The Aussie market finished up Thursday with the 5th day of gains in a row. It's a nice little run. But is it a bull market? If it is, it would contradict everything we've said about everything, and make us look very foolish (although not for the first time).

Here in the States everyone is keen to see the non-farm payrolls report. It comes out on Friday. Anecdotal evidence (what people say) suggests that the employment situation here is still pretty bad. But government statistics can say pretty much whatever you want them to say.

If you're looking for the internals of the market, try breadth. That is, if you want to judge how intrinsically strong a rally is, look at how broad it is. Is it just concentrated to a few of the big stocks (banks and basic material, for example). Or are all stocks marching up in lock stop on higher earnings and higher valuations. Is the equity premium visible?

Take a look at the chart below. It's the advance-decline index on the New York Stock Exchange from early 2007 unto today. The scale of the chart is less important than the trend. The index tracks the difference between advancing and declining issues on any given day. When there are more advancers than decliner, the index is bullish. When there are more decliners than advancers, it's bearish.

If you're trying to use the A/D ratio as a predictor of what's next (and who isn't?) then what does it really tell you? The chart above shows you that market breadth started to deteriorate months ahead of the actual high in the Dow Jones (which came later that year in October.) The June-July revelations that two Bear Stearns funds were in trouble accelerated the deterioration.

The March 2009 low in the A/D ratio more or less coincided with the low in the index. There wasn't any advance warning from the index. That's likely because the March lows were reversed by the active (and perhaps direct) support of the Federal Reserve via interest rates and a program of Treasury bond buying.

Whether the Fed worked a way, via its primary dealers, to get stocks moving too (another word is 'manipulation') is an interesting but ultimately unanswerable question. The important point here is that nothing in the fundamental mechanics of the market indicated a reversal. It was an external event.

And what about now? The A/D ratio is going up, up, and away. It could be that corporate cash positions are solid, the employment market won't get worse, and that the end is in sight for the U.S. housing market. Some combination of these factors could explain the steady advance of stocks since last march. But maybe not.

Our guess is that this is simply evidence of the Fed's Great Reflation (see Marc Faber's March Gloom, Boom, and Doom Report). All the new money created by the Fed, and the new lines off credit made available to U.S. financial institutions, made its way into the stock market by force off habit. It was easy to borrow and there was only one sensible place to put it: stocks.

But is that still the best trade going now?

No.

Your best bet, as we've been saying all along, is to retire now. Gradually liquidate your stock portfolio and pare it down. People are buying stocks now because it's what they've always done and what they're still told to do. But as a wealth survival strategy, the stock market is a death trap.

You should, by our reckoning, own a small portfolio of stocks leveraged to positive Black Swans (low probability but high magnitude events that drive a share price higher...like the discovery of a new ore body or the development of a new drug). These are the sort entrepreneurial ventures that will create new wealth. A portfolio of these business experiments is like a call option on the world we'll live in after governments have gone bankrupt and lost the ability to perpetuate the follies of the previous credit bubble.

But for now, the public sector campaign to bail out the plutocrats in the private sector is in full force. And in the meantime, the public sector in Europe is trying to save itself. Markets in Europe have reacted with contented indifference to the affair in Greece. Has anything important happened there?

Well, the Greek government presented a plan to cut spending by $6.8 billion. If effected, it will reduce the deficit-to-GDP ratio from 12.7% to 8.7% in the next year, which is pretty ambitious. The Greeks plan to do two things: raise revenue and cut spending.

The Greeks will raise taxes on fuel, tobacco, and sales taxes. And if the communist unions don't derail the plan, bonus payments to public sector servants will be cut by 30% and wages will be frozen for civil servants.

If Greece is having a fiscal crisis, why is anyone in the government getting a bonus payment at all?

The Greeks have $20 billion in sovereign debt maturing in April and May of this year. The negotiations between the Greeks and the rest of Europe are trundling along. But to what end? The Germans refuse to pony up for a bail out. But will the EU sacrifice Greece to save the Euro as a currency?

Nobody knows. But our main point today is that you should not think Greece has gone away. It's true that since February, the cost of insuring sovereign governments against default has fallen. According to the folks at Bespoke Investment Group, only Vietnam, Argentina, and Egypt have seen wider credit default swap spreads in the last two months.

So we have a pause in the crisis-think. Markets rally on reflationary monetary and fiscal policy. But the underlying structure of the fiscal welfare/warfare state is badly damaged. This is still an excellent time to reduce your exposure to stocks and add, on the dips, your exposure to precious metals and precious metals equities (in full knowledge that even gold stocks are going to decline on another general decline in stocks).

