This rally has gone on for so long most people think it is not a rally at all, but a new bull market. Worldwide, it has taken equities up some 73%...making it one of the greatest rallies ever.

What are we to think? Are we alone in thinking it's still a trap? What happened to the problems that led to the crisis of '07-'09?

If you don't think about it too much you might think everything is fine. Stocks are up. Business profits are up. GDP is up. Housing and unemployment seem to be stabilized. What's not to like?

The recovery is a done deal as far as most people see it. The rescue efforts, initiated by the feds, were a big success...or so they believe. It has been 12 months since the bottom...and the world still has not ended. Everything is back to normal...isn't it?

The problem in '07-'09 was that too many people owed too much money.

And what has happened to change that? The net level of indebtedness in the US has actually gone up since '07!

Huh? How's that? We're in a de-leveraging phase, aren't we?

Well...yes...but only in the private sector. The feds are still adding debt.

Let's look at the private sector first. There, we find unemployment still around 10%. Adult males in their prime working years, however, have fewer jobs than ever before. One figure we saw shows that only 4 out of 5 of them are working.

That is just the beginning of the problem for these fellows. They're getting fewer college degrees, compared to women, than ever before. They're earning less money too - again, compared to women. Fewer are the chief breadwinners in their households. And fewer are even in a household at all - more are alone.

Let's not get distracted by the suffering of the masculine part of the population...

..we're looking at what is going on in the broader economy. Is it healthy and growing? Or is the stock market just a honey trap...a bear market trap for the unwary investor?

The private sector is de-leveraging. Not only is the unemployment rate high, the typical family also lost a lot of money when its house went down in price. And since the typical householder is also in his 40s or 50s, he has to consider his retirement and how he's going to fund it.

Stocks? While they've bounced back nicely, the stock market is still well below its highs...and still in a losing position over the last ten years. A 73% gain sounds nice, but it would take a 100% gain to recover the losses of the '07-'09 bear market.

Houses? One out of four mortgaged houses is still underwater. In some new developments, the figure is as high as one out of two. And there is little likelihood that the owners will be high and dry anytime soon. People no longer expect to retire on the gains from their houses.

This leaves the middle-aged householder without much choice. He has to save money. Remember, the boom of the 2003-2007 period was caused by dis-saving. Now, a higher savings rate will mean less spending for many, many years. This is a fundamental and important change of direction for the economy. It will restrict business growth and restrain profit growth too.

So, is it possible to slough off the crisis and return to business as usual? Nope. Not possible. You can pretend that things are back to normal. You can act as if they are back to normal. You can invest as though they are back to normal. But you can also lose your money.

But they're not normal at all. They're different. The 1982 to 2007 period was...mostly...a boom time, caused by rapid increases in debt, asset prices, and consumer spending. The next period is...mostly...a bust time - when asset prices, private debt, and consumer spending go down.

Sooner or later, but probably sooner, the stock market will realize it. Our Crash Alert flag - tattered and faded - is still flying.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Americans Have No Money to Spend Because They Already Spent It!
• Is the Bear Market Rally… the Suckers’ Rally
• A Self-Fulfilling Rally in Stocks
• Stimulus Stimulates
• Bear Markets Do Not End With Stocks Still Trading at Nearly 20 Times Earnings

Consumers spent a little more than was expected of them. And manufacturing did a little better than expected too.

On the other hand, the federal government's tax receipts plunged in the month of February...and bank lending is still contracting. Last week it shrank $33 billion - the 7th week in a row it has contracted.

How does an economy expand when the banks are lending less money? Beats us.

We believe the "expansion" reported in the GDP figures is mostly counterfeit. It's government spending and hot money filtering into the economy. Still, it's amazing that the GDP figures are positive.

The Dow was flat yesterday. The euro rose a little - on expectations of a settlement of the Greek affair. Greece only had a month to sort out its problems. That was two weeks ago. The "clock is ticking," say news reports. Most likely, the Hellenes can't really sort their problems out on their own. Greece will need some sort of bailout - even if it is limited and tentative - from Germany. Stay tuned.

It will be interesting to see what happens when Britain runs into trouble financing its deficits. It won't have the Germans to help. Britain never took up the euro. It will be on its own.

But the big news from yesterday was the $19 boost in gold. Why did gold suddenly shoot up?

We don't know. But our guess is that gold will suddenly shoot up a lot more. We're in a deflationary period. That means everything is going down in price. But against what? Well, against money. Against real money that is - gold.

So gold should continue to go up until this deflationary period is over. That doesn't mean there won't be more hiccups and reverses in the gold bull market. But one of the surest trends of our time is the crack-up of the paper money system. And that is bound be good for gold.

Chris Wood of CSLA says he gives the dollar standard 5 more years. Maybe it will be a bit more...maybe a bit less. But one thing is sure. Governments cannot continue to run such huge deficits forever. There will come a day of reckoning...

The feds are hoping it comes at a time and place of their own choosing. They all want to ease their way out of their troubles...with the help of consumer price inflation. You heard central bankers talking last week about increasing the inflation target from 2% to 4%. If they can actually control inflation so precisely, it will be a miracle. But that is what they hope to do.

A few years of 4% inflation would do wonders. In ten years, they would have cut a third of the national debt - in real terms, of course (supposing that they don't add to it even faster). Not only that, the debts of the private sector would be eased too. At 6%...debts would be cut in half in a decade. With half the debt burden - the private sector might be ready to begin a new period of growth. That is the feds' real strategy...to de-leverage the private sector enough that it can grow...and increase tax receipts.

By the way, that was what happened in the Reagan administration. The inflation of the '70s forced up interest rates and caused the worst recession since the Great Depression. But it also lightened debt loads - so much that the economy was ready for another big growth spurt.

This growth really paid off in the '90s...and the very early years of the Bush junior administration. Thanks to growing tax revenues, both Clinton and Bush were able to pay down the huge debts of the Reagan years...and still increase spending. The economy was able to "grow its way" out of debt.

Then, with the war on terror and the micro-recession of 2001, the budget magic of the '90s was lost. Bush apparently never met a spending bill that he didn't like. Spending exploded...especially time bomb spending for health care, which increases automatically year after year.

