Uncertainty...chaos...bad decision making. This is what makes individual planning so hard in a world with fiat money. The supply of money (and thus the value) is always changing. Economic decisions that made sense with interest rates at one level make a lot less sense with interest rates at a different level. Mis-calculations are made. Good investments go bad.

Will the Reserve Bank's decision to raise interest rates for the first time in 19 months expose people who didn't plan for it? Of course it will. The housing sector is where we'll find out. And you already know what we think, don't you?

We think the Federal government behaved shamefully by suckering first home buyers in with free cash when interest rates were historically low. Now that rates have begun moving up, the most marginal buyers will begin feeling the pinch. And what will happen to house prices?

As far as stocks go, there might be an even bigger rates-related story playing out. The RBA becomes the first G-20 central bank to lift rates. Whether it's stupid or prescient no one knows. But we have to consider the possibility that it could ignite a reversal of the trend in global bond yields. Yields on government and corporate debt could be headed higher now.

Mind you we don't think the Fed will be raising short-term rates in America any time soon. It would crush what little chance there is for a recovery in U.S. housing. But on the longer end of the yield curve (the part the Fed does not control), investors might begin sending interest rates up and bond prices down. Relatively speaking, this makes stocks a lot more attractive.

Maybe that's why stocks in New York rallied over night. And maybe that's why Aussie stocks were up after yesterday's announcement and are up again this morning. It could also be that investors are buying the "recovery has begun" story, which would be goofy but possible. But for whatever reason, stocks are suddenly looking a lot more compelling than bonds.

But let us not forget gold. And how could we? It's so shiny. Gold hit an all time high of $1,040 yesterday. It won't make a new high in inflation-adjusted terms until it clears US$2,000. But the question on everyone's mind is whether gold is going to make higher highs from here...or corrects.

The case for the correction is simple. Check out the chart below. It's the commitment of traders report from the New York futures market. You can see from the figures at the bottom that both the number and the percentage of large speculators who are bullish is at record levels. That alone would dictate some short-term trading caution.

Click to enlarge

What's more, the emergence of the gold exchange traded funds (ETFs) has put a huge portion of the gold market in a very small number of hands. If the ETFs sell...who will they sell to? Or more succinctly, a lot of the gold demand is coming from a few institutions. If other institutions (central banks and sovereign wealth funds) don't pick up the slack, there will be more sellers than buyers and prices will fall.

But not so fast says the world of geopolitics. Gold could go much higher if the world's entire monetary order (or disorder) shifts away from the U.S. dollar. And that's just what the Independent's Robert Fisk wrote yesterday in an article that set the internet all a-twitter. He called it, "The demise of the dollar."

Fisk wrote that, "Gulf Arabs are planning -- along with China, Russia, Japan and France -- to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Cooperation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar...The transitional currency in the move away from dollars, according to Chinese banking sources, may well be gold."

Well then, that changes everything. In this role, gold becomes a hedge against devaluation in the U.S. dollar. It's not so much a hedge against inflation (a systematic increase in the supply of dollars printed to hold up the U.S. banking sector and finance a grasping Federal government) as it is a move to protect assets against a sudden dollar collapse.

Granted, in the ho hum developed Western world we live in, currencies simply don't suddenly collapse. They erode over time. And one fine day you find your purchasing power is not what it used to be.

But in emerging markets, basket case economies with massive fiscal imbalances do have sudden currency crises. FT writer and economist Willem Buiter calls them "sudden stops." And then, if you're an American or a Brit, he makes the somewhat terrifying point that these two developed economies have all the characteristics of an emerging market basket case economy.

Buiter writes that, "The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the 'sudden stop' - the cessation of capital inflows to both the private and public sectors. . . . But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world's leading reserve currency. A large fiscal stimulus from a government without fiscal credibility could be the trigger for a 'sudden stop'."

One important aspect of these "sudden stops" is that they are almost never events you would choose to participate in. But you have to anyway, or monetary events overtake your investment portfolio. This is why these episodes in monetary history are so chaotic. And it's why-if we're entering one of those episodes now (or at least the most unstable period of it as we move from one reserve currency to a basket of currencies)-the price swings in asset markets are going to be impressively volatile.

All that said, the move up in the Aussie cash rate has sent the Aussie dollar higher. Thus, the Aussie gold price went down overnight, not up. It could be that in the short term, the migration of global capital flows out of the USD favours Aussie equities more than gold (from an Australian perspective).

So about that 5,000 on the All Ordinaries....Does it now look a lot more likely given the events of the last 24 hours? Or are we on the cusp of a significant correction to the rally of the last six months? More on that tomorrow from the trading nebula.

And by the way, has there ever been a better time to figure out what gold is really all about? These are serious and far reaching issues. It's high time for a serious and far-reaching discussion of them. If that sort of thing interests you, make sure you read about the upcoming gold conference in Canberra early next month. You can read more about it here.

Dan Denning
for The Daily Reckoning Australia

• Gold, the Aussie Dollar, the Greenback and You
• AUD Price of Gold a Measure of Gold’s Strength Against Other Currencies
• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• Gold and Oil are Acting as Though They Expect Higher Rates of Inflation

But how much more insight do we really need? We know the world is in the early stages of recovering from the greatest debt binge of all time. The central bankers are trying to keep the party going and prevent debt deflation. But the accumulated liabilities from the boom have to be written down or written off. Balance sheets must be rebalanced.

And we also know that markets are giving way to politics. The free market is waning. Government run markets, on the other hand, are waxing.

For example, it appears China is beginning to throw its considerable economic weight around. It's doing so in a tentative, experimental manner, not sure if it will offend but not seeming to care all that much. And why should it? The world is perfectly happy to do business with the largest emerging market of the next fifty years. Other issues-human rights, the environment, and the Rule of Law-are secondary.

It should be interesting to watch. If economic Empires were like teenagers, they'd be temperamental, volatile, and inscrutable. And so China-which to be fair is a venerable 5,000 year old culture-is entering its economic adolescence. Proud, confident, and slightly unpredictable.

For instance, is China trying to put Australia in its place by arresting Rio Tinto executive Stern Hu? Is this a not-so-veiled message that if Australia wants to benefit from China's industrial growth and stimulus pending, it had better be more compliant on things like, oh...say...iron ore pricing? Is Australia just now discovering that the new economic order comes with certain terms and conditions that are not negotiable?

And here's the really interesting question: If China is flexing its economic muscle, can it simply change the rules of global capitalism? China's market is large. Its savings are legendary. And the Western model of capitalism doesn't have a lot of moral authority and the moment. So will businesses be willing to do business in China, on Chinese terms, at the risk of landing their executives or workers in jail if they run afoul of ambiguously defined laws?

From a Chinese perspective-and we're only imagining here-it must be a bit too much to be lectured by anyone in the West on the Rule of Law or corporate ethics. After all, there's been plenty of Law breaking/flouting/changing in capitalist economies over the last few years. Does China's government intervene, intimidate, and manipulate any less than governments in America, Britain, France, Germany , and Russia?

The fact that we're even asking that question-unless it's a really dumb question-is not good for markets. It means that in currency matters, business matters, regulatory matters, and tax matters, investors have less and less certainty about the environment they're operating in.

Not that investors ever have total certainty. But the more variable and unpredictable (and capricious) the action of the State is, the more you can expect investors to lay up their stores in cash and sit on the sidelines. When you can't trust a currency or a sovereign bond...well then you're probably going to become very conservative about your future capital spending (and borrowing). All of which argues for either a second dip to the American (global) recession or anemic economic growth.

And then there was this bit of dollar subterfuge from the G-8 summit in Italy. "We should have a better system for reserve currency issuance and regulation so that we can maintain relative stability of major reserve currencies' exchange rates and promote a diversified and rational international reserve currency system," said Chinese State Councilor Dai Bingguo, according to today's Age.

How about that? China has 70% of its foreign currency reserves in U.S. dollars. It's walking a fine line. It would clearly like to rattle its currency saber in order to keep American deficit spending (and potential dollar devaluation) from threatening the value of those investments. But by repeatedly brining up the dollar's weaknesses, it does the very thing it wants to avoid; threatening the value of its dollar-based investments.