It's probably not just stocks you should re-think, though. Last week we mentioned that fund manager Colonial First State (owned by the Commonwealth Bank) has told investors in its Mortgage Income Fund that it could be as long as four years before they get their money back. The average age of the 17,000 investors in the fund is 74 years old.

Redemptions in the $850 million fund were frozen not long after the Federal government guaranteed bank deposits. High-yield mortgage trusts are not bank accounts. Investors and pensioners who treated them like high-yield bank accounts - because that's how they were sold - were suddenly not generating needed income on precious savings. And now the savings are locked up.

But it wasn't just the government guarantee that pummeled the mortgage and property funds. It was the underlying securities. On February 9th, Colonial announced it would wind down the Mortgage Income Fund because the bad debts on some of the underlying property loans were, "too big to manage." It has another $1 billion of pensioner savings locked up in similar funds.

Now without knowing the composition of assets in the other funds, it would be hasty to say that mortgage funds in general are lousy investments. However we're inclined to think just that. But more importantly, there's a point here about having your money locked up in large pools of capital these days.

These large pools of capital - mortgage funds, property funds, super funds, 401(k) plans in the States - are extremely attractive to people who need capital. Call it "captive capital." Banks covet it because it keeps them cashed up when facing declining asset values in commercial and residential property.

Governments covet the capital even more. It's a ready source of funding for government deficits. If you can compel banks to buy government bonds (via credit requirements), or if you can compel savers to own government bonds for "safety" and "annuity" reasons, then you can force people to fund your deficits. That means you may not have to cut spending so deeply that you lose an election because of it.

So what should you expect and what should you prepare for? Higher taxes are a given. "Nutter expected to tax sugary drinks, set trash fee," reports a Philadelphia newspaper. The Nutter in this case, quite appropriately, refers to the Mayor. He's taxing fizzy drinks and garbage to raise extra money for the city. At the city and state level, you can expect a lot more of these creative ways to finance spending - along with cuts in services.

This is part and parcel of the over-reach of the Welfare state. If the U.S. Warfare State has over-reached in Iraq and Afghanistan, it's been over-reaching domestically for years with programs paid for out of an empty pocket. The same is true in Europe, Japan, and increasingly, in Australia.

Some places are better off than others. Australia has a relatively smaller public sector debt burden. But the country overall, if you look at the net foreign debt, owes its prosperity to foreign lenders. You can expect the strain on public sector finances to only increase in the coming years.

All of that suggests, to us anyway, that you should re-think your reliance on traditional income and savings vehicles. Look for changes to be made that make it harder for you to get at your money. Or, if you can withdraw it from certain accounts and schemes, you will do so at a massive penalty. Governments need capital. And when they can't compel you to use yours to finance their spending, they are going to get at least a pound of flesh if you choose to remove your money from the system.

What should you do instead?

As we said above, a small portfolio of stocks - business projects leveraged to very high returns - is nearly the only good reason to stay in stocks. The other good reason is that as governments monetize debts and confidence in paper money fails, stocks may beat inflation a lot better than cash. The rally of the last year is evidence of that.

Next week, when we get back to Australia, we'll take on the main objection to all of this: deflation. That argument is simple. As the global debt burden becomes too heavy, it will crush asset values, leading to falling asset prices across the board, including precious metals. We have too many objections to this to list here. But stay tuned next week. Until then!

Dan Denning
for The Daily Reckoning Australia

• Why I Would Have Raised the Interest Rates
• Nationalised Banking System Will Come from Global Market Rout
• A Bull Market That’s Missing Parts
• Price-to-Earnings Ratio of the S&P 500 Index
• 40 Years of Inflation, 80 Years of Dow/Gold

Both the S&P 500 and the Dow Jones Industrials finished up over 1.5%. There were two drivers of the feel good vibe. First was New York's Empire Manufacturing Survey. It concluded that "conditions" were improving.

As far as we can tell, that doesn't mean anyone actually made and sold more stuff in New York State. But it does mean the state of mind - how people feel about things - appeared to improve. Hooray! It's nice people feel better about things. But things are still pretty bad anyway.

The bigger story is that Greece hasn't been abandoned by the rest of Europe...yet. Europe could probably leave Greece behind and preserve the integrity (such as it is) of the euro as a sound currency. But 50 years of harping on about social justice and economic harmony and humane capitalism is going to make it hard for policymakers to leave Greece to its own devices.

