton - until it hit a reef in 1998. After the LTCM sinking, Meriwether swam ashore, dried himself off, and went back to doing what he did best - taking a big piece of investors' money. But in 2008, his flagship fund is down 28%. And he's not the only one. It was the worst quarter ever for the hedge funds. And March was almost as bad for hedge fund managers as it was for Julius Caesar; the average fund was down 2.4% in the month alone. Some of the big, well-known funds fell much more. Endeavor Capital dropped 34%. London Diversified Fund Management's flagship fund lost 10%. And in New York, Pardus Capital Management, which seems to specialize in airline stocks, refused redemptions on its $2 billion fund.

Alert readers will already be asking questions. Isn't the whole idea of a 'hedge' fund to hedge against market disasters, by taking countervailing positions in different asset classes? We assume that was a rhetorical question, since everyone knows hedge funds ceased to hedge a long time ago. Instead, they are some of the biggest go-for-broke gamblers in the financial world.

It is the old principal/agent problem - a traditional bugaboo among economists - says a colleague. You hire someone to do a job for you and you assume he's on your team. And then you discover than your doctor operates a funeral parlor on the side. It's a problem in business and politics as well as the investment world. Turn your back for just a moment and your CEO is awarding himself stock options and your kids are wearing your socks; your local politicians are hiring their girlfriends, and your hedge fund manager is taking extraordinary risks with your money.

In the world of hedge funds, the problem was particularly acute. Because the managers have such lopsided incentives. If they make money, they take 20% of it off the table and put it in their own pockets. If they lose it, you, the investor, get to keep the whole loss. Heads I win, tails you lose. This is why Warren Buffett calls hedge funds a "compensation system," not an asset class. Over time, the hedge fund manager is practically guaranteed to end up with more of your money than you have. John Kay, writing in the Financial Times last month, demonstrated that if Buffett had charged like a hedge fund, he would have ended up with 90% of his client's money in the 42 years he's been investing.

But in the recent stormy weather, 50 hedge funds have washed up. Only about 7,950 left to go.

Bill Bonner
The Daily Reckoning Australia

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"Don't worry," the bright young man at a London private banking told us, "we maintain the highest levels of professionalism and use the most sophisticated tools of modern portfolio management."

That was just what we were worried about. What follows is a lament…and a complaint…about the current state of people in the financial métier: they have been disabled by their own theories…handicapped by their own greasy trade.

We were impressed by the man in front of us. Handsome, well-dressed, well spoken in three different languages, he had spent years learning the principles of economics, finance and business management. His palaver to prospective clients was flawless. Yes, he said, the research department is keenly searching for alpha…but it knows that 80% of performance comes from careful asset allocation, which the bank's strategists have calculated based on risk/return analyses going back a hundred years. The expected return from Japanese equities over the next five years, for example, will be precisely 7.56%…but with an anticipated volatility of 20.43%.

But then we learned that we didn't have to live with volatility. The firm's analysts have done extensive research, he explained; they've been able to find many different asset classes that had equal and opposite volatilities.

When Japanese stocks bob in one direction, for example, the firm's Ultra-leveraged Macro Opportunity Hedge fund weaves in another.

Just throw the mathematicians a bone; they'll figure out how to put these things together so that you can optimize your return while minimizing your risk. Then, according to the math whizzes' calculations, you could find yourself with a 90% probability that your $100 investment will grow to somewhere between $292 and $132 in year 10. This, it should be mentioned, is a "nominal" value. Even if the target is hit, the $132 may not even buy you a cup of coffee in London. It barely buys you one now.

So many numbers… 6s and 7s…5s and 4s…every number the Arabs ever invented is brought into service. But what do they really mean?

"Can you tell us what the price of oil will be next week," we began to torment our interlocutor. "Or, how about the dollar?"

"Of course not."

"Then, how can you make projections ten years out…on investments, all of which will be greatly influenced by the price of oil, the strength of the dollar, inflation rates and completely unforeseeable events?"