Free markets-one simple. Now complicated.

French President Nickolas Sarkozy tried to defuse the situation, but he only managed to sound like a moron. "These are complex subjects where positions have to evolve, but we can't remain based on a single currency," he said.

Then, proving that politicians knows more about dating leggy models than running an economy economics, he added, "We have to ask ourselves: Shouldn't a politically multi-polar world correspond to an economically multi-monetary world?"

If the Lion is the King of the Jungle, should he not also be King of England?

You can argue about where political power comes from. Some say trade. Some say sound institutions governed by the Rule of Law. Some say the barrel of a gun. For example, a nation can have a small economy. But with a small nuclear arsenal, it's going to punch above its weight geopolitically.

But economic power is not based on exclusively on coercion or the ability to intimidate your trading partners/strategic rivals. A "multi-monetary" world would be fine by us if it meant there was a free market in money. You would be free to use whatever money suited you best, and you would judge that money on its stability and its utility.

Yet as we begin the week, it's becoming plain to see that there's no such thing as a "multi-monetary" world right now. It's really a "bi-monetary" world. There is government printed (fiat) money-backed by nothing except the economic potential of the economy from which it comes (or the coercive power of the State which issues it). And there is free market money.

Free market money-at least in a world rife with mistrust about government money-is going to be gold and silver. In a geopolitically influenced market, a bi-metallic view on money may turn out to be the biggest winner.

And for what it's worth, we believe the larger cost of the credit bubble-in addition to the trillions in household wealth wiped out and trillions more in misallocated capital-is how far from its traditional roots Western capitalism has strayed. When people are free, when rules are clear and fair, when money is sound, and when private property is respected and money is not confiscated by the State, political liberty and economic liberty thrive side by side. Indeed, one is not possible without the other. More on the subject this week.

Dan Denning
for The Daily Reckoning Australia

• Nobody Appreciates Laissez-Faire Capitalism
• China Will Rule the Business World While America Finds Itself Heavily in Debt
• HOORAH FOR CAPITALISM!
• The War On Capitalism Continues
• Free Market Capitalism, The God That Failed

The Dow rose again yesterday - up 101 points. Oil went up too - to $56. The dollar held steady. And gold was up again...to $911.

"Emerging market surge...Investors pile in on hopes of improved global economy," says the Financial Times.

And this from the Telegraph: "Recession 'over by Christmas,' says Fed chief Bernanke."

He did not say "Mission Accomplished." That phrase was used too recently by another high official. In that event, the mission turned out to be not as accomplished as he thought.

Will the government's War on Capitalism turn out better than their War on Terrorism? Or their War on Drugs? Or their War on Poverty?

"The last successful government program was WWII," said Jimmy Breslin. Since then, almost all of them have been useless or counterproductive. But year in and year out, they've given federal hacks more money and power.

The current War on Capitalism didn't begin a year ago, by the way. The feds have been conducting a dirty, undercover campaign against the free market for many years. Instead of permitting willing lenders and borrowers to set the price of credit, for example, the Federal Reserve imposed its own short-term rates many times over the last 50 years. Eleven times during that period, capitalism tried to correct the "borrow and spend" economy. Each time, the feds rushed in with more credit on even easier terms. By the recession of 2001-2002, the feds were intervening with such heavy hands that it set off the bubble in housing prices in the 2002-2007 period.

And when the bubble exploded, the fed's dirty campaign turned into a major war with huge pitched battles...and millions of casualties.

Bloomberg reported yesterday, "nearly a quarter of US homeowners are underwater." When the Fed flooded the market with so much easy credit, it pushed up housing prices way beyond what people could afford. Capitalism struck back - blowing up the dikes that held all that liquidity in place. But the explosion blew out the cushion of equity that kept homeowners afloat. House prices are still falling at a 14% annual rate. "Less than before," say the bulls. But still going down.

This has left some communities - such as Salinas, California - with as much as one-third of the housing stock worth less than the money owed against it.

And in Victorville, California, the bank decided it had too many foreclosed houses. An entire new development of 16 houses - some completed, with granite countertops and all...some incomplete - had been foreclosed. Squatters and vandals were making a mess of the place. So the bank demolished the lot of them.

And overstretched homeowners who have an "Alt-A" or "Option ARM" mortgage are in trouble come 2011...when the majority of these loans will reset at a higher rate. You think it was bad when the first wave of defaults hit the United States? This could have even more catastrophic consequences.

Today, the results of the stress test on banks are out. They show some banks in good shape. Others need more capital. Bank of America, for example, is said to need another $34 billion. Wells Fargo needs $15 billion. GMAC and Citi both need more cash.

But investors decided to look at the part of the glass that was full rather than the part that was empty. They pushed up financial sector stocks generally.

If capitalism had its way, it would sort out the banks quickly. Banks that couldn't raise the money they needed would go out of business. Their assets would be bought up by the solid banks. Life would go on.

But the feds' war against capitalism prevents this kind of simple resolution. Instead, weak, mismanaged institutions are kept alive with taxpayers' money.

"Trillions of dollars have been thrown at the system so that we can avoid the natural process of creative destruction," write Matthew Richardson and Nouriel Roubini in today's Financial Times.

Our next question: where is all this money going to come from?

Bill Bonner
for The Daily Reckoning Australia

• Free Market Capitalism, The God That Failed
• Capitalism Always Takes an Economy Where it Ought to Be
• Why Those Who Praise Capitalism Have So Little faith in It
• Stock Market Continues Its Recovery
• Capitalism is Inherently Unstable

Richard Layard from the London School of Economics, offered a way forward:

"We should stop the worship of money and create a more human society," he writes. "Happiness has not risen since the 1950s in the US or Britain," he points out, despite big increases in wealth. "Modern happiness research can help find answers," he believes.

"Old fashioned socialist planning is the only coherent alternative to a collapsing capitalist economy," an alert FT reader added.

Given the depth of these insights, we decided not to dive into this discussion headfirst. Instead, we will simply mock the swimmers from the bank. Brazil's president, Lula da Silva, for example, could only come up with a campaign slogan: "The future of human beings is what really matters." But who can blame them? They want a capitalism that makes people happy...fairer, gentler, greener... they want to reform it...to housebreak it...to cut its balls off so they can safely put it on a leash and introduce it to their daughters.

But they miss the point of it altogether: we can't reform capitalism; it reforms us. Capitalism punishes mistakes and rewards virtue (or good luck) - not necessarily quickly or gently...but roughly and imperfectly, like a hanging judge in a frontier town. On paper, of course, we can do better. Imagine a world where public employees are saints and geniuses who do such a swell job of allocating capital we want for nothing. But then, when we get a chance to see them in action, we find that they are bigger rascals than the capitalists themselves.

This week, under pressure from its new proprietor - the U.S. government - AIG released a list showing who had gotten more than $100 billion of its bailout money. At the top of the list of recipients was a familiar name - Goldman Sachs. In a truly astonishing co-incidence, Goldman is the firm that had been run by the very person who headed up the AIG rescue - former Treasury Secretary Hank Paulson. And what serendipity! Lloyd Bankfein - Goldman's top man now - was actually in the room with the feds when the AIG rescue plan was put together.

"...we can't reform capitalism; it reforms us. Capitalism punishes mistakes and rewards virtue (or good luck) - not necessarily quickly or gently...but roughly and imperfectly..."

In the room; in the deal. But the big scalawags ducked out of the press almost immediately. Instead, the headlines focused on the small fry. AIG paid bonuses of $450 million - some charged it was $1 billion - to its executives. These guys shouldn't get bonuses, came the popular outcry; they should get a firing squad.

