The Guv also said he would not be too timid about raising interest rates. He believes the threat [of global financial calamity] has passed and that the bigger threat may well be inflation. That kind of tough talk sent the Aussie dollar right up to over 92 cents against the greenback. If it weren't late fall, now might be the perfect time to take a trip to America and see how cheap things really are.

But it is a bit surprising that a Central banker would say he's not sure there WILL be another shock to the world's financial system. The last twenty years show a history of regular shocks. The economic models of economists suggest these shocks are 100-year or even 500-year events. But they just keep happening!

The Peso Crisis...the Asian Crisis...the Russian bond crisis which led to the fall of Long Term Capital Management...Bear Stearns...Iceland...Northern Rock...the entire GFC...nope! None of those could ever happen again. Especially in a world that's reducing debt where asset markets are now undervalued and house prices have dramatically corrected and banks have recapitalised.

Well, that's the story that Stevens probably believes. But you know our view. There's a lot more bad debt out there posing as assets. There are more credit write downs. Banks have a boatload of commercial real estate and residential housing assets and a thin slice of equity capital supporting them. There is still a lot of leverage in the financial system. And that leverage exposes banks to losses.

For example, today's AFR cites research from the International Monetary Fund and concludes that Aussie banks could lose as much as two percent of total loans outstanding if corporate and household defaults increase. And gee, that's not likely at all when interest rates rise quickly, is it?

According to the AFR, the IMF report does conclude Aussie banks are "very sound", but they could lose $33 billion from rising defaults. We're not sure what default rate the report assumed, but we reckon it was probably too low. Nearly everyone in the financial establishment underestimated the depth of the crisis last time, too.

The other threat is that that Aussie banks source 30% of their loan funding from international credit markets, according to the IMF. Australia's short-term external debt is about $400 billion this year, according to the AFR. Is that really a threat?

It doesn't seem like one right now. Interest rates are rising and the Aussie dollar looks like it's headed to parity against the USD. This makes Australia a popular destination for international capital flows. After all, you have heaps of foreign investors pouring in to buy Australian property. The place is a capital nirvana!

But yes, it is vulnerability. For one, it means growth in the Australian economy is not sourced from domestic savings but from borrowed foreign money, which must later be repaid. Second, it means that the income and rent from Australia's capital stock (houses, property, shares, and bonds) may not be making Australians rich or even staying in Australia.

Granted, if the Boomers are selling their houses to Chinese investors in order to finance a comfortable retirement, it should work out well for the Boomers. But their children may be renting from Chinese landlords for a long time to come. And no, we're not blaming the Chinese for this at all. It's a great move for Chinese investors. But it may not be such a great development in the capital structure of Australia.

But at the moment, you wouldn't get that sense that rising public debts and the transfer of ownership of Australia's capital assets are any worry whatsoever. Sure haven't seen much of it in the papers or on the TV shows. It's like everyone's forgotten that the more integrated the world's financial markets have become, the more they've tended toward instability. Or everyone believes whatever was wrong before has been fixed now.

One person who had his wagon fixed yesterday was Bank of America CEO Ken Lewis. America's new pay tsar (the U.S. Treasury Special Master for Compensation, Kenneth Feinberg) stripped Lewis of his 2009 salary. Don't cry for Lewis just yet. His retirement package will leave him with between US$70 and US$120 million.

But why is there even a pay master to begin with? Isn't that the job of boards of directors and shareholders? Could government charades to regulate the corporate sector get any more cosmetic? Coming soon, a pay master for your job.

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• Aussie Banks are Scrambling to Raise Their Tier 1 Capital Ratios
• Bank for International Settlements Report Looks at Origins of Credit Crisis
• Stress Testing the Banks
• Gold, the Aussie Dollar, the Greenback and You

Let's take the earnings recovery story first. Tomorrow we're going to have a look at the outlook for Aussie bank earnings. But for now, is there a case to be made for stocks as an asset class? Are they really recovering?