This means the debt crisis is consolidating itself into ever fewer and larger entities...the European Union...the U.S. government...and the U.K. government to name a few. In order to save Greece, historians may write, it was necessary to destroy the Euro.

But investors don't have time machines. In the modern era of central banking, new lines of credit and public assumption of large liabilities - plus more credit creation - has always been the way out of a pinch. Below, we'll tell you why this makes the inevitable disaster that much worse.

Here in Australia, it looks like the financial crisis is receding. We have our doubts. But according to Gail Kelly and the good people at Westpac, bad debts were down even more than expected in the first quarter. That's the good news. The bad news is that, "the average cost of funding is going up."

The strategic weakness of the Australian banking sector - and perhaps the whole economy - is that it's a capital importer. That's why even when Aussie banks didn't have boatloads of U.S. subprime debt; they still faced higher capital costs when the global cost of capital went up. So what?

If Greece goes down or sovereign debt default spreads go up, it's going to make importing money into Australia more expensive. And that will probably slow credit growth in the economy. Aussie banks will get jealous of their capital and stingier with their lending. Maybe even house prices - contrary to the laws of Australian financial gravity - will fall.

And if you think that's gloomy, then you won't want to read what Albert Edwards from Societe Generale has to say about the status quo. Writing earlier this week, Edwards says, "My own view on this is that obviously we should never have got into this wholly avoidable mess in the first place. But having got here, there really is no way out that does not trigger a major market-moving upheaval."

"Ultimately economic prosperity over the past decade has been a sham: a totally unsustainable Ponzi scheme built on a mountain of private sector debt. GDP has simply been brought forward from the future and now it's payback time. The trouble is that, as the private sector debt unwinds, there is no political appetite to allow GDP to decline to its 'correct' level as this would involve a depression. So burgeoning public sector deficits and Quantitative Easing are required to maintain the fig-leaf of continued prosperity."

This what we meant above about the inevitability of the disaster that approaches. When the government "brings forward" demand for housing via the FHOG or for consumer goods via stimulus, it's stealing growth from the future in order to maintain current living standards. In our view, this just perpetuates the misallocation of resources that took place in the credit boom and keeps the money in the weak hands (the financial sector) that took so many bad risks in the first place.

A real free market punishes financial failure with bankruptcy or insolvency. By not allowing a recession to take its natural course, monetary and fiscal policy prevent the conditions for the next growth phase. What's worse, they're doubling down on the debt-backed model of prosperity and piling up more liabilities on the public sector balance sheet.

That's the stage we're at now. And one insignificant survey on manufacturing sentiment in New York State doesn't change much. And by the way, the more important news yesterday is that demand for U.S. bonds by foreign investors fell by its largest amount ever. Strong dollar?

Foreign holdings of U.S. Treasury securities fell by $53 billion December. China reduced its holdings by $34.2 billion. The end game is beginning in the Chimerica relationship of vendor financing (China buys U.S. bonds to help keep U.S. rates low so Americans can buy what China makes).

What China doesn't buy, you can get the Fed will have to monetise - unless the Congress and the President suddenly cut American spending. You can see from the chart below that Japan is now a larger holder of long-term U.S. securities than China.

Click to zoom in on Foreign Holders of Treasury Securities data

The long-term trade on this is to get the heck out of U.S. assets. Whether "risk assets" like commodity currencies or commodities are the ultimate refuge is yet to be seen. But oil, gold, and resource stocks are certainly getting a big today on greenback weakness.

Dan Denning
for The Daily Reckoning Australia

• The Story Behind China Dumping its US Treasury Debt
• The Great Correction: Awaiting Bailouts that Will Never Come
• USA Has Fives Times As Much Sovereign Debt As All the PIIGS Put Together
• 1 Out of 10 American Mortgages Are Owned by Other Countries
• China Buys its Own Gold

It's easy to fall back on generalities - that America is a great country, and that we always rise to great challenges and will do so again. True, but we can only succeed by taking action, and we have a lot of action to take. Let's say we do take only small steps to address our fiscal crisis. Let's say we stop cutting taxes, but we don't increase them radically either. Let's say our government continues to take in about the same level of historical revenues, but we hold discretionary spending to 2008 levels as a percentage of the economy, and we don't expand health care or other entitlements any further. That sounds pretty benign, but it's actually a disaster scenario for our children.