You'll recall the story. The insurance giant AIG lost money on a series of gambles. For example, it gambled that it could insure the mortgage payments of people who couldn't afford to buy a house. During the bubble years, people bought houses at outrageous prices. They could borrow 80% of the purchase price from government-backed debt mongers Fannie Mae and Freddie Mac. Buyers were supposed to put up the other 20% themselves, giving lenders a margin of safety in case the transactions didn't work out as planned. But, if an insurance company would guarantee the other 20%, Fannie could cover 100% of this "enhanced" mortgage loan. AIG found that insuring this part of the loan was profitable - as long as nobody asked questions. But then the market price for the collateral dropped - by as much as 50% in some areas. Suddenly, people were walking away from their houses. Defaults on these "enhanced" loans ran at 5 times the rates on normal Fannie-backed mortgages.

An ordinary person would look at these facts and pronounce the same judgment as the capitalist market: AIG and Fannie both deserve to go broke. But give him enough higher education in the economics department, or a job in government, and the fool rushes in --with someone else's money.

In the theory of bailouts, an ailing firm is given a helping hand when it needs it. This gives it time to get back on its feet, and prevents it from dragging down its employees, lenders, investors and counterparties. But what actually happens is much simpler. Money is goes from the pocket of the person who earned it...to the pocket of someone who didn't...from the innocent bystander to the fellow who caused the accident. Capitalism takes money away from erring capitalists; the capitalism improvers give it back to them.

And who decides who gets the loot? Ah...as soon as you hold them up to the light, the angels' wings fall off. By and large, these are the same cherubim and seraphim - such as Hank Paulson - who were supposed to be leading...regulating...and controlling capitalism when it ran into a ditch. Not a single one raised a warning. Instead, they whooped for the free market and passed the whiskey bottle to the driver! And now, thanks to their bailouts, AIG continues writing insurance against mortgage loans. Seventy-three AIG executives continue getting $1 million bonuses. A long line of reckless counterparties goes unpunished. And Hank Paulson offers advice to Financial Times readers on how to make capitalism work better.

But that is always the problem with improving capitalism...even in the slapstick American way. The reformers promise a 'new deal,' but they've always got an ace up their sleeve somewhere.

Bill Bonner
for The Daily Reckoning Australia

• Fannie and Freddie in a Free Market Economy
• Fannie Mae and Freddie Mac Investors Have Already Lost 80% of Their Money
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• Let Us Explain How the Financial Industry Worked
• Feds to Buy Government Debt

Finally, a nation with a little backbone...a little integrity...a little good sense. And guess what, it's that dreary socialist refrigerator - Sweden. Asked to bailout its GM-owned automaker, Saab, the country's Prime Minister just said 'no.' Good for him...

"Voters did not pick me to buy loss-making car factories," he explained.

But it's a time of contradictions, paradoxes and oxymorons. Up is down. Right is left. In is out. Good is bad.

The socialists are the only ones protecting the free market, now. Americans are scuttling it with every chance they get. The stocks of capitalist companies are going up in communist China...but in America, they're going down. Since November, the Shanghai index has outperformed the S&P by 75%.

And back in the United States, projects that were considered too marginal to justify spending money a year ago are now thought to be indispensable. And the IOUs of the biggest spendthrift on the planet are the hottest item on the market. Ten-year Treasury notes are now priced to yield only 2.99% - just as the Obama administration announces a $1.75 trillion budget deficit.

Even crooks and criminals are flummoxed. A guy walks into a big downtown bank. He points a gun at the teller and says: "Give me all your money."

The teller replies calmly: "You don't understand. This is a bank. We don't have any money."

The only people with money now are the people who never earned any...the people who print the stuff.

But back to China:

All the things that used to convince pundits that China was hopeless now persuade them that it's the hope of the entire world. "China's autocrats can announce a stimulus - and get on with it," writes John Authers, admiringly, in the Financial Times. They don't have to beg and bicker with the dunderheads in Congress. They can just do it.

And China's banks are more solid, too. "China's are in good health, with both loans and deposits rising. American counterparts are not."

But our irony cup runneth over when we read Auther's next comparison:

"Finally, there is confidence in officialdom." The markets have lost confidence in Tim Geithner and the rest of the feds, he says. "Meanwhile, hope...is pinned on the audacity of Chinese officialdom and is ability somehow to keep their economy on course."

Everything is so topsy-turvy, dear reader, we think we're going to throw up.

The whole world now turns its weary eyes...not to that bastion of free- market leadership, the United States of America, but to a country that has only had a quasi-free-market in goods and services for less than a quarter century...a country still run by Maoists. It is to them that we supposedly look to save the world economy!

What a great time to be alive! Practically every headline makes us want to reach for a drink. And we're finally getting to see something that we only read about in the history books...yes, we're going to find out what makes a depression so great.

Bankruptcy filings in the United States were up 37% in February, over the year before. House sales plunge, say the papers. Auto sales plunge, say the websites. Joblessness soars, says this morning's news. Corporate America laid off 158% more workers this February, as compared to a year ago. Since the beginning of the year, layoffs are running 191% ahead of the same period in 2008. Almost a half a million people have lost their jobs so far this year...and there are 10 months left to go.

The Dow gained 149 points yesterday. Our "Crash Alert" flag is still flying...but the Dow is probably going to rally for the next few days.

Gold, meanwhile, continues its correction. It fell to $906 yesterday. Goldbugs, don't despair. Have faith. The commies aren't going to pull the world economy out of its tailspin. The bailouts and boondoggles in the West aren't going to do it either. Buying gold is still the smartest long-term decision that you can make for your portfolio...and we suggest you take advantage of this correction. Buy some while the price is low - and even better, you can get the yellow metal for just a penny per ounce.

Remember, this is a depression, not a recession. Both America and Chinese economies have lived in a grand, symbiotic delusion for the last 10 years. America believed it could let the Chinese do all the sweating and saving. China believed it could make money by selling to people who couldn't afford to buy. Now, both economies need perestroika. Both need to be refocused. China will turn its economy towards domestic consumption...and military spending, no doubt. America will have to accept a lower standard of living with fewer imports.

These adjustments take time. The last time the world went through a depression was in the '30s. Every major economy - except Britain - fell backwards...all of them losing more than 20% of GDP. It took three years before they hit the bottom. Then, some bounced back quickly - Germany and Japan - thanks to military spending. Others - the United States and France - barely bounced at all.

*** More bubbles ready to burst. In the United States, public pension systems are under-funded by about $1 trillion. Firemen, teachers, policemen, municipal workers...state bureaucrats. Every one of them is looking to the feds for a bailout.

Oh...and AIG is getting its FOURTH go-round of rescue money. The fifth one will come around soon enough. And there's Detroit...California...student loans...commercial loans...the banks...the homeowners...the unemployed...the sick...the halt...the lame...the blind...the plain stupid.

Where will the feds get the money?

They'll continue to borrow it. Then, when lenders get tired of lending, they'll print it. That's when gold will really fly...but that might not be for another few years.

For the moment, lenders like buying U.S. government IOUs. It's the only thing they feel they can trust. One way or another, they're sure Uncle Sam will make his payments.

But, as we've been saying, we live in an upside down world. If and when the fear subsides, investors are going to look elsewhere for yield. Prices will begin to rise again. So will yields. So, the U.S. government will have to pay more to borrow. Thus, as things get better for the economy...they will get worse for the U.S. Treasury. It will find itself with higher and higher interest costs...and no way to pay them.

What will they do? Throw up their hands and admit they can't make their payments? Or print money? We've already made our guess; they will do the wrong thing.

*** What is the right thing to do?

"Leave it to time to affect a permanent cure by the slow process of adapting the structure of production..." said Friedrich Hayek.

"Depressions are not simply evils, which we might attempt to suppress," added Schumpeter, "but forms of something which has to be done, namely, adjustment to change."

The economy needs to be restructured. The dead wood needs to be burnt off. But the feds are trying to stop the fire.

Alas, said Schumpeter, "most of what would be effective in remedying a depression would be equally effective in preventing this adjustment."

Bradford Delong explains:

"...certain investments should not have been made. The best that can be done in such circumstances is to shut down those production processes that turned out to have been based on assumptions about future demands that did not come to pass. The liquidation of such investments and businesses releases factors of production from unprofitable uses; they can then be redeployed in other sectors of the technologically dynamic economy. Without the initial liquidation the redeployment cannot take place. And, said Hayek, depressions are this process of liquidation and preparation for the redeployment of resources.