Then came the depression...known popularly as the Great Recession of 2007-2009. Tax revenues fell. Spending increased even more. And now the deficits come hard and fast. And there seems to be no way to "grow our way out" of them. All of the conditions that made for a boom in the early '80s are making for a bust in the early 2010s. Interest rates are at record lows, not record highs. Stocks are high, not low. Bonds are high, not low. The government is the solution, not the problem.

Bill Bonner
for The Daily Reckoning Australia

• Have the Feds Given the Economy a Miracle Drug?
• Japan and its Economy Did Not Have Secret to Everlasting Success
• The Fallacy of the Fallacy of Composition
• Government Pretending Debt-fueled Spending is the Same as Growth
• China Reduces Holdings of Treasury Securities

To understand what's taking place in China today, we need to rewind the clock about a decade. At that time the Chinese government chose a policy of growth at any cost. To achieve that, it kept its currency (the renminbi) at artificially low levels against the dollar -- this helped already cheap Chinese-made goods become even cheaper than its competitors'. The US and global consumers were eager to buy them. China turned into a significant exporter to the US. Normally, if free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, if China let its currency appreciate, its exports would have become more expensive and the demand for Chinese products would have declined, and its economy wouldn't have grown at 10% a year.

But China isn't your local democracy, and it needed to grow at any cost. So instead, through the government-controlled banking system, China accumulated a couple trillion dollars of foreign reserves in US dollars and euros. This had an unintended consequence: It helped keep US interest rates at very low levels, and lent a friendly hand in the financing of a huge consumption binge by the US consumer (i.e., China's largest customer).

The more China sold to the US, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. The US consumer was in turn happy to leverage its future (through the "always" appreciating asset, its home) and delighted to consume cheap Chinese-made goods.

This symbiotic match made in heaven between China and the US consumer worked great as long as housing prices kept rising and the financial machine kept multiplying dollars. But all good things come to an end, and great things come to an end with a bang. The financial meltdown erupted upon us and, well, you know how that story played out.

So now let's fast-forward a year. Today the global economy is stabilizing. But the US consumers of Chinese-made goods are now deleveraging, unemployment is high, US banks aren't lending.

Despite this, the Chinese export-based economy has clocked growth of 8.7% in 2009. The rest of the world looks at the Chinese growth miracle with envy; it seems that China has got economics figured out. But don't hurry to trade your democracy for an authoritarian system. The Chinese grass is not as green as it appears.

First, one shouldn't believe all the economic numbers that are put out by the Chinese government. This is the government that magically managed to report 6% to 8% GDP growth in the midst of the financial crisis, when its exports were down more than 25%, tonnage of goods shipped through its railroads was down by double digits, and its electricity consumption was falling like a rock.

Second, China will do anything to grow its economy, as the alternatives will lead to political unrest. A lot of peasants moved to the cities in search of higher-paying jobs during the go-go times. Because China lacks the social safety net of the developed world, unemployed people aren't just inconvenienced by the loss of their jobs, they starve (this explains the high savings rate in China) and hungry people don't complain, they riot. Once you look at what's taking place in the Chinese economy through that lens, the decisions of its leaders start making sense, or at least become understandable.

Unlike Western democracies, where central banks can pump a lot of money into the financial system but can't force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The Chinese government controls the banks, thus it can make them lend, and it can force state-owned enterprises (one-third of the economy) to borrow and to spend. Also, China can spend infrastructure project money very fast -- if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good.

China has spent a tremendous amount of money on infrastructure over the last decade and there are definitely long-term benefits to having better highways, fast railroads, more hospitals, etc. But government is horrible at allocating large amounts of capital, especially at the speed it was done in China. Political decisions (driven by the goal of full employment) are often uneconomical, and corruption and cronyism result in projects that destroy value.

Infrastructure and real estate projects are where you get your biggest bang for the buck if your goal is to maintain employment, because they require a lot of unskilled labor; and this is where in the past a lot of Chinese money was spent. This also explains why the Chinese keep building skyscrapers even though the adjacent ones are still vacant.

Though Chinese economic growth in the past was very high, more recently the quality of growth has been low. For example, in an echo of past Chinese government asset-allocation decisions, China built the largest shopping mall in the world, the South China Mall, which is still 99% vacant years after construction. China also built a whole city, Ordos, in Inner Mongolia, on spec for one million residents who never appeared.

The inefficiencies are also evident in industrial overcapacity. According to Pivot Capital, Chinese excess capacity in cement is greater than the consumption of the US, Japan, and India combined. Also, Chinese idle production of steel is greater than the production capacity of Japan and South Korea combined. Similarly disturbing statistics are true for many other industrial commodities. The enormous stimulus amplified problems that already existed to financial-crisis levels. China is a less shiny but more drastic version of Dubai.

There is speculation that the Chinese consumer will pick up the demand slack for the US and European consumers who are deleveraging and buying fewer Chinese-made goods. This may happen, but it will take decades. The US and European consumers are two-thirds of much larger economies. The Chinese consumer is only one-third of the Chinese economy.

We look at China and are mesmerized by its 1.3 billion people, its achievements of the last decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. This was the case with railroads in the US in the late 19th century: The railroads were supposed to change the landscape of the US, and they did, but that didn't prevent a lot of them from going out of business first. The Internet was supposed to change how we communicate, and it did, but in the process it generated a tremendous bubble, followed by the loss of wealth for many. The Chinese economy is no exception. Its long-term future may be bright, but in the short run we've got a bubble on our hands.

Everyone wants a shortcut to greatness, but there isn't one. It would be great if the word (economic) cycle only existed in a singular form, and the only cycle we had in the economy was happy expansion. If there were no cycles, there would be no painful recessions. But as heaven couldn't exist without hell, or capitalism without failure, economic expansion can't exist without recession. China has been trying to bend the laws of economics for awhile, and with the control it exerts over its economy it may seem, at least for a short while, that the laws of economics work differently in China. But this is only a temporary mirage, which must be followed by huge pain and drastic consequences. No, there's no shortcut to greatness - not in politics, not in personal life, and certainly not in economics.