Let's take the example of kids born in early 2000, when our national budget was in balance and the technology-powered future seemed bright.

During the first eight years of their lives, we have learned, the nation's financial hole grew by 176 percent to $56.4 trillion. And the number is not standing still. That was its size as of September 30, 2008 - before the official declaration of a recession, before the significant market declines of October 2008, and before the big stimulus and bailout bills designed to jump-start the economy and address our immediate financial crisis. In fiscal 2007, recall, our budget deficit was $161 billion, or 1.2 percent of the economy. By 2009, the deficit soared to $1.42 trillion, which is about 9.9 percent of the economy. Just think about that for a second. Our federal deficit grew by almost nine times in the past two fiscal years!

Given our scenario - no benefit cuts, no tax hikes - the government would have to finance this gaping hole mainly by borrowing money from domestic and foreign investors, with interest. Don't forget, according to the GAO's latest long-range budget simulation, even without an increase in overall interest rates, our interest payments would become the largest single expenditure in the federal budget in about twelve years. And what do we get for that interest?

Nothing!

Of course, something will have to give before we get to that point. However, the government has overpromised and underdelivered for far too long. How can we fix things? Will we cut benefits, those mandatory payments that are chiseled into law? Or will we raise taxes to onerous levels? We will probably have to do some combination of both. That is, we will have to renegotiate the social contract with our fellow citizens and raise taxes. However we do that, our kids will pay the price. And the bigger the bill we pass on to them, the bleaker the future we will bequeath to them.

Let's assume that Washington policy makers continue to punt on making tough spending choices and ultimately raise taxes to address the growing deficits. Nobody will reach in our kids' pockets and take their money because the government will take it before it even reaches their pockets. What will that mean for their after-tax income? Right now, on average, Americans pay about 21percent of their income in federal taxes and another 10 percent to state and local governments. By 2030, to pay our rising bills, that amount could be at least 45 percent - higher even than the average 42 percent that most Europeans pay. By 2040, it would be at least 53 percent and climbing. In reality, total taxes in 2030 and 2040 would be even higher than these estimates because of the fiscal challenges facing state and local governments - such as Medicaid costs, unfunded retiree health care promises, underfunded pension plans, deferred maintenance and other critical infrastructure needs, and higher education funding.

With reductions in disposable income like that, the children of 2000 will inherit a much different kind of America in 2030. That's when they will be turning thirty, entering their most productive years.

So much of their money will be devoted to keeping the government afloat that they'll have relatively little for everything else in life. Their homes will be smaller and drabber. There will be less to spend for cars, vacations, dinners out, and big TV sets, all of which their parents took for granted. They'll still read about the consumer society and conspicuous consumption, but mainly in history texts. Maybe it's a good idea for America to become less materialistic - but the idea should be to give our children that choice, not to impoverish them.

Regards,

David Walker
for The Daily Reckoning Australia

• The US Federal Budget
• Federal Government Making Taxpayers Pay Taxes for Nothing
• Naturally the Feds Want to Raise as Much Money as They Can
• A World of Financial Freeloaders
• Japan’s Slow-Motion Demographic Catastrophe

But first, we were poring over the reader e-mail last night. Many readers think we are being unfair, unconstructive, and un-brief in our critiques of Ben Bernanke, bankers, Kevin Rudd, and other economic know-nothing from across the political spectrum. So let us take a moment to be as clear as possible: policy makers and politicians are morons.

We're told Ben Bernanke is the right man to get us out of the trouble we're in. But isn't Ben Bernanke the man who got us into the trouble to begin with? Didn't he and Alan Greenspan lower interest rates so much they created a worldwide credit boom that is now deflating? Wasn't it their policies that enabled banks and Wall Street to securitise commercial and residential mortgages and send them far and wide into the balance sheets of the world as "assets"? And aren't those "assets" now falling in value, continuing to wipe out equity at the household and corporate level?

It is clear that politicians are still slovenly serving the interests of their corporate masters in the financial world. And it is clear that the financial world has every reason to encourage government stimulus, loan guarantees, and lower interest rates. This keeps the great leveraged credit machine of the Financial Economy motoring. And that machine keeps the financial industry in tall cotton.

Besides, the limits on executive compensation are window-dressing for public (voter) consumption. With bonuses limited by statute, we reckon more compensation for the financial industry will move back to stock option grants. That means for the financial industry to preserve its privileged status, stock prices have to move higher. And nothing enables that like credit. Borrow money and plough it back into stocks to line your pocket. Does that sound like something that may be happening?