"As Schumpeter put it, policy does not allow a choice between depression and no depression, but between depression now and a worse depression later: 'inflation pushed far enough [would] undoubtedly turn depression into the sham prosperity so familiar from European postwar experience, [and]... would, in the end, lead to a collapse worse than the one it was called in to remedy.' For 'recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another [worse] crisis ahead.'

*** We got on the Paris metro this morning. In the car, there were two fellows...bums...in worn-out jackets...scuffed-out shoes, without socks. They didn't seem drunk or drugged, just very tired. One bent over with is his head on his knees. The other was bent over too but uncomfortable...swaying, as if he was about to be sick. Both had an eastern European ...or Turkish look. Maybe they were gypsies...dark complexions, but European features...rough, course...with thick hands and dirty fingernails. Occasionally, they exchanged words in a language we didn't understand. The older one seemed less well than the younger man, who was probably in his 40s. As they tried to sleep, the younger one fell off his seat. Catching himself...he put his head back on his knees...and then, a minute later, he fell off again...this time right onto his head. Then, he picked himself up and sat down...and dozed off again.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• The New Chinese Era
• A Long Time Before Investors Will Gamble on Housing Debt
• China Was the Maker and the United States Was the Taker
• The More Money in a Financial System the Less Each Unit is Worth
• China Reduces Holdings of Treasury Securities

But let us take a moment to bow our heads and offer this Prayer of Thanksgiving...

Thank you, good Lord, for everything.
We are still alive. We are still solvent.
Help us stay that way. If not both, at least the former.
Lead us not into temptation. Keep us in gold and cash until this is over.
And thank you for bringing the man called Obama to the White House...he might not be any better, but he could hardly be worse; or could he?

Okay, we've said our prayers...now, down to business...

Yesterday, the stock market continued its recovery. The Dow was up 247 points. Oil sank to $54. Gold lost $7.40 to come to rest at $811.

We have been waiting for a major rally. Perhaps it is here. But watch out. It is probably temptation coming...

Wait...this is national holiday in America. This is probably a good day to tell you:

What We Believe

Yes, dear reader, we may be cynics, scoffers and doubters here at The Daily Reckoning, but we're not nihilists. We have our beliefs. And feelings too. Really.

Here is what we think:

Financial markets are part of public life. As a consequence they follow the rules of all public spectacles. That is, they are one part rational and sensible...one part incomprehensible...and one part pure humbug. You never know exactly which part it is you're looking at.

But the markets are also moral, not mechanical. That is, they follow moral rules, such as - Thou Shalt Buy Low and Sell High...Thou Shalt Save Thy Money...Thou Shalt Not Speculate Unless Thou Knowest Exactly What Thou Art Doing.

Break those commandments...and you're on the road to money Hell. No point in tinkering with the machine. You can't 'fix' it. That's just the way it works. Financial sins are punished, one way or another.

But moral lessons - as opposed to mechanical knowledge - are cyclical, rather than cumulative. One generation learns. The next forgets. That's why the biggest market trends tend to follow great, long cycles - approximately generational in length. In 1929, for example, stocks hit a generational high. They didn't recover until 1954 - 25 years later. They reached a peak in 1966...and then declined until 1982. They didn't reach another major peak until 2000 - 34 years later.

We all know what has happened since. The market tried to correct in 2001-2002, but the feds wouldn't let it. They inflated the biggest bubble of credit and speculation in history...

...that bubble has just burst.

What now? Well, we can expect a long period of regret, reorganizing and repentance. It takes time to undo mistakes. It takes time to learn. It takes time to correct the errors of a 25-year bull market.

If the real top of the bull market cycle came in 2000, we will probably see the next peak around 2025. Meanwhile, there is a dark valley to cross.

But wait...there's more.

Because while the private economy is reluctantly owning up to its mistakes...going into rehab...making amends...rebuilding balance sheets....and promising never to do such stupid things again...

...our leaders are doing all they can to stop the learning process.

"Here's $800 billion," was yesterday's temptation. "Go out and have a good time."

"Rescue, Part 2" is how the International Herald Tribune describes it. The plan itself has two features. In the first, the feds will spend $200 billion to buy up loans made to consumers and small business. In the second, another $600 billion will be offered to the mortgage industry.

Our colleagues at contrarianprofits.com describe the program:

"It's an $800 billion slush fund aimed at loosening credit for homebuyers, consumers and small businesses.

"And it may get bigger...

"Treasury Secretary Hank Paulson has left the door open for more funds. He says, "The facility may be expanded over time and eligible asset classes may be expanded later."

"Why doesn't this come as a surprise?

"So there is still no telling how much more money the government will throw at this crisis. But our back-of-the-envelope calculations puts the running total at over $8 trillion."

The Washington Post sums it up beautifully. "A year ago, the central bank had assets of $868 billion, of which about 90 percent was in Treasuries. Last week, it had assets of $2.2 trillion on its books, of which 22 percent was in Treasuries."

How this will end, we don't really know.

But we know this: You can't pump $8 trillion in funny money into the economy and not expect consequences."

Meanwhile, the Europeans don't want to be left behind:

"The European Commission urged EU governments Wednesday to jointly combat the economic slowdown with euro200 billion (US$256.22 billion) in spending and tax cuts to boost growth and consumer and business confidence.

"If fully enacted, its two-year ``European Economic Recovery Plan'' would see the 27 EU governments spend 1.5 percent of the bloc's gross domestic product to halt the slowdown that has already pushed some European nations into recession."

But let's not get distracted by the details. The markets are teaching people a lesson. The feds don't like it. They want people to believe that the economy is a mechanical system...that they just need to find the right screws to turn...and the right levers to pull.

Since the "machine" is visibly slowing down, these simpletons think they can get it going again. Just add more fuel!

Of course, as we saw in 2001-2007, the feds can certainly have a big effect on the economy. Their "economy as a machine" theory often seems to work. In fact, practically everyone believes it will work. They just argue about which screw to turn...and who should do the screwing.

The Keynesians say you turn the screw marked "fiscal policy." When private spending slumps, just replace it with government spending. Pretty simple, no? But when the feds turned that screw - arguably, too far - in the '60s and '70s, it didn't seem to work. Instead, they got stagflation.

So, Milton Friedman pointed to the lever marked "monetary policy." Give that a pull, he said. It will make sure that the economy always has just the right amount of credit at just the right price. So, Maggie Thatcher and Ronald Reagan both pulled on the monetary policy lever. And Alan Greenspan swore by it. He yanked it so hard in the recession of 2001-2002, the handle practically broke off. Milton Friedman was still alive at the time and actually approved of Greenspan's handiwork, saying that he had 'spared the economy a worse recession,' or words to that effect.

Now the machine has broken down again. It has thrown itself into reverse; the 3rd quarter showed an absolute decline in US output - and it's speeding up in the wrong direction! And now the terrified feds are 'pulling out all the stops.' Which means they using both Keynes and Friedman, and every other tool they can get their hands on.

But the real problem is this: the "economy as a machine" theory is much too simple. No theory, said the philosopher Godel, is ever complete. In science, each one is a stepping stone, towards a fuller and more complete theory. Even theories that take you in the wrong direction are useful - at least in science. They are eliminated...and discarded, so science can take a new direction.

In economics, no theory is ever discarded. Instead, they are merely recycled as market conditions change. "Markets make opinions," say the oldtimers. In a boom, it is the free market theories everyone wants. "Leave the market alone...it will take care of itself," they say. But in a bust, the cry goes up: "Help!"

For the moment, Mr. Market's correction still dominates the economy. One way or another, it will continue for many years. But the Feds are turning the screws and pulling on the levers. Keynes is in fashion...for the present. But Friedman is still around too. Between the lot of them, they ought to be able to do some spectacular damage

But there is plenty of room for surprises...and more mischief from the feds. At some point, we presume the feds will succumb to the lure of the printing press. By some accounts, they already have. Then, we'll really see some excitement.

So, enjoy your Thanksgiving turkey...and stay tuned.