Regards,

Vitaliy N. Katsenelson
for The Daily Reckoning Australia

• The Chinese and the Fed Both Buying U.S. Treasury Bonds
• China, the Miracle Economy
• Total Implosion of the Chinese Economy
• Chinese Economy Seems to be Growing
• The New Chinese Era

Same story, different continent. Or is it, different continent, different story altogether? Your editor is still working out what day it is and what time zone he's in. Your body tells you it's time for a cheeseburger. But your brain tells you it's six a.m. Confusing. We'll push on and do our best to make sense out of today's news.

From the looks of things Aussie stocks got the week off to a rip-roaring start. Stocks were up over 1% in Australia on Monday. You could take your pick of "reasons" why. For example, gross operating profits in corporate Australia were up 2.2% in the last quarter according to the Australian Bureau of Statistics, on a seasonally adjusted basis.

Now, if you have infinite patience, you can read how the ABS makes its seasonal adjustments on this data series in notes 17-20 here. We read it three times and still don't really understand it, except for the part about how interest rates or other events can affect profits in a way that the statistical models can't anticipate.

You could proceed to rubbish the statistical models for being unable to predict the future. But models aren't people. They are designed by people, however. And the fact that a model can't anticipate something like the GFC shows you how limited our powers of foresight are as a species.

But we do know that financial markets are getting more volatile in recent years, not less. Is it globalization? Is it the digitalization of trading data and continuous, algorithmic trading models? Does the pursuit of an informational advantage (or the belief that one is possible) drive people to trade more?

Who knows? But our guess is that the amount of uncertainty in a system multiplies with the addition of more people. This fits roughly with the idea that the more networked the world's markets are, the more unstable they become. That is not a good sign.

But what does any of this have to do with the ABS release on corporate profits? We'll get to that in just one minute. But to be pedantic, gross operating profits are just another way of saying net sales. Gross operating profits are not the same as net income. Net income is what you get after you back out silly old expenses like payroll, taxes, and your fixed and variable overheads.

You can wrap all that up by saying the ABS number probably tells you very little - or actually misinforms you - about whether Australian firms are getting more or less profitable. The argument for less profitable is easy to make: rising interest rates and stretched consumer wallets.

But wait, you say! Housing prices are going. Business investment has increased. Households are adding valuable new houses to their personal balance sheets and businesses are adding capital assets to their balance sheet. This is a country getting richer!

Maybe. Or maybe it's a country levering up to buy assets again. For example, in another ABS release we learn that the country's net debt figure has reached a new all time high, both in nominal terms and as a percentage of GDP. The net debt (public, private, household) is $647 billion. It was up $14.2 billion in the December quarter and his over 60% of GDP.

Whether this matters or not depends on who you ask. For example, the current account deficit - also released recently - came in at a booming $17.5 Billion. That's 5.5% of GDP. But there's a whole school of thought in Australia that it doesn't really matter. A resource-producing economy is bound to import heaps of capital goods. As long as you take what you buy and make more money on what you produce - helped along by a favourable terms of trade where you get paid for more what you sell and pay less for what you buy - everything's groovy baby.

But the basic assumption in this scenario is that the borrowed money is productive investment. Maybe it will be. Maybe it won't be. You'd expect an Australia gearing up for another mining boom to increase capital goods and industrial transport equipment. It did both in the quarter.

Yet the surprising thing about the whole report in the current account deficit is in its composition. The goods and services deficit, which includes capital goods, was just over $6 billion. But the larger part of the deficit was what the ABS calls the "primary income deficit." That grew too and was $11.2 billion in the quarter.

Now according to the IMF, primary (or factor) income is made up of repayments and dividends from your loans or investments. You'd gather, then, that a primary income deficit means you're paying out more on foreign investments in you than you're getting paid on your investments overseas, give or take a few nuances. So what?

Well, to borrow a line from Michael Sutchbury in today's Australian, the persistence of the current account deficit and the large primary income deficit mean that Australia's "Domestic savings are not large enough to finance the mining boom." The country is going to have go deeper into debt just to mine what China wants - and that itself assumes that China's resource wants are endless and growing.

For now the country is in the sweet spot. So much so, that everyone is expecting the Reserve Bank to raise the cash rate to 4% when it meets later today. If he raises rates now, Glenn Stevens will be the first central banker to raise rates this year. Trail blazer and rate raiser.

It will be seen and sold as good news. You have an economy that was hurt less by the GFC, apparently, than other countries. And we'll always have China, won't we?

But the net foreign debt and current account deficit are a reminder that much of Australia's current prosperity - from house prices to mining profits - comes via borrowed money. Of the $647 billion in net foreign debt, $426 billion - or 65% - is owed by Australia's financial corporations.

So what did those banks get for their buck? A bunch of dodgy mortgages and shopping malls? Or something on which to build the long-lasting wealth of the nation? We'll find out soon enough (maybe even tomorrow!).

Meanwhile, your editor has completed phase one of his "Operation Exodus." Our U.S. bank required us to travel all the way to the branch where we originally opened our account in order to obtain the privilege of wiring money on-line. You can presume this draconian requirement is meant to discourage people from transferring money - in this case out of the country.

And it's not just American banks eager to hold on to their capital. Tomorrow, we'll tell you about a subsidiary for a major Australian bank that has told investors they can't have their money...for another for years. Until then...

Dan Denning
for The Daily Reckoning Australia

• Australia’s Current Account Deficit Up 4%
• Australian Trade Deficit Grows for 75th Consecutive Month
• Australian Credit Card Debt Grew by 9% in February
• Balance Sheet Bailout Begins
• The Dark Underbelly of Australia’s Resource Boom: Chinese Resource Demand

Battelino says, "It's hard to put a finger on exactly how much investment is going to take place, but I don't think it's unreasonable to expect mining investments to rise to 6 per cent of GDP over the next few years. That would be about twice as high as it got to in the previous boom. It's a very big boom."

He reckons the boom could last into the 2020s. "Past booms do not seem to have lasted more than about 15 years before resource depletion or international or domestic developments acted to slow economic activity and bring the boom to an end." But fear not!