Well, the S&P 500 closed down in New York. But it's up 57% from its low. That's impressive. It's also expensive. The index now sells for 20 times operating profits, which is pretty optimistic, given how crappy the world economy has been in the last year.

"But that was last year," you say. In the future, things can't help but be better! And relatively speaking, that's probably true. Our friend Dan Ferris writes, that, "Last year, the S&P 500 lost $23.25 per share for the fourth quarter. In the second quarter of 2009, 369 out of 478 companies, representing perhaps 97% or 98% of the total market cap, reported negative earnings over the previous year."

Compared to last year, this year HAS to be better. You can't get much worse than negative earnings. And with trillions in credit backstopping the financial system and making it possible to generate profits on paper assets, you'd expect to see at least some engineered earnings in the next two quarters that look absolutely dazzling when compared to last year's numbers.

"So," says Dan, "for the next two or three quarters, you can expect plenty of reports of vastly improved earnings, even if those results aren't really so great. As you parse the news and evaluate your own investment goals, keep your head about you and don't be afraid to spend extra time getting deeper into a company's numbers, its market, its history, and its future prospects than you normally would. And for Newfoundland's sake, don't buy anything that isn't dirt-cheap."

Absolutely speaking, the popping of the credit bubble fatally undermined the business models of a lot of heavily leveraged companies, including many, many banks (both big and small). We reckon that the capital cushions of those banks are still in danger from further falls in asset values. Yes, that's not a popular or even common view. But we'll expand on it tomorrow.

In the meantime, you can always tell when stocks are out of favour in Australia. Everyone starts talking about what a good investment property is. But Australian housing is not exactly a cheap asset. The Governor of the Reserve Bank, Glenn Stevens, said as much earlier this week.

And this morning, we peeled our eyes over this paper on Aussie houses by RBA man Tony Richards. Richard's inadvertently made a lot of interesting points. One was that the so-called improvement in affordability over the last year is, "mainly due to movements in interest rates rather than in house."

He added that, "Mortgage rates are particularly low at present and, as the Bank has noted on a number of occasions, it is not reasonable to expect that interest rates will stay at the current low levels indefinitely. When they do rise towards more normal levels, discussions on housing affordability will again focus more on the level of housing prices relative to incomes."

That is clever to suggest that when rates rise people will have to find another way to say that houses are affordable. But we reckon when rates rise, as they eventually must, a lot of new home buyers will find out that access to cheap credit does not make a house affordable. It just makes the amount of debt you owe to the bank a lot larger.

The most interesting part of the paper, for our twenty minutes, was the discussion of 'underlying demand'. 'Underlying demand' is the phrase that gets trotted out when the banks and real estate brokers tell you there's a housing shortage, or when the RBA tells you not to worry about a house price crash in Australia. But what does it really mean?

Richards says the four components of 'underlying demand' are population growth, household size, new houses to replaced demolished homes, and demand for "second or vacant homes." Note that none of these are like the Ten Commandments. They aren't carved in stone. They are changeable.

By the way, who on earth can afford to own a home they neither live in, nor rent? "Honey we're going to buy a third home. But we're not going to generate any rental income from it. And we're certainly not going to live in it. We're just going to pay the mortgage on it."

"But why would we do that dear?"

"Because we can. To show how rich we are. We can afford it. And to support underlying housing demand. What else are we going to do with that money, buy stocks?

Returning to reality, Richards says that a preference for smaller household sizes, along with rising incomes and a rising population all factor in to strong "underlying demand." But if you spend exactly forty two seconds scrutinising this claim, you'll find that it simply doesn't hold up. "Underlying demand" as a bullish factor in Australian housing is a fiction propagated by property spruikers and money lenders.

Take rising incomes. Rising incomes are a function of a growing economy. But in a prolonged recession—or just a period of slower growth, or a world in which wages in the Western world are gradually deflated as the global work force grows (especially in manufacturing)—income growth is going to be harder to achieve across the economy.