*** Frugalista. It's the latest thing, dear reader. Just as we predicted, being thrifty has become fashionable again...so fashionable they even have a word for it: frugalista. It means someone who doesn't like to spend money but it nevertheless very stylish.

Spending money is soooo 2007...appearing rich is soooo passé.....having a big car, a big house, a big bank account is soooo, like, yesterday.

Chic poverty. Coming soon, to neighborhoods near you.

Bill Bonner
for The Daily Reckoning Australia

• The Fed Will Cut Rates Today
• 2009 Federal Deficit Could Go As High As $2 Trillion
• The Fed Continues to Bamboozle Consumers Into Thinking They Are Richer Than They Really Are
• They Say the Stock Market ‘Looks Ahead’
• How Much Worse Can the Stock Market Get? A Lot Worse

All around us is virgin territory. No one has ever been here before. But watch out, these virgins are vicious amazons. In this wild place, you can forget living it up. Don't even think about getting rich. Riches? If you've got 'em...hide 'em. Luxury? Who needs it anyway? The best you'll be able to do is survive. And then, maybe, years from now, we can put our financial lives back together again...and get on with things...

Never before have seen so much wealth disappear in such a short time. The latest report from MSCI shows the planet's losses from the sell-off of equities has now reached more than $30 trillion - or more than twice the GDP of the U.S.A.!

And this is just stocks. Reported write-downs, write-offs and credit losses have reached almost a trillion. And losses of housing prices in the United States alone - the only country for which we have reliable figures - has reached about $5 trillion.

Nor have we ever seen such a rapid reaction. In the space of a few months, people have gone from believing that nothing could go wrong to thinking that there's nothing that won't go wrong. Where once they thought that free-market capitalism would make them rich...they now believe that the government can save them from getting poor. And where only a year ago they thought the world's globalized economy would always give them everything they needed "just in time," they now believe they better keep a few sheckels on hand "just in case."

And just look at the bonds! A few months ago, investors stretched for yields. Now, it's safety they reach for. They dump corporate bonds for fear they may be "toxic," and grab U.S. Treasury debt with both hands. Investors now seem to have an unqualified trust in the full faith and credit of the world's largest debtor. Yields on 91-day T-bills have fallen to 0.11% - scarcely a tenth of one percent!

Yes, dear reader, the "Great Unwind"...the "Big Bust"...the "Great De-leveraging" - call it what you want; we've never seen anything like it.

The Dow rose 151 points yesterday - a limp and pathetic little attempt buck the downward trend. Gold lost $6.80...leaving it at $735.

China's stock market had managed an 18% rebound...following the announcement of its half-trillion dollar bailout plan. But yesterday, Chinese stocks were collapsing again.

The latest news from America tells us that housing prices are still going down in 4 out of 5 cities. Homebuilders' wives are hiding the shotguns and pouring out the whiskey; their husbands' confidence has never been lower, according to this morning's news report.

Big towns...little towns...in the sophisticated cities and out in bumpkin country, the story is the same. The Wall Street Journal tells us that the "fall in crop prices" is putting an end to the boom in the boonies.

U.S. producer prices fell 2.8% in October - the most they've ever fallen. And the Big Three automakers say that if they don't get some help soon, the results will be "catastrophic."

Meanwhile, over on the sunny California coast, the whole state is going up in smoke...it's not only going broke, it's burning up.

"I have to dust the ash off my car every morning," reports daughter Maria, recently arrived in LA and hoping to make it big in the motion pictures. "It's eerie...there's always a little smoke and soot in the air..."

Not only is the bust unlike anything we've ever seen before...so is the planet-wide effort to stop it. All over the globe, the feds are going 'into the wild' with extraordinary measures. They're mobilizing troops to fight the crisis in the boardrooms. They'll fight it in the stock markets. They'll fight it at home - with house-to-house combat to stop foreclosures and defaults. They'll fight it abroad - the U.S. government is even loaning money to foreign governments! They'll fight it with loans and giveaways. They'll fight it with fiscal policy. They'll fight it with monetary policy. They'll fight it with every weapon available to them - including the printing press.

And they will lose.

*** To give you an idea of the wild measures undertaken by the feds, we look at what is happening at the world's leading bank - the U.S. Federal Reserve.

The short form of how the Fed operates is this: it holds a certain amount of securities in its vault; this is the cornerstone capital - or monetary base - of the whole banking structure. How does it get this capital? It buys it, creating the money to pay for it as necessary. Naturally, the Fed doesn't want to create too much money or the inflation rate would get out of control and economists would point their fingers accusingly. But now, people fear dandruff more than inflation. So, the Fed has gone wild.

From the day of its founding in 1913 to September 24, 2008 the Fed's assets - the aforementioned cornerstone capital for the US financial system - grew to $1 trillion. By November 14, 2008 the amount had grown to over $2 trillion. And in a speech in Texas, the head of the Dallas branch of the Fed said he expected the total to reach $3 trillion by year-end.

For the moment, this explosion of monetary inflation is hardly noticed. Asset deflation has the headlines. People worry about having too few dollars, not about having too many.

Comes the news this morning that U.S. business chiefs are asking the up-coming Obama administration for another $500 billion 'stimulus' program. They'll get it. And much more. Trillions worth.

Trying to stimulate the economy with easier credit in the early 2000s, Alan Greenspan overdid it. He gave the world the credit it wanted, and created the biggest bubble in human history.

Now that bubble is collapsing and his successor - Ben Bernanke - is confronted with a new problem. Now it is cash that people want - income to pay their debts! Bernanke will give them what they want. And, most likely, he will overdo it too.

*** At a recent hearing on Treasury Department use of government assistance funds, Ron Paul, who is well-known for often calling out the Federal Reserve chairman on their liberal use of the printing press, took on Big Ben. Here is the transcript of their interaction, in case you missed the C-SPAN coverage:

Ron Paul: The Austrian free market economists had predicted all these problems would come, and they were certainly correct in everything that they said. Of course they're not very satisfied including myself with the so-called solutions, because it looks like we're spending a lot of energy and a lot of money trying to patch a system together that is unworkable.

So we have Congress spending a lot of money, we have Treasury very much involved in trying to pick and choose which worthless asset that we're going to buy, and of course the Federal Reserve is involved in injecting trillions of dollars that nobody seems to be keeping track of.

But what we're failing to do I think is to recognize that the system no longer works, but I can understand why we do this because if Congress couldn't do this and if the Fed couldn't do this and Treasury couldn't do this, it would make us all irrelevant. And instead of looking at the causes of this, and then finding the solutions aren't going to be found here, we have to make ourselves feel pretty important.

But I think there's another reason we think we're pretty important, it's because in a way our interference in the market corrections that tried to come about since 1971 seem to work. I mean, the failure was established in 1971 with a system that had no way of automatically correcting the balance of payment and the current account deficits.

And that's where the problems have been, and economists - whether they were left or right or middle - over the last several decades have always said, this current account deficit is a big problem. And now it's totally out of hand. So here we are struggling with all these rules and shifting back and forth and really getting nowhere.

My question is directed toward, when we come to the full realization that the system is unworkable, what are we going to do, what have you thought about doing, and already we see talk in the newspapers. We see articles about a new international world reserve currency, and to me that's pretty important, because the fiat dollar reserve system is not going to work anymore, and that's the information that we have to accept and decide what we're going to do in the future.

Also, this is not new in history. Currencies have failed, financial systems have failed, and generally, to restore the confidence that everybody is talking about, they usually have to go back to a currency with integrity to it, rather than just fiat money.

And, you know, the stages is there. It's not impossible, already the central banks of the world still own 15% of all the gold that was ever mined in all of history. So they hold on to this gold for some reason, and therefore something has to give, or are we going to keep trying to waste more money and time patching this system together.

Just last week there was a report that Iran purchased 75 billion dollars worth of gold, took their reserves out of Europe, bought gold and put it in Asia. So is that a sign of the times, is that moving on?

My question is, in your meetings, and you had a meeting just recently with other central bankers, does this thought come up about a new international world reserve currency, and if so, does the subject of gold ever come up?