"On this occasion, the growth potential of countries such as China and India suggests that the expansion and resource demand could continue for an extended period. Whether this eventuates, however, will depend on, at least to some extent, the economic management skills of the authorities in these countries, not to mention our own."

But there are plenty of sceptics on the China story already. Our old friend Marc Faber told Bloomberg that, "It does not make sense for China to build more empty buildings and add to capacities in industries where you already have overcapacity. I think the Chinese economy will decelerate very substantially in 2010 and could even crash."

And what would that mean for Australia and Aussie stocks? Quite a lot, of course. Faber says that, "If the Chinese economy decelerates or crashes, what you have is a disastrous environment for industrial commodities."

That couldn't be any clearer.

But maybe we are overly pessimistic. We're hopping on a plane tomorrow and headed to the other side of the world to discuss these and other matters with some old friends who've been in the investment game for a long time. If they are more sanguine about things, then we'll be really worried.

Dan Denning
for The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• China, the Miracle Economy
• BRIC – Brazil, Russia, India and China Suffer High Rates of Inflation
• The ASX Bubble, Fueled by China
• Stocks for the Lifeboat

Instead, we're going to review your 2010 asset allocation strategy in a roundabout way by exposing some of the snarky disinformation being put out by the mainstream media about gold, courtesy of Michael Pascoe at the Age.

By the way, apologies for any typos and grammar errors in today's edition. Your editor was late getting his copy to the e-mail senders who normally clean it up. We'll own up to every single error.

First though, let's just check to see that markets are still functioning normally. That is, let's just check to see that heavy government intervention is supporting house prices (by providing guarantees to home lenders), GDP growth (by spending money on infrastructure), and disguising the true state of the labour market (by lying about how many people are out of work).

Yep. Situation normal, all fouled up. The oil price, the U.S. dollar, and bond yields were all up on bullish industrial production figures in the U.S. The "recovery" meme is taking a tenuous hold. Stocks were down. Because why would stocks rise if the economy were recovering?

Ah. Well that tells you something right there. It tells you that stocks haven't risen in anticipation of a global recovery. They're just enjoying the benefits of all that monetary and fiscal smack being peddled in Washington, London, Tokyo and Canberra. It's hard to rally on fundamentals when you're already over-valued.

Speaking of value, let us now return to the question of element number 79 on the periodic table. The snarky article we mentioned at the top is this one from Michael Pascoe at the age, titled "There's more gold where that came from."

In the article Pascoe takes on the issue of "peak gold." But how well has he done in accurately stating the argument for gold? And more importantly, is he right about the relationship between market prices and gold? Well, obviously we think he's pretty wrong. But let's see what he's said.

"Part of the dogma of the less rational gold bugs is that the world is running out of the stuff. As an article of faith, it makes a pleasant change from the idea that fiat money is about to be exposed as huge confidence trick and we're heading back to the caves."

Webster's defines "dogma" as "a religious doctrine that is proclaimed as true without proof." Already you can see what Pascoe is up to. Gold bugs are nutters and zealots. Apparently 5,000 years of monetary history where gold has proven utility as a medium of exchange and store of value does not qualify as empirical evidence of gold's value. There's no pleasing some people, especially those who come to an argument with their mind already made up.

But that's fair enough. Opinion journalists get paid to give opinions. They cloak themselves in supposed objectivity because that makes their views more respectable to the mainstream. But we've never been concerned about respectability here at the Daily Reckoning. Why base your judgments on what other people will think of them?

We're entirely subjective in our views. But at least it's transparent. And at least we base our conclusions on facts and arguments. And we've not once argued here - although perhaps some gold bugs have - that the world is running out of gold. That is not what "peak gold" means at all.

The first step in any debate is to define your terms. So we will do so here and say that "peak gold" mean's declining annual gold production. We'll prove that in a minute. But just so it's clear, no one in this space is saying the world is running out of gold. But gold IS getting harder to find and more expensive to mine. And the supply of paper money continues to grow faster than annual gold mine production.

We won't dwell on the subject of paper money too much longer, except to say Pascoe's dismissal of the current status quo is nearly as laughable as it is naive. He says 'peak gold' "makes a pleasant change from the idea that fiat money is about to be exposed as huge confidence trick and we're heading back to the caves."

Seriously. How can any objective observer take a look at fiscal and monetary of the last three years and assume that central banking and fiat money are not a giant con job on the general public? Fiat money allows the government to create money backed by nothing. Not only does decrease purchasing power - especially hurting savers and those on fixed income - it accelerates the misuse of real resources.

When it comes down to it, it's a kind of theft. The government prints money and gets the benefit of using it first before purchasing power is diminished. It trades paper money for real goods and services - things which take labour and raw materials to produce. The systematic inflation inherent in fiat currencies IS theft of real labour and resources.

As long as that inflation makes house prices and stock prices go up, it appears to please everyone. But it's the argument of this publication that the monetary regime in place since August of 1971 - when Richard Nixon took the U.S. off the gold standard - is a) a fraud, and b) in the process of disintegrating. It's disintegrating because, at it's heart, it's based on the idea that money doesn't have any real tangible value.

Gold does, of course, have tangible value. To the extent that it's intrinsically valuable, it's valuable because it's physical properties - relatively scarcity, durability, transportability, divisibility, homogeneity - make it particularly useful as a monetary unit of exchange. To suggest it has no inherent value is to misunderstand the qualities that make money useful, and more importantly, sound.

But back to the issue of production. It's not just the nut jobs in the newsletter industry warning that gold production is falling. It's the gold miners. Of course you have to discount what they're saying to the extent that they're talking their own book. But they do know their own business and they are saying that 2009 could be the last year for some time that gold production rises.

Omar Jabara, the spokesman for Newmont Mining in the US, says that in terms of production, "2009 is the outlier as far as the trend. The trend is that production has been in a general decline since 2000. Why does that matter?

Pascoe says, quite correctly in theory, that price discovery and market mechanisms help ensure that supply grows when prices rise. Or, in his own words, "The 'peak gold' story isn't quite as dodgy as some of the 'peak oil' scare mongering the more sensationalist media have trotted out over the years - we'll never run out of oil as the market mechanism very successfully rations it and because, at a price, we simply make the stuff. Shell, for example, is spending $20 billion building a gas-to-diesel plant in Qatar."