Our point is that this whole interlude since the collapse of Lehman Brothers is an attempt to preserve the status quo ante. If the tools of monetary and fiscal policy (which are clumsy and theoretically flawed anyway) exist to make the financial and estate industry thrive, the real economy will continue to get screwed. We'd argue this recent recovery is nothing but an attempt to resuscitate the money-shuffling arrangement that was so profitable up until late 2007.

At least some people agree. "A UN think tank on trade has warned that the current financial market rebound is not a 'real recovery' and that any world economic growth recorded in 2010 was unlikely to exceed 1.6 per cent," reports today's Australian.

"The depth of the recession has been so important that of course there will be a rebound ... but we still do not see that this is a real recovery," says Supachai Panitchpakdi, secretary-general of the United Nations Conference on Trade and Development (UNCTAD). "The actual increase in the commodities prices is mainly driven by appetite for more risk," he says. More on this in just a second.

UNCTAD's Chief economist Heiner Flassbeck, said, "the markets had been fuelled by financial speculation that in turn was driven by expectations of recovery. 'But anticipation of recovery is just a fiction, it is not there.'"The UNCTAD report also noted that, "Tumbling profits in the real economy, previous over-investment in real estate and rising unemployment will continue to constrain private consumption and investment for the foreseeable future."

Hmm. Maybe UNCTAD is reading the Daily Reckoning. But if not, for those who have eyes to see it, the truth is plainly in sight. You cannot correct the global imbalances of a leveraged boom with more leverage. But let's tackle on specific aspect of the report that suggests commodity prices may again be the subject of financial speculation. Is it true?

Frankly it's hard to say. We're more confident that profits in the real economy - once you take away the effect of credit and government money - are regressing to an historic mean. Some companies will make more. Some less. But the average will be lower.

However we did see one interesting chart yesterday from our trader Gabriel Andre. We were discussing with him whether the euphoria about Australia - the dollar, the stock market, real estate, and commodities - was suspiciously reminiscent of June 2007. You know, right before the ore hit the fan. Is all this feel-good news a sign of worry?

We decided to tackle the question with a picture. It's the chart you see below. The chart tracks the performance of Worley Parsons - a proxy for infrastructure and capital spending in the mining industry - versus the CRB commodity index. We are asking a question with this chart. The question is, does a peak in Worley's stock presage a downturn in the resource sector generally?

Click to enlarge

Gabriel writes that, "The level of $30 looks as a strong resistance for the stock. It's a previous low where it bounced back several times in 2007 and 2008. The recent action suggests the $30 may be a new high, finding resistance, especially because the correlation is obvious with the CRB and the CRB has already started correcting.

"If you pay attention to the details on the chart, it looks like the correlation is stronger on the downside. Worley can fall when the CRB rises. But when the CRB falls, Worley generally falls too. If you were asking me to turn this observation into a trading idea, it would be to short-sell WOR at the current levels with a stop-loss at $31. A correction towards $20 is possible.

Gabriel has been working on a system to trade these chart patterns in ASX 200 stocks for the last four months. Look for more information on that later this week. And in the meantime, keep in mind that if Worley is a proxy for the bull market in Aussie resource stocks, the charts are suggesting that all the positive momentum since March may be reaching its limit. When you check in the turn down on the CRB, you should be prepared for the possibility of a correction in commodity prices too.

If that happens, it would be perfectly consistent with the tenor of the news these days. As excited as we are ourselves about certain resource projects, the level of bullish consensus about commodity prices and corporate earnings is a warning sign. But - this is important - that doesn't mean you have to head for the hills.

As Gabriel's work is showing, you can use these kinds of signals to take profits before rallies expire. It can also save you from mis-timing your entry into a blue chip share. And ultimately, it should be able to help you identify the best time to get back into the share, after the inevitable correction has done its work.

We meant to write more about gold, sound money, and unsound economic thinking. But that will have to wait until tomorrow. Until then...

Dan Denning
for The Daily Reckoning Australia

• Worley Parsons (ASX: WOR) Announces Pilbara Solar Energy Project
• CRB Index Correction Likely to Go Further
• Note to Australia: Buy Resources, Not Banks
• Chinese Government Expected to Sign Off on Second Stimulus Package
• Government Preparing Another Stimulus

A W-shaped recovery?

Forget it...there ain't no letter in the alphabet that describes a "recovery" we're likely to have.