How do you restore the confidence? Have you recently had conversations with any central banker, and is there a move on to replace the dollar system, because the dollar system is essentially declared dead, because it's not working, but this indeed was predictable because of these tremendous imbalances that were never allowed to be corrected, and they were always patched up. We always came in. We'd spend, we'd inflate, we would run up deficits, and since '71 we've been able to correct these problems.

Could you tell me what kind of conversations you've had regarding a new reserve currency?

Ben Bernanke: Yes, Congressman. I don't think the dollar system is dead. I think the dollar remains the premier international currency. We've seen a good deal of appreciation in the dollar recently during the crisis precisely because there's been a lot of interest in the safe haven and the liquidity of dollar markets.

And the Federal Reserve has been engaged in swap agreements to make sure there's enough dollar liquidity in other countries because the need for dollars is so strong. So I think the dollar system remains quite strong.

I do agree with you very much on one point, which is about the current accounts. The current account imbalances have proved to a very serious problem. It was in fact the large capital inflows in those current accounts which created a lot of the financial imbalances we saw and have led to some of the problems we are seeing, and one of the silver linings in this huge grey cloud is that we're seeing some improvement and greater balance in our current account deficits.

Ron Paul: But does the subject of a new regime ever come up?

Ben Bernanke: No, it doesn't.

Ron Paul: And does the subject of gold ever come up in any of your conversations?

Ben Bernanke: Only in terms of the sales that the central banks are planning.

The I.O.U.S.A. team interviewed the Congressman for the documentary. If you didn't have a chance to see the film when it was in theaters, now's your chance. We are offering an exclusive package to long time DR sufferers: you can get the DVD (before it is released to the general public), the companion book and your own personal bailout package. Don't let this opportunity pass you by...quantities are limited, and are going fast.

*** GWB - you can't say we didn't warn you. A top British judge has just announced that he considers the Bush administration's attack on Iraq as a violation of international law. Years from now, George W. Bush is likely to be charged with war crimes and human rights violations. Normally, this would pose no problem. A former U.S. president could expect the protection of the U.S. government. But as Americans sink into depression they are not likely to feel kindly towards their ex-president. They will blame him for the decline of their incomes...and for the fall of their empire. They are likely to want to cooperate with the world's new institutions...and throw over their own former commander-in-chief.

Advice to GWB: Go back to Texas. Don't ever leave home again.

*** Colleague Patrick Cox, at Breakthrough Technology Alert offers some rare optimism into this otherwise downright gloomy market:

"Yes, we have been swindled by politicians who pushed the U.S. banking system into the shape it's in today. The people who tried to stop the meltdown have utterly failed to explain the root of the problem to the American people. We've officially entered recession now and policymakers will do little to address the real problems.

"Though the hit the economy has suffered recently pales in comparison with the drain on world resources associated with that war, our situation is similar. We are at a point of incredible opportunities.

"The reason is, in a word, science. The accelerating pace of breakthrough discoveries will deliver economic benefits that few fathom today. While the entire world will gain from these discoveries, investors who understand what we are going through now will profit most and earliest. Even better, the return on these stocks will be so great that even relatively modest investments will produce fortunes.

"Let me give you a few hints about the shape of things to come. Just in the last few weeks, two groups of scientists announced the discovery of microorganisms that produce biodiesel naturally. Professor Gary Strobel from Montana State University discovered a fungus deep in the Patagonian rain forests of Argentina. This organism naturally produces the long chain hydrocarbons needed to create fuels.

"Even bigger news is coming on the medical front. I predict that real stem cell therapies will be offered offshore within the year. Currently, there is a billion-dollar industry offering stem cell snake oil, but real lifesaving and life-extending therapies are already available in the laboratory. These therapies are relatively inexpensive to produce and will revolutionize medicine. Even the FDA will come around when wealthy early adopters begin reporting true rejuvenation results. By the end of Obama's first term, we will see SC and other therapies that will radically cut the cost of treating horrendously expensive illnesses."

Patrick has been alerting us to a breakthrough that could change the way we view modern medicine. And when news breaks - which is rumored to happen tonight - those who have gotten in on this revolutionary idea stand to make some pretty major gains.

*** We got a letter from Her Majesty's government.

"Winter Fuel Payments...don't miss out!"

Yes, dear reader, this is how societies collapse. People invent problems. Then, they find solutions to the problems. Then, the solutions cause more problems. And finally the cost of all the solutions brings the whole system falling down.

A news report out today tells us that the weekend will be cold. An "arctic blast" is said to be on its way.

Of course, some parts of the city already feel as though they were in a nuclear winter. London's main industry is finance. And finance has iced up. A headline in yesterday's paper told us that London is expected to lose 370,000 jobs over the next two years.

But thank God for the world improvers:

"Our records show that you may become eligible for a payment this winter," begins the letter.

Why? Because your editor is enrolled in the Britain's national health service (a requirement for employment). NHS records must have revealed to the authorities that your editor turned 60 in September. Accordingly, he is eligible for 125 pounds to help him with his heating costs this winter.

Imagine the miserable bureaucrats administering this program. They have computers to program...letters to write...records to keep...internal procedures to devise, administer and respect. They have to hire people...and then support them for the rest of their lives, paying for pensions and holiday, just like any other business. Then, they have to work out internal disputes...make sure the coffee maker is working properly...and organize an annual Christmas party. It probably costs more than 125 pounds to send out each check!

And why should someone over 60 get money and not someone under 30? The older person has had 30 more years to stuff newspaper in the cracks, firewood in his garage and money in his bank account. If he's cold this winter...it's his own damn fault.

But if you're going to give him money to help him keep warm, why not some extra money to help him with his eating needs? He has to eat, doesn't he? And why doesn't HM Government just send him a bottle of Chateau Margaux? Maybe 1985. To help him with his drinking needs.

Until tomorrow,

Bill Bonner
The Daily Reckoning Australia

• Oil Prices Decline but Consumers Aren’t Out of the Woods Yet
• Housing Market Drops Housing Prices by 16%
• The Feds Are Counting on Fannie and Freddie to End the Nation’s Housing Misery
• Dealing with Future Economic Problems Today
• Denmark, Spain, the U.K. and Ireland Have Begun to Register Falling Housing Prices

We've had decades of misallocated capital in the U.S. Instead of saving, we've been spending... way beyond our means. Rather than investing in something productive, we've been gambling, taking on ever greater risks in the hope of the big payoff. Instead of creating the clean balance sheets that support stability - at all levels, personal, corporate, and governmental - we've piled up mountains of unsustainable debt.

The tragedy is that the prudent will suffer right along with the reckless. Misallocations of capital must be unwound, one way or another, before an economy can get back on its feet. It will be no simple task, and it's made even more difficult by those who put themselves in charge of the clean-up: certain residents of Washington, D.C.

At the center of the storm are two men who propose to save the nation, and they could hardly be more different.

Secretary of the Treasury Henry Paulson is the Street's guy. The former CEO of Goldman Sachs, the most powerful and successful investment bank, he brings a Wall Street insider's perspective to the table. However committed to public service he may be, he cannot be expected to act against the interests of his friends in the banking community.

And then there's Fed Chairman Ben Bernanke, a pure academician. For better or worse, Bernanke's specialty is America's Great Depression, and he considers himself an expert on the subject. Above all else, he wants to be remembered as the guy who understood how to steer the country away from the shoals of a Second Great Depression.

There is no question that Big Ben and Hammerin' Hank are trying to navigate in unfamiliar waters. Today's economy hardly mirrors that of a decade ago, much less the conditions of the 1930s.

Back in the spring of 2007, as the initial cracks in the structure began to appear, few were expecting the broken-levee crisis that has since unfolded. Savants such as our own Doug Casey and Bud Conrad saw it coming and said so, but no one in the mainstream was listening.

What was actually happening was that the first dominoes - subprime borrowers who should never have been approved - had begun to fall. In and of themselves, they would have been little more than straws in the wind. But because of the multiplier effect of the derivatives market, their influence reached far beyond a few blown mortgages. As more and more debtors were unable to pay, mortgage-backed securities lost value. And then the securities based on the MBSs lost value. And then...