Running out of gold? Don' worry!! We'll just make more of it!

It's hard to reconcile this with the fact that the gold price has been rising since 2000, but gold production has not. In late 1998 the gold price was in the mid $200s and annual global production was just under 2,500 tonnes per year. Since then, the gold price is up 340%. Yet production this year is set to be just over 2,400 tonnes. That's an increase over last year, mind you. But still down from the production level over ten years ago. So why aren't higher prices attracting new producers?

Well there are a couple of factors here. First, a lot of the big mines that were producing in the 1970s - especially in South Africa - are seeing production declines. That's not say all the mines are played out. But they're having to dig deeper and pay more for labour and energy, all of which leads to rising production costs.

That is, despite the rising price, production costs are rising faster for some companies. Those companies are making less money from the price rise, leaving less to invest in new exploration and production. Besides which, surely Pascoe would know that there's no such thing as just-in-time gold production.

You have to find the stuff. And it has to exist in an ore body that's economic to mine at current gold prices. And you have to get permits to mine it. All of that takes time and money - usually years - during which central bank printing presses are busy churning out new paper notes at a much faster rate. The supply of paper money is growing a lot faster than the annual mine supply of gold, which does not look like growing much at all in the coming years.

Barrick Gold's Vincent Borg says that, "it's a fact that gold production form mines has been in decline since 2001 and has gone from 85 million ounces to about 75 million ounces a year...It sort of goes down about one million ounces every year and or forecast is that it will continue to decline despite the higher price."

In most markets, higher prices to attract new producers. But as we've said before, quoting our friend Doug Casey, gold mining is a lousy, capital-intensive, highly-regulated business. It is not like opening a lemonade stand. Therefore gold production does not automatically increase because prices are higher. That's a fact, not a dogma.

Yet Pascoe persists. He quotes StandardBank analyst Waler de Wet, who, presumably because he has a South African sounding name, must be right about gold. De Wet told clients that, "Given that the US gold mine production is 10% of global mine production, if you assume gold resources are proportionate to current mine production, global resources could be 330,000 tonnes. That is another 137 years of production."

The argument here is that higher gold prices turn more resources into proven reserves. That is, marginal gold projects become economically viable with higher gold prices. But the reason that these projects were marginal to begin with is that they were more expensive to bring into production (away from infrastructure, lower ore grades, smaller ore bodies). If the margins don't improve on the projects, there's no guarantee anyone is going to bother producing them, especially if the cost of production is rising as much or more than the gold price.

Further, why would anyone assume that "gold resources are proportionate to current mind production?" It seems like a rather large assumption to make. As anyone who's spent any time analysing resource stocks knows, a resource is not the same thing as a proven reserve.

The energy market is fortunate that higher oil prices make other sources of unconventional more economically viable. That's why Australia's LNG and coal-seam-gas industries have done so well this year (a trend Kris Sayce profited from in Australian Small Cap Investigator and Alex Cowie is bullish on in Diggers and Drillers.)

But you can't just "make more" gold the way you can make more energy. The world doesn't need oil. The world needs fuel and the work that fuel can do when you burn it. Thus, high oil prices lead to investment opportunities in oil and other energy sources, which eventually brings down the price of energy.

The funny thing is that the last time we checked, the oil prices is above $70. This confirms the peak oil thesis. The age of cheap energy is over. Oil is still out there. But it's getting harder to find and more expensive to produce. The cheap stuff is going fast.

With gold, of course there is more gold in the ground waiting to be mined. But who's going to mine it? And at what cost? It's an expensive business. And even if exploration spending boomed and turned up even more gold, it will take years to bring into annual mine supply.

You could argue that the rising gold price is only a function of scaremongering by newsletters like the Daily Reckoning - or that it's being ramped up by speculators and fund managers. This would explain why gold producers didn't increase production to meet rising prices. They saw the price rise as fictional or fundamentally unsound.

We wouldn't agree with that argument, mind you. But it's one way to explain why gold production isn't more price sensitive. The other is the simpler one: gold production is hard to increase, no matter what economic theory or Michael Pascoe says.

But by the end of the article you can see that Pascoe doesn't really have his head in the argument, just his heart. "The gold price's recent stall thanks to the Greece and Dubai-inspired up-tick in the US dollar demonstrates just how much of the gold rally has really been a currency story rather than anything intrinsically valuable about the yellow metal.

"It's just another alternative to greenbacks, one that doesn't do much productive or pay dividends but relies purely on speculation for any non-currency price improvement. The unkind might think that's why the gold bugs keep the scare campaigns coming - that and the need to sell more internet newsletters."

He's partially right and mostly wrong here. Yes, the rising gold price is a function of the bear market in paper money. Gold is better money than paper, if you're a gold bull. That makes gold stocks a leveraged speculation on higher gold prices. We don't have to say any of that to sell newsletters. After all, this one is free.

But we keep saying it because it continues to be important. Only a numbskull would ignore all the warnings about paper money coming from the markets in the last two years. Rising fiscal deficits...insolvent banking systems...the re-monetisation of gold by central banks as a reserve asset. These aren't articles of faith. They're facts.

Of course gold isn't an investment panacea. But it's something you should take a lot more seriously than Michael Pascoe does. Unless you're worried about being respectable amongst those of your friends who thought that a currency crisis was something that only happened in history books, and not something you ought to prepare for.

Dan Denning
for The Daily Reckoning Australia

• Australia Presents Investors With Great Portfolio of Energy Choices
• Aussie Gold Price Moves Up
• Gold is the Oldest Form of Wealth
• Sustainability of U.S. Deficits Reason Why Investors Own Some Gold
• Gold, the Dollar and Inflation

Not much time for reckoning today, dear reader. Bill is traversing the globe somewhere and I'm about to board a plane. Still...

Dollar in, risky Mediterranean debt out. At least, that's what the markets were indicating earlier today. Indexes from The Thames to The Nile and back again were in the red last we checked. The euro was down too.