"Well, these are not predictions. They are projections, based on many years of experience. Our researchers are the best in the business, with degrees from Harvard, MIT and Oxbridge. Of course, no one knows what the future will bring…but these projections are the best output of modern portfolio management."

Pointing to a helpful chart supplied by the investment firm, we continued our interrogation:

"In the last 6 months, Merrill Lynch has had to write down an amount equal to almost half its book value? UBS has written off 40%. If these financial engineers were really able to project earnings and risk out to 2 decimal places, how come they couldn't protect themselves from this blow up?"

They ought to give special parking places to anyone who studied business, economics or finance in the last 30 years. Higher education has lowered their I.Qs. Years of toil in academia have weakened their vision and taken the common sense right out of them.

A blind man could have seen the blow-up in sub-prime coming. But somehow, the geniuses missed it. What went wrong? The disabling infection may be understood by looking at how the hot shots handle risk. Of course, they don't really have any way of knowing what real risk is; no one can know the future. For all we know, a plague will wipe us all out in the next three weeks. None of us knows what the price of oil will be next week…or next year…or 10 years from now. Nor do any of us know what real risks the oil market faces. War…weather…technological advance…who can say?

But rather than admit that it just didn't know…the financial industry embarked on a staggering series of myths and conceits that must have taken the gods' breath away.

Since they couldn't know real risk, they substituted volatility as a proxy, which is a little like getting an inflatable doll to take your wife's place at a dinner party; the conversation may be dull, but at least she won't contradict you.

Once they had shut up risk, they could say whatever they wanted. They could pretend that price movements, for example, were like natural phenomena. It was absurd and everyone knew it. Prices depended on what people thought; volcanic eruptions did not. But Richard Fama put forward the Efficient Market Hypothesis in the 1960s as if he had stolen the gods' fire. He claimed market data could be treated as if they were random fluctuations. If an earthquake had stuck Rome only twice in the last 100 years, the 'risk' of an earthquake was only 2%. For all they know, the streets of the Eternal City will rock and roll every day for the next 200 years…but this little subterfuge gave their mathematicians something to work with. Then, looking at price patterns as if they were seismic records, they could make all sorts of fantastic simulations…and come up with fancy new products, such as a Highly Leveraged, Sub-prime Debt Portfolio. Using historical norms, they pressed the junk credits together like potted meat and -- in a miracle that would have floored Jesus - transformed it into Prime A.

But it was all nonsense. The prices thought to be random weren't random at all, but the consequence of practices, ideas, and institutions built up over centuries. Change the circumstances…and the numbers changed too. As Soros puts it, markets are 'reflexive.' In our words, prices are neither fixed nor random…but subject to influence. For example, it was observed that stocks outperformed bonds over the longterm. Stocks for the Long Run was the title of a best-selling investment book in 1994, which argued that stocks would make you rich if you held them long enough. This long-term reward was in return for investors' willingness to take short-term risks; they called it the risk premium…which they defined, again, as volatility. Stocks were down in some periods, but always up over the long term. Thus, for a person who could wait, there was no risk at all.

By 1999, no truth was more obvious: stocks would make you rich. By then, the whole financial world was alight…stocks had risen three times since 1994 - to over 11,000 on the Dow by the end of the year. Now, it was time to pour on the gasoline. Another best-seller appeared that year: Dow 36,000.

No one seemed to notice that those data points that convinced investors that stocks were such a great investment were registered when people thought stocks weren't so great. For much of the stock market's history, investors had demanded higher dividend yields from stocks than they got from bonds - to make up for the risk. And they had rarely paid more than 20 times earnings. Yet, in 1999, the p/e ratio of the S&P rose over 32 - about twice the long term average. Circumstances had changed; the insight was no longer valid. And the fire went out.

The Dow may still go to 36,000, probably when a cup of coffee goes to $132. Last we looked, it was almost 10 years later and the Dow was back to where it ended 1999. During this time, too, the dollar has lost about 30% of its purchasing power…so the investor who believed in stocks for the long run is down about a third.

To be continued…

Bill Bonner
The Daily Reckoning Australia

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