Here's where CDSs were supposed to ride to the rescue. They didn't, for the simple reason that they had long since strayed far from their original insurance intent and become primarily an instrument that gave derivatives market players access to an asset class (mortgages) without having to actually own the asset.

As MBS values were hammered by defaults on the underlying loans, buyers of CDS protection began trying to collect. That hit CDS sellers, who were being drained of cash. Further out, derivatives speculators who had bet the wrong way defaulted or went bankrupt, sending shockwaves back down the line. Slowly at first, and then with increasing speed, the capital necessary to keep the system alive started drying up.

Everyone is familiar by now with the institutions that have collapsed or been bought out or taken over by the government. The list of names is stunning: Bear Stearns, Countrywide Credit, MBIA, Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia. Wall Street has undergone a transformation unimaginable a year ago. The big investment banks are gone - bankrupted or swallowed up by someone else. Even the two that remain standing, Goldman and JP Morgan, have had to reinvent themselves as bank holding companies to save their own hides.

The movement of capital among financial institutions is based not only on integrity but on confidence. Right now, that confidence has evaporated. Banks are carrying so much paper of indeterminate value that it's impossible to price in the risk of making a loan. So they aren't lending to each other, out of fear that they'll never get their money back.

The credit market, upon which our economy depends, has seized up.

When the government finally got around to admitting that there was a problem, it was already too late for any simple fix. So Washington had only two options: stand back and let the market sort things out or take drastic, emergency action.

No one knows quite what to make of Washington's response to the credit crisis. Some are howling that it's socialism, others that it's fascism or, at best, corporatism, an unholy alliance of private enterprise and the state.

Whatever the name, there is no question that the government is boldly going where none has gone before, helping to bail out some financial institutions and seizing control of others.

The Treasury Department now has $700 billion - albeit with some strings attached - with which it can buy up toxic waste paper through the Troubled Asset Relief Program (TARP). Taking this direction, instead of making direct loans, allows the "assets" they buy to be resold somewhere down the road. And perhaps, the plan's defenders say, even at a profit. Like that's gonna happen.

Proceeding in ways never before tried, in early October the Fed announced it was opening the Commercial Paper Funding Facility. For the first time, it will buy unsecured paper. To facilitate this and to cover potential losses, the Treasury will deposit an unspecified amount at the Fed. This is in addition to the Treasury's own buying spree, and the Fannie Freddie conservatorship, and the expansion of the FDIC to cover deposits up to $250,000, a move likely to send that agency back to the Treasury for another fill-up.

All the government's actions to date have accomplished... well, precious little. For the time being, credit remains frozen. Banks are still making overnight loans to other banks, but only very selectively. The stock market, despite coming off its lows, is extremely volatile after enduring its worst crash ever. Commodities have sold off. States and municipalities are facing severe budget cuts and, in some cases, bankruptcy. Money markets are in trouble. Pensions and retirement funds are at risk. And recession, or worse, looms increasingly large on the horizon.

Nor is the crisis purely an American problem. Much of the U.S. bad paper was sold to gullible Europeans, and world economies and markets are so interconnected that if one sneezes, someone else catches a cold. Already there have been big bailouts in Germany and England. The Irish government recently announced it was guaranteeing all bank deposits, which attracted a flood of money from elsewhere in the European Union, enraged other members of the EU, and raised questions of how long that shaky confederation can endure as each country charts its own path through the economic minefield.

This is a once-in-a-lifetime event, a train to nowhere, and it will cause no end of suffering.

Since we can't stop it, we'll do the next best thing, which is to protect ourselves. That means assessing the likely fallout from the government's meddling in the market, and developing guidelines for the best way to ride out the hurricane.

Some consequences are already baked in the cake. Casey Research Chief Economist Bud Conrad has been studying the unfolding crisis for years. Based on his work, this is what we foresee:

• More financial institutions will collapse. So will many hedge funds. Money market funds are also shaky; although the government will do all it can to keep them solvent, those that invest in anything but Treasury bills are at risk.
• The economy will fall into recession. By most lights, it's already here. It won't be brief, and there is even a chance that despite all the Fed's pump priming, we could drop into a depression. For however long credit remains tight, business will be unable to function normally, and the consumer-driven economy will grind to a halt.
• The whole structured finance model under which we've been operating is broken. The packaging of mortgages and other forms of consumer debt is impossible when no one will buy the packages. The trillions of dollars of outstanding mortgage derivatives will have to be unwound somehow.
• Without debt leverage, private equity financing is dead. Raising money for business start-ups or expansion will be extremely challenging. IPOs will be few and far between. Leveraged buyouts are gone. Mergers and acquisitions will mostly be limited to distress sales.
• At best, the government will succeed at what it's trying to do, i.e., stave off a depression, by sacrificing the dollar and allowing a fairly high level of inflation. If we're lucky, it won't turn into hyperinflation.
• Interest rates are going up. On the day of the coordinated, worldwide rate cut, the Fed lowered its discount rate by 50 basis points, yet the yield on the 10-year Treasuries rose from 3.5 to 3.7%. The Fed's credibility is about shot, as it has debased its own balance sheet by swapping good debt for bad. With more than half of its reserves gone, it could itself become the subject of a Treasury Department bailout.
• It is highly likely that the era of U.S. economic dominance, when the almighty dollar served as the reserve currency of the world, is drawing to a close.

But on the bright side... Well, there is no bright side. The hole that we've dug for ourselves will take a while to climb out of, and it won't be easy. But at least you can protect yourself.

• Hell, Meet Handbasket, Part I
• When Gold Ruled the Earth, Part II
• Great Depression Survival Guide, Part II
• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• 1 Out of 10 American Mortgages Are Owned by Other Countries

Occasionally, we offer a hyperbolic view - on the nature of man, his markets, or his government. Then, what do you know...some fool goes and makes a prophet of us!

Long ago, we wrote that "Americans would gladly give up their liberties to anyone who could guarantee a rising housing market," or words to that effect.

And here we have the latest news...

Liberation, the French socialist newspaper, has a smug cartoon showing George Bush begging on the street: "Can you spare a trillion?" asks the American president.

Yes, the cost of the bailout is advertised at $700 billion. But it could reach much higher. We see the trillion-dollar figure in several places; it seems to have originated with Harvard economist Ken Rogoff, who figured the cost at about twice as much as the Resolution Trust Company. The RTC cost the nation 3% of GDP as it took over crumbling S&Ls in the '90s. This debacle is much more serious, he guesses; it will cost at least twice in GDP terms...say, 7%...or about $1 trillion in round numbers.

Where do the feds get that kind of ready cash? Ah...they sell their souls...liquidate their rights...and wrap chains of debt around every American's neck. The U.S. government deficit is already $490 billion. With the cost of the slump...and the bailout...it is expected to top $1 trillion...or more.

Not since the '30s has the United States seen such sweeping reorganization of its economic institutions. Not since Roosevelt...and the New Deal.

But wait, the United States was supposed to be a leader in freedom. We were so adamant about it we practically forced it upon the poor Arabs and Afghanis... But now that people are losing their houses and Wall Street bonuses are in jeopardy...freedom is the last thing we need.

Ban short selling! Nationalize the mortgage lenders! Nationalize the insurers! Take on the bad debts and bail out the bad investments of the whole financial industry! Spend a billion. Fifty billion. A thousand billion!

"How fabulous," writes Brian Reade in the British tabloid The Mirror. "Thanks to the way it props up the USA's two biggest mortgage firms, more than half of American homes are now effectively owned by the state... Who'd have imagined that when the most right-wing of neo-cons leaves office 50% of the Land of the Free will effectively be [public housing]"?

Yes, almost every imbecilic act we could imagine has become fact. No exaggeration is too extreme. Life imitates farce.

A few years ago, in a moment of lighthearted hyperbole...we suggested that the War on Terror was such an absurdity... "Why not a War on Bear Markets?" we wrote.

And now, we have one!