We say that in the spirit of mischief as well as elucidation. Of course, the world won't stay in a depression forever. And even depression ain't so bad, once you get used to it. The world economy will probably drag around a bit on the bottom...with low, or negative, growth rates in most places...until it finds a new model. The old model is dead. The authorities can put on as much rouge and powder as they want. They could even give the corpse jolts of electricity to make it sit up. But they can't revive it. It's finished. Over. Kaput.

The old model involved lots of players playing lots of different roles. But the main protagonists were the USA. and China. Not to put too fine a point on it, but China was the maker; the United States was the taker. It was a relationship that seemed to serve both parties well...but one that actually enabled foolish and, ultimately, destructive behavior - especially on the part of the United States.

When we were growing up, China was a 'Red Menace.' It was full of mad people doing mad things. They humiliated people by making them wear dunce hats and march through town. The Chinese made steel in backyard barbecues. They built hidden palaces for Mao (the Great Helmsman)...wore odd outfits...and threw female babies onto trash piles. (We're not making any of this up!)

But then came a period of sanity. Deng Xiaoping decided to turn the whole country in the direction of capitalism. At first, this was thought to be a great boon to the West. We had won! And suddenly, there were a billion more consumers in the world economy. Company executives went to sleep with sweet dreams: 'If we can sell one refrigerator to just one out of every 1,000 Chinese...'

The dreams became nightmares. Instead of selling American-made refrigerators to the Chinese, the Chinese sold Chinese-made refrigerators...and toaster ovens...and tables...and every gadget, gizmo and whatchamacallit known to man...to Americans. Instead of being a consumer...China became a manufacturer - taking the 'export route' to prosperity, pioneered by Japan in the '60s and '70s...and perfected later by Korea and Taiwan. Instead of adding to the world's demand for products made by the developed countries, China became the biggest supplier of stuff on the planet.

China made...China sold...China took its money, bought US Treasury paper, thereby helping to keep lending rates low in the United States, and made some more. It worked beautifully as long as Americans were willing and able to continue spending. But no camel's back is infinitely strong. The final straw came in 2007 - with total debt equal to 370% of GDP.

And now the jig is up. The old formula won't work - neither for Americans nor for the Chinese. Despite the urging of their government, Americans cannot be expected to take on more debt in order to continue consuming more stuff from China. Nor can the Chinese reasonably expect to work themselves out of an overcapacity problem by creating more of it.

But the officials in both countries seem equally benighted. They don't seem to think very deeply, no matter what language they think in. On one side of the Pacific, the Americans think they can bring a recovery by encouraging consumers to borrow and consume more stuff. On the other, officials offer credit to entrepreneurs and industrialists - encouraging them to build more factories and add more capacity so they can make more stuff. Neither seems to realize that the real problem is THAT THE WORLD HAS TOO MUCH STUFF ALREADY.

In the United States, the private sector drags its feet; it's had enough of debt. But along come the feds like Fred Astaire or Arthur Murray...ready to borrow and spend until the champagne runs out. When it comes to self-destruction, the feds are no slouches.

They're borrowing and spending trillions - $8 trillion is to be added to US debt over the next 8 years. So far, this money has done nothing to relieve the underlying problem: the consumer has too much debt and too little income. The government can give him a tax rebate...or give him a check for a clunker. These giveaways will produce a temporary boost. But when the giveaways give way there is nothing left. Does the guy who bought a car with government cash in 2009 buy another one in 2010? Does the fellow who brought his mortgage up-to-date with a tax rebate in 2008 go out and buy a new house in 2009?

The problems are real...at the heart of the real economy. They are not problems that can be solved by monkeying with the money supply, interest rates, or even fiscal policy. They are problems that need to be solved by the real economy...in the real economy...by consumers, who need to pay off their debts, and by businessmen, who need to adjust to the realities of the real world - adapting their capacity so as to produce things for people who can actually afford to buy them. It's a long process...with many bankruptcies and disappointments along the way...

That process has only just begun. It will deepen and get worse, as both consumers and businessmen realize that there will be no quick recovery...and no return to the old model - ever. Look for more layoffs...more foreclosures...more cutbacks and workouts...

Look for more depression, dear reader...

And learn to like it; it will be with us for a long time.

The Dow bounced yesterday...up 82 points, after a sell-off on Monday. This leaves it still about 1,000 points shy of the comparable rally of 1930. Will it continue bouncing until it equals the 1930 level? Or is the rally over? We wait to find out...