That the Greeks are in trouble is hardly breaking news, of course... Heck, even those geniuses at the ratings agencies had time to figure it out! Fitch, one of the agencies NOT responsible for forecasting the biggest economic tsunami since (at least) the Great Depression, just downgraded Greece's sovereign rating from a single-A-minus to BBB+. So NOW investors run for the hills?

The only thing really surprising about all this brouhaha is that investors should find it at all surprising in the first place. Did they think Dubai was going to be a one off occurrence? That the same immutable laws of nature would not also apply to other overleveraged, undercapitalized economies? Not likely!

If the agencies are crying wolf, dear reader, your lamb dinner is likely already minced meat. Fitch worries that Greece's government debt burden may reach 130% of GDP before stabilizing and that it has a poor record of debt management.

Now why pick on the Greeks, we wonder? If imprudence and debt additions are the indictments, why not hall the United Kingdom in for questioning? And what about those hot-to-trot Baltic economies? And what about those American consumers? Household liabilities for the average American family now happen to weigh in at a familiar 130% of total disposable income.

It doesn't take a ratings agency to figure out that consuming more than one produces must eventually end in tears...either for the spender or the lender...or both! It's little wonder then that American banks are tightening their belts so much. Consumer lending fell 1.7% during October, representing the ninth consecutive monthly decline and a 4% drop since its July 2008 peak. Curiously, consumer economies don't tend to fare too well when consumers start (or are forced to) economize.

And it's not only the American Gap-goers who find themselves in a tight credit squeeze either.

Joel Bowman
for The Daily Reckoning Australia

• Ratings Agencies Put Spain on Negative Debt Watch
• Trichet Should Tell Greeks to Drop Dead
• Dollar Up, Gold Down
• Will Bailing Out the Greeks Really Make American Businesses More Profitable?
• Surely Gold Will Trade at One Times the Dow

Greece was last night downgraded by ratings agency Fitch from A- to BBB+ and was placed on negative credit watch. That means there could be more downgrades to come.

The Greek budget deficit is currently 12% of GDP. And that makes a mockery of the stability and growth pact of the Euro Zone which requires member nations to have a 3% deficit limit. What a farce.

Not only that, but the Greek government debt will reach 130% of GDP next year.

But the really interesting thing about this situation is to understand what the repercussions of the downgrade are.

The Greek banks have been playing the carry trade by borrowing from the European Central Bank (ECB) and then investing in Greek government bonds. This is a fun game where you borrow low and lend high and then laugh all the way to the bank.

Well, actually they are the bank. So they just laugh.

This is a merry old dance until someone does something really unfair like downgrade the bonds that you're buying! In the last month 10-year Greek government bonds have sold off from 137 basis points over 10 year German bunds (German bonds) to 220 points over German bunds.

The wider the spread, the greater the perceived risk. That's nearly a full percentage point in a month.

When interest rates go up the value of the bond naturally goes down. A full percentage point sell off in yields corresponds to a large fall in the value of the bonds. And Greek banks are full to the eyeballs with Greek bonds.

Now suddenly, the fun game of making free money doesn't seem like so much fun. Because they're losing money instead. Poor banks.

Now let me think, is there anywhere else in the world where banks are borrowing money from their central bank at really low interest rates? Is there anywhere else where they're using that money to load up on long term government debt?

And is there anywhere else where government's interest rates are kept low by all of this buying by the banks?

Hmmm. How about America? The land of the free... lunch... for banks.

This is the most enormous carry trade. The government gets what they want by keeping their interest rates low at a time when they need to borrow a huge amount of money.

The Chinese aren't buying as many bonds as they used to because they're not selling as much stuff to the Yanks. Plus they don't trust the Americans not to turn their currency into little more than toilet paper.

Not only that but the price of oil is a lot lower than it was a few years ago so the Middle East isn't recycling as many petro dollars into US bonds either. Therefore the banks have been enticed into buying US bonds by lending them money for nothing so that they can make the difference in the yield.

The only problem with this game is that the banks are loading up on bonds at a time when interest rates are at their lowest in a generation. Which way do you think yields are going to go from here over the next few years?

Especially since last night we were told that both the UK and the US are at risk of having their AAA credit rating downgraded as well!

Oh dear. Suddenly it's starting to look a lot like Greece. Except 1,000 times larger.

What appears to be free money for US banks now, could end up being a noose around their neck before long. Who's going to bail them out then?

That's led to the markets taking a battering on the back of the news about Greece.

The main point to take out of this is that Dubai has been found to have no clothes on, and now the Greeks a few weeks later. Who else is swimming naked?

Credit default swaps on sovereign debt around the world have been going higher and higher in the past few months. The term "treasury yields" has become an oxymoron because there is no yield and stock markets are resting near their highs after rallying 60% in less than a year.

Something has to give before long.

The free money from the Fed is coming face to face with the reality of economics.

It's for that reason I've positioned Slipstream Trader subscribers to be as market neutral as possible.

We're short one of the Australian banks, a transport stock and an oil stock. But we're also exposed to upside from new technology in the energy sector and to the recovery in fertiliser stocks next year.

There's also some exposure to the cyclical recovery in the Steel sector.

The philosophy I'm using is to take some money off the table as quickly as possible. That way I can lower the risk profile of the trade. In effect it turns the trade into a free call option.

As the positions are sitting now, there's the potential to swipe some decent short term profits, and then leave the rest of the position to pick up some longer term gains.

As any trader will tell you, it's important to be nimble in responding to any signs of a sustained pullback in prices. Because I've no doubt that when the music stops on this rally, the sell off could be vicious and quick.

Memories of last year remain fresh in many people's mind. They won't need too much prodding to press the panic button.

Murray Dawes
Editor, Slipstream Trader
for The Daily Reckoning Australia

• U.S. Bonds Better than Greek or Other Sovereign Bonds
• The Single Best Trade for 2010
• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• E-mail Update for Paid-up Subscribers Only
• Is It Really the End of the Dollar Carry Trade?

Probably a good thing US markets were closed for Thanksgiving when this news came out. In Europe, the Dubai affair caused the biggest drop in 7 months. European banks have lent $40 billion to Dubai.

Jim Chanos, a famous short seller, thinks Dubai is merely the camel's nose in the tent, so to speak. "China is Dubai times 1,000...if not a million."