Yes, the Prime Minister of England, Gordon Brown, compared the U.S.- led, global fight against falling asset prices to the "war against terrorism."

And yes, it is similar in many respects. It will cost about the same amount - over $1 trillion. And it will produce the same general results: less freedom for everyone.

Already, the dems and reps are warming up for a major battle against free markets.

Both parties seem to think that it would be shameful for prices of debt and equity to fall to what they are really worth - that is, to what willing buyers would pay for them. Over the weekend, the pols joined hands in trying to prevent it. The $700 billion program allows the feds to buy almost any piece of junk that investors don't want. It says so right here in the Financial Times. The feds can buy "residential and commercial mortgage-backed securities, with discretion for the Treasury Secretary and Fed chairman to add others as needed."

We'd put that last phrase in italics, if we knew how to do so. Because it leaves the door of the fed's EZ lending bank open to anything...24- hours a day.

The Treasury has a "blank check...to buy troubled assets," says the FT.

"This was very necessary," said Hank Paulson. Then, slipping from farce into Dada or the theatre of the absurd: "We did this to protect the taxpayer," (showing no confidence that American taxpayers can actually protect themselves.)

While writing a blank check, the politicians also limbered up for their election campaigns...each trying to come up with catchy new slogans and new ways to punish Wall Street publicly, (while actually trying to let them off the hook for billions of dollars worth of bad investments).

"Greed," said Obama, was the source of the problem. "Greed," said McCain, was the real problem. Cap Wall Street salaries! Reregulate!

This was "not time for ideological purity," suggested John Boehner, the Republican House majority leader, calling for unity. No, this was time for pandering...posturing...and promises.

And so, principles were out the window. "I'm a free-market non- interventionist," Boehner continued, "But we face a crisis, and if we don't act, and quickly, we're going to jeopardize our economy."

Principles are fine, in other words, until they get in the way of house prices!

*** Roosevelt is back. But which Roosevelt? Obama is positioning himself as the Franklin version: ranting against free markets and Wall Street.

McCain prefers Teddy - an interventionist too, but one who preferred meddling in the affairs of foreign nations to meddling in the domestic economy.

Which was worse? Teddy, with his bullying guns? Or Franklin with his greasy butter?

Hard to say which did more damage. The first set the United States on its imperial course... He was so worried that the vacillating Woodrow might not get the United States into WWI before it was over, he threatened to raise his own army and intervene on his own. The U.S. has bumbled into practically every important fight on the planet ever since.

Franklin, meanwhile, set up Fannie and Freddie to help solve the nation's housing needs. He set up dozens of other agencies, subsidizers and regulators. Taking Bismarck's example for his model, he turned the United States from a basically free-market economy...to a "mixed economy" - with heavy government influence and control.

And now, we suffer both Roosevelts...both pay for both guns and butter. We bear the burdens of constant inflation and eternal war, in other words; and both will remain with us no matter which Roosevelt wins in November.

*** Niall Ferguson writes in today's Financial Times. We like Ferguson. He usually comes to see the world the way we do; he is just a little slow:

"On one side can be seen the chain reaction of deleveragings as banks, other companies and households all battle to stabilize balance sheets that became much too highly geared in the days of easy money; as the resulting credit contraction and forced asset sales create a vicious downward spiral; as the slowdown spreads to Main Street and from Main Street to the world.

"On the other side are the Fed and the Treasury, desperately manning the monetary and fiscal pumps while trying to decide who is too big to fail and who is not."

So, the war is on! The war on bear markets! The war against deflation! The war against good sense...

Keep your head down, dear reader. We're not sure how this will end...

Bill Bonner
for The Daily Reckoning Australia

• Bear Market to Last at Least Five Years
• Fannie and Freddie in a Free Market Economy
• After the Bailout of Wall Street, Everybody Wants Cash
• Irving Fisher Remains Immensely Important in the History of Economic Thought
• The Global Financial System is Falling Apart and the World Economy is Slowing Down

The two great political figures of the last thirty years were Mrs. Thatcher and Mr. Reagan. These titans from the two sides of the Atlantic led the way to a new idea of how the world should work. Thenceforth, capitalism was king. But it was a new kind of capitalism they had crowned, one with a strange, unnatural face. It was not the old free enterprise, king of the jungle, red in tooth and claw. This new capitalism was more like the owner of a pet shop, where all the animals were cute and cuddly - and didn't eat the customers.

Mrs. Thatcher and Mr. Reagan and their followers had seen how centrally planned economies worked; the Chinese and Russians showed what happened when bureaucrats ran an economy. The free market seemed like the best alternative. But the trouble was, these new 'conservatives' had no real respect for it. Instead of quaking before it in genuine fear and awe, like Moses before the burning bush, they began to believe that they could be its master. Then, they developed a whole host of fantasies about what this tamed beast could do for them.

Not only could the free market solve the problem of poverty, it could solve almost every other problem too. It was a social panacea. Just look at the wealthy countries, they said. Switzerland is clean and prosperous. By contrast, communist China is a dump. People are healthier and happier in capitalist countries, where they have better automobiles and lower birthrates. Science, supported by the free market, would find cures to diseases too...and even help people live longer. The logic was simple enough: free enterprise made people rich. And with their money, they could do wonders - cleaning up the factories, building hospitals and clinics, organizing public day care and Pilates classes...even getting rid of smoking!

Nothing was too absurd or contradictory for the True Believers. Gradually, they began to confuse the fruit with the tree...and then mistake the tree for a lamppost. Financial incentives were thought to be the key to everything. If an executive failed to maximize shareholder value, it was because his bonus was not large enough. If students showed poor test results, it was because teachers were paid by the job, not by the outcome. And if terrorists attacked a building in New York, it was because they lacked financial opportunities in Cairo. (Later, people were dumbfounded when doctors who had worked for the National Health Service tried to blow up cars in Glasgow and London.)

The ideas were slippery but they greased the skids. Soon, the marks were ready to go along with anything. Shareholders consented to hundreds of millions in bonuses and stock options for key executives. Investors signed up for hedge funds, willingly giving managers "2% and 20%" for putting quarters in the slot machine for them. Taxpayers allowed huge tax cuts - widely believed to be aiding the wealthy - because they looked forward to the day when they would be wealthy too. And almost everyone, everywhere eagerly went on a spending spree, in the belief that this new, kindler, gentler capitalism would add wealth faster than they could get rid of it. And if they overspent, hyper-capitalism would soon catch up.

In public finance, this delusion led to Dick Cheney's famous quip: "Deficits don't matter." This, in turn, led to the greatest explosion of government red ink the planet had ever seen. During the first seven years of the George W. Bush administration, about $20 trillion was added to the U.S. 'financing gap' - more than under all America's other presidents put together.

What was good for the top was good for the bottom. Private households, too, ran deficits of their own. Savings rates fell close to zero while U.S. household debt rose from less than $2 trillion in the first year of the Reagan administration to nearly $13 trillion in the 6th year of the present administration.

In Britain the story is about the same. Before the Thatcher revolution, household debt was about 65% of household income. By 1988, it had reached 100%. And by 2007, it was more than 150%.

When a consumer spends a dollar he earned, it is taken in as income to the businesses that receive it. But it offset by a cost too - a wage expense. But if the consumer spends a borrowed dollar, it comes to business like manna from heaven, with no balancing wage cost. Higher profits, greater leverage, more debt - it was all catnip to Wall Street. Financial assets were only 4.5 times GDP in 1980. Now they are 10 times as large. But that is nothing compared to the sugary confections of the credit industry. Credit default swaps, alone, are said to be worth $45 trillion.

The earnings of the financial sector equaled only 10% of total corporate earnings in 1980. By 2007, they made up 40% of the total, even though they still only employed 5% of the workforce.

But, "that game is now up," says the Economist . The "new" capitalism was a fraud. It didn't make people rich. It only allowed them to get rich - or poor - depending on what they did with it. Americans used their economic freedom to ruin themselves. But that's just the way capitalism really works. You don't get what you expect...or what you want; you get what you deserve.

Bill Bonner
The Daily Reckoning Australia

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