Bill Bonner
for The Daily Reckoning Australia

• The Codependent Relationship Between China and the United States
• Economists Agreed the Stimulus Was Working and the Recession Was Coming to an End
• Roubini Says United States Will Climb Out of Recession Towards End of Year
• Geithner Reassures China that America Takes Financial Obligations Seriously
• Is Inflation Necessary for Recovery and Growth in the United States?

"The bears are throwing in the towel, and the Aussie [dollar] is undervalued," Paresh Upadhyaya, a fund manager in Boston, tells Bloomberg. "Asia is still going to expand, and China and India will have growth above 5 percent. That's fuelling demand for commodities, so Australia's exports are holding up much better than the rest of the G-10 countries."

Paresh was also referring to the 21% rise in the Aussie dollar versus the U.S. dollar since February 25th. That's the Aussie's fastest rise against the greenback since the currency floated in 1983. Some analysts are taking this as evidence that Australia's currency and its economy are going to benefit more than any other Western nation from China's nearly $800 billion stimulus package. So China and Australia have decoupled from America and recoupled together, you might say.

All of that may be true. Or it may be a heaping helping of wishful thinking. But for today, anyway, it doesn't seem to matter at all. Today, the Aussie share market is dealing with the resumption of covered short-selling on financial stocks. It's also dealing with the possibility that the deal between Rio Tinto and Chinalco may be scrapped.

That's a lot to deal with. And when you've got the Dear Leader cooking off nuclear bombs in North Korea, it's enough to be a rally killer. Shares are lower at today's open.

What about the economy? Is it getting better? Are structural fiscal deficits a good thing? RBA director Warwick McKibbin warned yesterday that deficit spending driven by political ideology is not a good cure for recession. "The danger is you add too much to the fiscal deficit," he said. "Sure, some of it is temporary, but a lot is structural because it is based on ideology."

He was referring, we assume, to the idea of borrowing money that you then give a way to be spent because you think what the economy needs is "stimulation." It doesn't increase productivity. "Most fiscal policy doesn't do anything except switch spending from one period to another," he added. When you change fiscal policy, all you do is stimulate the economy today out of future possible growth."

Dan Denning
for The Daily Reckoning Australia

• The Country is Going into a Recession with its Finances in the Worst Shape Ever
• The Dark Underbelly of Australia’s Resource Boom: Chinese Resource Demand
• Economy Free to Recover?
• Federal Government Making Taxpayers Pay Taxes for Nothing
• Dealing with Future Economic Problems Today

First, let's look at what those penny pinchers in the federal government are up to. The Congressional Budget Office (CBO) recently released its analysis of the Obama Administration's ten-year budget proposal. The projected deficit for (fiscal year) 2009 is a whopping $1.8 trillion. Now the president has said, in effect, that you need to spend money to save money, but the CBO projects deficits once again exceeding $1 trillion by 2018. In fact, over the whole CBO forecast from 2009-2019, the lowest the deficit ever goes is $658 billion.

This should be rather surprising to anyone who actually took Obama at his word when he promised to restore fiscal discipline to Washington. In fact, the CBO projects that the outstanding federal debt held by the public will increase from 40.8% of GDP in 2008 to 82.4% in 2019. In other words, the CBO predicts a doubling of the national debt in a mere decade.

One last thing to give you chills (and not the good kind): The CBO is not exactly a doom-and-gloom forecasting service. They're run by the government, for crying out loud. This is the same CBO that projected at the start of the Bush Administration ten years of an accumulated $5.6 trillion in budget surpluses.

I would caution readers not to dismiss all CBO numbers as obviously meaningless. On the contrary, I think we will see the same pattern play out under Obama as under Bush: Because the CBO in both cases is grossly overstating future tax receipts, its projections for the Obama proposal are going to turn out just as rosy as they did back in 2001. Besides anemic tax receipts, if mortgage defaults continue to increase, the CBO projections on losses from the Treasury's numerous "rescue" measures will also be far too optimistic.

In short, I think we should view the doubling of the national debt (as a share of the overall economy) over the next decade as a naïve best- case scenario.

If fiscal policy is a disaster, monetary policy is even worse. Unfortunately, the issues here get very complicated, and so it's difficult for the layman to know whom to trust. Not only do left- wingers like Paul Krugman say that we need more inflation, but even (alleged) right-wingers like Greg Mankiw are saying the exact same thing. With all due respect, those guys are crazy.