And rising populations? Well, it's always possible for the government to reduce legal immigration if it's concerned about too many people competing for too few jobs. That knocks another plank out of underlying demand.

And then there's the preference for smaller households. Of course there's a preference for having your own castle and being your own King, if you can afford it. But the RBA's own data show that after many years of smaller and smaller household sizes, the trend is now swinging to larger households.

This could be by preference. After all, living alone has its benefits, but it can be awfully lonely. Or it could be by necessity—children living at home longer to save money or taking on flatmates to ease the pain of higher rates.

But whatever is behind the trend in rising household sizes, the main point is that the elements that go into "underlying demand" don't automatically suggest a level of demand for houses that will always rise. Quite the contrary, in fact.

And of course one of the biggest factors in demand for housing is the availability of credit via low interest rates. We reckon that when you add a couple of hundred basis points to the current cash rate, you'd take quite a bit of momentum away from "underlying demand" for housing.

How about some reader mail?

Dear DR,

Phil Cantrill

Intriguing scenario. Politically, it's a mess. Financially, we reckon the big issue is the value of toxic CDOs to banks and financial firms. Regardless of what happens to homeowners, those CDOs are due for a haircut. And when that happens, watch out for more bank failures and a second buffeting of the financial system.

Hi Dan,

Peter H

Dan Denning
for The Daily Reckoning Australia

• Aussie Housing Market Actually Leads the U.S. by Three Years
• Property Spruikers Claim Australia Suffers from a ‘Chronic Housing Shortage’
• The Australian Resource Boom Isn’t Dead Yet
• The Mother of All Housing Booms
• Housing and Unemployment Are Weaknesses in the U.S. Economy

House prices were up 3.3% nationally in the second quarter of the year, according to Australian Property Monitors. The group said that the weighted average median house price in the most expensive capital city suburbs was $796,559. In the slightly less expensive suburbs the weighted average median house price was $405,872.

Ouch.

Aussie stocks are up as we write, bucking the global trend from yesterday. This comes after a 7% retreat by Chinese stocks in Shanghai and lower stocks in New York. What happened in China? Well, China's benchmark CSI 300 Index was up nearly 93% for the year before yesterday's retreat. China's monetary authorities have ignited a speculative bubble and made noises about reining it in yesterday.

Bloomberg reports that Chinese stocks, "Plunged amid speculation the central bank is poised to order lenders to set aside larger reserves, Beijing-based Caijing magazine reported today on its Web site. Market News International said Chinese equities fell on speculation regulators will increase a tax on stock trading."

Yesterday we asked the question of what would make Australia's economy grow in the next twenty years. We return to that question today. The Reserve Bank has said that Aussie banks will have to move cautiously as they repair their balances sheets. This suggests growth through debt may be harder to achieve. The RBA also said that the household sector's twenty year credit binge is over (now that asset prices are returning from orbit). Again, growth through debt is looking dubious as a national survival strategy.

Let's also assume that the government cannot borrow its way to larger stimulus payments. With lower spending forecast for government, businesses, and households, you begin to wonder if Australia's economy has a home grown engine, or if it will rely on something else, or someone else beyond the borders. If domestic demand falls, that leaves housing as the only industry firing on all cylinders (for now).

Now you can try building a national economy around the housing industry. But what you get is a nation of mortgage lenders, builders, real estate agents, speculators, and bombastic television presenters. You also get a huge speculative bubble. It's been tried in America and didn't work out so well.

If not housing, then why not resources? "Over the medium term," said Glenn Stevens earlier this week, "the emergence of China (and other countries such as India) will continue, and will offer opportunities for Australia." This is not news. But what the Governor said next is newsworthy.

"If commodity prices do stay at their relatively high levels on the back of strong emerging world demand, the mineral extraction sector and all those parts of the Australian economy that service it and feel its flow-on effects, will expand. Other sectors, will, relatively, contract over time."

Hmmn.