"People are panicking: this whole process counters everything that the rulers have been saying and the way it has been communicated before the holidays is confusing," said one hedge fund manager.

The 'rulers' are the fellows who run "Dubai World," and incidentally Dubai itself. Whether they are fools, knaves or sly geniuses was what everyone wanted to know. Dubai officials announced that they had raised $5 billion on Tuesday. Two hours later they said they weren't paying interest on it or on any of the rest of the $80 billion in borrowings. What's going on? Are they really broke? Or are they playing for some kind of advantage?

"Dubai gambles with its financial reputation," says one headline at the FT.

Then, on the facing page, the editors think they know how the gamble will turn out:

"A breath-taking blunder in Dubai...Dubai is looking more like Argentina than Singapore - but a lot less predictable," says the FT editorial.

No on is sure what is going on. Most people take from this story what we knew all along: lending to shady characters in sunny places is not an easy way to make money. Especially when the shady characters own the country.

Trouble is, shady characters run near all the world's countries. If an investor cannot trust the ruling family of Dubai, how can he trust the commies who run China? Or the hacks who run the United States of America?

To err is human. For a central banker, it is practically a professional requirement. Count on a major 'error' to trigger a sell-off in the world's bond market.

But Dubai's mistake did not infect all other sovereign debt. German bond yields went down, not up. Investors sought safety from Dubai debt in Deutschland debt.

But what is the real meaning of what is going on in Dubai? It's the story of the collapse of the financial industry. Dubai has no oil...no natural resources...and no real industry. The rulers tried to turn it into a financial center. Entirely financed by debt. And now finance itself is falling apart.

"The camel put his nose in the tent," says colleague Simone Wapler. "He saw that there was nothing there."

What will he think when he gets a closer look at Britain's finances? Britain, too, relies heavily on the financial industry. And Britain, too, is heavily dependent on debt. Its public finances are among the worst in the world. Japan's public debt, to add another example, is already 200% of GDP. It's expected to reach 300% in a few years. And yet, Japan - like the US and Britain - just keeps borrowing. How long can this go on? When will Britain, the US, and Japan announce their own moratoria on debt service payments?

This bubbly bounce must not have much time left. And it is surrounded by 10,000 pins.

On Friday, US markets reacted to the Dubai news. The Dow lost 154 points. Gold lost $14. Oil slipped to $76.

Our crash flag is still flying. But that was not a crash. Just a bad day. And today's news tells us that other Gulf States are rallying around Dubai, ready to extend a helping hand and lend a buck or two. Oil is rallying on the news.

Does that mean this bubbly trend is stronger than we thought? Is this a bubble made of Kevlar? Will it resist other pins?

We wouldn't count on it. When China pops, we'll see US stocks down a lot more than 154 points. In fact, we expect to see the Dow in 5,000- ish territory when this bounce is over. And when that happens, emerging markets will probably be hit even harder.

Dubai was a "wake up call," for investors in emerging markets, says The New York Times today.

But the pin that pricks recovery hopes won't necessarily be imported. There are plenty of sharp objects in the homeland too. There is, for example, the growing realization that the recovery is a fraud.

"Half a recovery," says a New York Times columnist, may be all we get.

Today, the press will concentrate on analyzing Black Friday sales results. Already, The Wall Street Journal has rendered its verdict: more shoppers; fewer sales.

If the initial reports are correct, the traffic wasn't bad on Friday. But retail outlets were only able to snag sales by offering discounts. It's a deflationary world, after all. Shoppers want lower prices to make up for the fact that they have less money to spend. And they'll get lower prices too. Because this is a de-leveraging cycle. The world has too much debt, too many factories and too many workers...at least for the real, available purchasing power. Prices will go down naturally until excesses are absorbed...dismantled...or converted to other uses.

But wait...there are also unnatural forces at work. Governments are bailing out bungled companies. They're supplying zombie industries with fresh blood from the taxpayers. They're standing in the way of the de- leveraging progress. They're creating "money" out of thin air.

It's this last point that is most explosive. As long as government is just stalling the correction, it doesn't cause too much distortion or volatility. But when it fiddles with the money...oh la la; that's where it gets interesting.

Traditionally, people buy gold when they think the monetary authorities are up to something. Throughout the world, investors are getting edgy...they're wondering how it is possible to add so much cash and credit to the economy without sending prices to the moon.

We'll tell you how it's possible: there's a depression. In a depression, the flow of cash and credit coagulates. Even if you increase the cash in bank vaults, it doesn't circulate into the real economy. Banks don't lend. People don't borrow. Consumers don't consume.

It just sits there...waiting for the end of the depression...like a teenager waiting for Friday...

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Dubai, Built on Debt and Sand
• Arab Wealth Pours Back into Dubai
• Qatar Relies on Natural Gas Reserves While Dubai Leans on Trade and Finance
• Dubai Debt Story More Like Bear Stearns Less Like Lehman Brothers
• Is Dubai the Bubble It’s Made Out to be?

First off, house prices are still rising in Australia, but for the second month in a row sales are falling. Here in Melbourne, the average house price is now $510,000 according to the RP Data Index. Melbourne prices are up 15% since January. Granted, that's not quite as good as the stock market this year. The All Ords is up nearly 30% year to date. But it's not bad for houses is it?

Nationally, Aussie house prices are up 10% for the year. That's a good year, even by bubble standards. The only somewhat alarming news yesterday is that thanks to the retreat of first home buyers and the chance of higher interest rates, sales have fallen for the second month in a row.

We'll get back to the insane level of Aussie house prices in a moment. But about those interest rates. The Reserve Bank, as you know, meets today to decide whether to hike Aussie rates again. If the bank did hike the overnight cash rate to 3.75% it would do so in the face of pretty weak growth everywhere else.

Would it be bold? Would it be prudent? Or does it even matter?

Our guess is that central bankers here are pretty much making it up as they go along and hoping for the best. They will announce their decision with wise central banker words that sound a lot like this: "Blah blah blah blah. Blah blah blah! Blah blah....inflation expectations are muted. Blah. Thank you. Blah blah."