Normally, I do my best unshaved-guy-wearing-a-sandwich-board routine by showing this Fed chart of the monetary base. But every time I do that, some wise guy argues that I don't understand how our banking system works, and that because of "deleveraging" we are actually experiencing a shrinking money supply.

No, we aren't. It's true that there are forces tending to shrink the money supply, but Bernanke has more than overwhelmed them. All of the standard measures of the money stock went way up during 2008, even though prices (as measured by the CPI) fell in some months. For example, the monetary aggregate M1 consists of very liquid items such as actual currency held by the public, and checking account deposits. It does not include the monetary base (which we know has exploded through the roof). Even so, look at the annual percentage graph of M1 recently; it's grown at almost a record rate:

Now the reason prices haven't exploded is that the demand to hold U.S. dollars has also increased dramatically. (That's also what happened in the 1980s: the Reagan tax cuts and Volcker's squelching of severe price inflation made it much more attractive to hold dollars, and so the Fed got away with printing a bunch even though the CPI didn't increase wildly.)

Once people get over the shock of the financial crisis, the new money Bernanke has pumped into the system will begin pushing up prices. Others have used this analogy before me, but it's still apt: The U.S. economy right now is like Wile E. Coyote right after he runs off a cliff but hasn't yet looked down. Once the spell of a "deflationary spiral" is broken by a full quarter of significant price hikes, there will be an avalanche as people come to their senses.

Some analysts concede that the traditional Fed policies have indeed left the dollar vulnerable to serious devaluation, but they think the central bank wizards can save the day by acquiring new "tools." For example, San Francisco Fed president Janet Yellen has been arguing that the Fed should be able to issue its own debt, to give the Fed more flexibility. The idea is that when the time comes for the Fed to sop up the excess reserves it has pumped into the banking system, it would be devastating to the incipient economic recovery if the Fed has to dump a bunch of mortgage-backed securities, or Treasury bonds, back onto the market. This would ruin the banks with MBS on their balance sheets, and/or it would push up interest rates for the government. Thus, the Fed would have painted itself into a corner, and it would have to choose between massive CPI hikes or a renewed recession. To avoid that nasty tradeoff, Yellen argues that if the Fed could sell its own debt, then it could drain reserves out of the banking system without unloading its own balance sheet.

For a different idea, economists Woodward and Hall think the Fed just needs the ability to charge banks for holding reserves. The Fed already (recently) obtained the right to pay interest on reserves, and so Woodward and Hall think the Fed should also have the ability to do the opposite, i.e. to be able to pay a negative interest rate on reserves that banks hold on deposit with the Fed.

How does this avert the threat of hyperinflation? Simple, according to Woodward and Hall. If banks ever start loaning out too much of their (now massive) excess reserves, and thereby start causing large price inflation, then the Fed can simply raise the interest rate it pays on reserves. Banks would then find it more profitable to lend to the Fed, as it were, rather than lending reserves out to homebuyers and other borrowers in the private sector. Voila! Problem solved.

Obviously these tricks can't avoid the consequences of Bernanke's mad money printing spree. At best, they would merely push back the day of reckoning, while ensuring that it grows exponentially (quite literally).

A quick numerical example: Let's say the Fed wants to drain $100 billion in reserves out of the banking system, in order to cool off rising prices. But it doesn't want to sell off some of its assets on its balance sheet (like "toxic" mortgage-backed securities), so instead the Fed sells $100 billion worth of the brand new "Fed bonds," as Yellen hopes.

In the beginning, this will indeed solve the problem. When people in the private sector buy the Fed-issued bonds, they write checks on their banks and ultimately those banks see their reserves go down at the Fed. There is less money held by the public, and so prices don't rise as quickly.

But what happens when the Fed bonds mature? For example, if the Fed sold a 12-month bond paying 1% interest, then after the year has passed our private sector buyers will hand over the securities and now their checking accounts will be credited with $101 billion. At that point, the economy would be in the same position as before, only worse: there would be an extra billion in newly created reserves (because of interest on the Fed debt).

The financial gurus running our financial system and advising our political leaders aren't even thinking two steps ahead when making their cockamamie recommendations. For those readers who share my skepticism, the solution seems clear: You need to transfer your wealth out of assets denominated in fixed streams of U.S. dollars, and switch to something that responds to large price inflation. In short, sell your corporate and government bonds, and start stocking up on precious metals.

Regards,

Robert Murphy
for The Daily Reckoning Australia

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