And while we're on the subject of doublespeak designed to obfuscate the truth, check out the graph below. Unless we're statistically illiterate, it appears to suggest that the number of households compared to dwellings has actually grown in Australia in the last twenty years.

Gasp! Wouldn't this mean there is a housing surplus and NOT a housing shortage (as is repeated ad nauseam by real estate industry spruikers?)

RBA Deputy Governor Ric Battelino explains in the report linked to above. "A significant proportion of dwelling investment," Battelino writes, "appears to have gone into holiday homes or second homes. Census data show that the number of dwellings built has exceeded the increase in the number of households by a large margin."

Emphasis added here is ours. "As a result, the ratio of the number of dwellings to the number of households has been rising over time; as at 2006, there were 8 per cent more dwellings in Australia than there were households. Presumably, most of this surplus reflects holiday houses and second houses."

Well how about that?!

Obviously the definition of two terms here is key, dwellings and households. If a dwelling is a caravan or shed out back where you nip away for a drink on the holidays to escape the in-laws, then the data don't suggest there are too many unoccupied houses in Australia. After all, we know some people who spend 30% of their waking hours sitting on a bar stool. But you wouldn't call that a dwelling, would you?

The ABS defines a dwelling in the following way, "In general terms, a dwelling is a structure which is intended to have people live in it, and which is habitable on Census Night. Some examples of dwellings are houses, motels, flats, caravans, prisons, tents, humpies and houseboats."

Okay then. Having learned that a hupmie is a kind of lean-to in the bush, this definition appears to suggest that not every dwelling is a brand new suburban McMansion. Some places you can live in, others you can pass out in (the Gatwick Hotel on Fitzroy Street...or the drunk tank at the local lock-up, for example). It would be fair to say that not all dwellings are houses.

But we must still define the term "household." Is that a family unit? Or is it an idea of suburban nuclear family wellness?

Luckily, the Australian Bureau of Statistics is good enough to define this for us. It writes that an Australian household is, "One or more persons, at least one of whom is at least 15 years of age, usually resident in the same private dwelling."

Now that we know what dwellings and households are, it's fair to ask if there is a housing shortage in Australia. So we'll ask: is there a housing shortage in Australia? Our answer is pretty simple: no.

There are plenty of places for people to live in Australia. But many of them are apparently not for sale, or in places people would prefer to live (and you know these days it's all about what you deserve, not what is realistic). According to Battelino, much of the dwelling investment is on second homes or improvements to existing homes. It doesn't go to produce new homes.

Blah blah blah.

The persistent claim that underlying demand for housing suggests a housing shortage continues to be pure garbage. People buy houses when they have access to credit and can support the mortgage payments with rising incomes. Interest rates are coming off multi-generational lows in Australia. They are headed up globally. As the price of money rises, wouldn't you expect demand for it to fall, and "underlying" demand for housing finance to fall too?

And what about household incomes? If household income includes the rather generous definition given by the ABS, then you could argue that Australian house prices might not be as high, relative to household incomes, as the more often quoted house-price-to-median-wage ratio. And after all, most households have two wage earners these days, which might lower the ratio even more.

Since our financial newsletter business does not depend on advertising dollars from the real estate industry or banks for survival, we feel compelled (and empowered!) to point out a simple fact: Aussie house prices are built on a bubble of borrowed money. Prices will fall when the money runs out and the national delirium over rising property values recedes.

The facts show that the level of debt in Australia has been steadily rising faster than incomes for ten years. Most of this borrowed money went to buy houses because houses were going up in price. Hurry! Get on the ladder now! You don't want to miss out! You idiot!

But this whole household financial model - using debt to bid up asset values - is no different in principle than businesses or investors gearing up to speculate on stock prices. Once the easy money - the money borrowed by Aussie banks globally to fuel local house prices through new lending - goes away, so do the house price gains. Underlying demand vanishes as credit gets more expensive and home prices decouple from reality (and incomes).

In case you hadn't noticed, the easy money IS going away. That is, the global boom in assets from loose central bank lending practices is blowing up. Right now, it's succeeded in inflating new bubbles. But when it blows up the second time around, it's going to take a lot of assets and markets with it. China...some commodity prices...and Australian house prices.

According to the ABS (emphasis added is ours), "Between September 1990 and September 2008, the ratio of total household debt to assets held by households rose from 9% to 19%. In other words, debt grew twice as fast as the total value of assets held by households. The sharp increase in the debt to asset ratio from December 2007 to September 2008 was due to a decline in the value of household assets."

But because prices have been rising faster than incomes, the increased debt ratio is actually delivering Aussies less ownership of their new homes. "Among the different types of debt, housing debt as a proportion of housing assets rose from 11% to 29%, which means overall, households have come to own a relatively smaller proportion of their houses."

This is why households in Australia will eventually join the global trend and deleverage. They'll reduce debts to match slower income growth. And if you're going to argue that a mining investment boom leads to GDP growth in Australia that's counter to the global trend, you still have to prove that GDP growth translates into higher income growth. In the meantime, have a look at the chart below.

The ABS reports that, "Over the past decade, household debt grew much faster than income. The ratio of household debt to annual disposable household income peaked at 160% in December 2007 and March 2008. The ratio decreased over the last three quarters, reaching 153% in December 2008. Housing debt as a proportion of disposable income followed a similar pattern, and made up 87% of all debt in December 2008."

A bubble by any other name would still look like a bubble. You can talk about Australian preferences for large houses. Or their willingness to take on higher debt levels and reduce saving because of rising stock prices. Or the "underlying" demand for houses.

But all those are variables in the supply and demand dynamic. And the thing about variables is that they vary. When the cost of credit changes, financial behaviour changes too. Part of the process is rational and part is psychological. Deleveraging is as much about fear as it is about prudence.

The end result, however, is that all over the world asset prices supported by debt are falling. Why would Australian housing be any different?

Dan Denning
for The Daily Reckoning Australia

• Australian House Prices Are Severely and Seriously Unaffordable
• Aussie Housing Market Actually Leads the U.S. by Three Years
• House Prices Always Go Structurally Higher in Australia
• Reserve Bank Agrees There is a Housing Shortage in Australia
• American House Prices Continue to Fall While the Same Can’t Be Said About Australian House Prices