Does this make the Aussie economy a one trick resource pony? And even if it does, so what? Investors can still profit by finding the lowest-cost mineral extractors with the best ore bodies. As Mr. Stevens noted, even the correction in commodity prices has left them at higher inflation-adjusted levels that previous corrections. Prices came off. But they didn't crash permanently. Stevens doesn't think they will, either.

"A significant structural rise in demand for energy and resources has occurred, as a result of the cumulative growth of the emerging world. This seems more likely to be a feature of the international economy for some time than to go away," he says.

That could either be very true, or famous last words before a burst Chinese credit bubble rips the legs off of Australia's economy. But we'll go along with the Governor in the assumption that China's emergence as an industrial giant is a decade's long affair. It will have its ups and downs. But the general trend will be mostly up, accounting for the structural rise in demand for energy and resources."

It sounds, generally, like pretty good news. Of course, you want to be more than just a giant quarry. Wages and profits will be higher for Aussie firms if they can figure out ways to increase productivity and add more value. Investors can capture some of these rising profits and productivity increases through dividends or share price gains.

But adding value in the resource extraction business-and capturing that value added as an investment income-is not a simple proposition. The biggest value add (with the biggest profits) comes higher up the economic food chain (somewhere between retailing and pure intellectual property, where you produce nothing physical, but still collect rents or royalties on your production).

Australia's national income could benefit from a few industries higher up in the chain of production. But the country's current position is not a terrible one to be in either. That's not to say there aren't a few risks with hitching your wagon to China's rising star.

"If we are more integrated into China's expansion," Stevens said, "will be similarly more exposed to the consequences of whatever might go wrong in that country. So our understanding of how the Chinese economy works and what risks may be accumulating there, will need continual work."

Speaking of accumulating risks, one final note today. Reuters reports that, "The U.S. Treasury sold $39 billion in five-year debt Wednesday in an auction that drew poor demand, raising worries over the cost of financing the government's burgeoning budget deficit." The big-to-cover ratio for the five-year notes was just 1.92, its lowest level in a year.

Will a U.S. bond auction fail this year? It's not likely. The Feds will rig it to avoid that. But if investors are getting choosier about financing government debt, you wonder how that may affect the ability of the Australian Office of Financial Management to fund this country's growing fiscal deficit....

Dan Denning
for The Daily Reckoning Australia

• Glenn Stevens Says Australia’s Economy Has Been Travelling Better Than Others
• Australian Iron Ore Shares on China’s Menu
• Australian Housing Market Getting Stronger Despite Fear of Inflation
• IMF Report Concludes Aussie Banks are “Very Sound”…
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package

Actually that's not fair. Rallies don't last forever. If you go back to March 6th, the ASX 200 closed at 3,145. It's up over 1,000 points since then-or 32.5% if you're trading at home. You'd expect a correction or consolidation at some point. We may be at that point.

But let's not leave Mr. Stevens out altogether. The Governor of the Reserve Bank of Australia gave a fascinating speech yesterday in Sydney. The market reacted to the speech by pushing up the Aussie dollar. It did so because Mr. Stevens said that Australia's economy and financial system have, "been travelling rather better" than other industrial economies.

This leads some people to believe the next move for Aussie interest rates is up, which is bullish for the currency (given that interest rate differentials to the U.S dollar and the Japanese yen are currently the big driver for the Aussie). Another way of looking at it is that interest rates are rising because the economy is healthier than we all thought.

We'll see about that. Stocks are certainly pricing in a profit recovery (about which we have our doubts). But Mr. Stevens also had a bit to say about credit markets and balance sheets, in comments that were not as widely reported as his comments on Australian housing. More on housing in a second.

But what about our claim this week that corporate cash flows are headed back to early 20th century level growth rates because of the burst credit bubble? Does the Governor of Australia's central bank agree? Judge for yourself.

Stevens writes that, "The pace of global growth, and the easy availability of credit, seen in the period up to 2007 was not the norm. It is unlikely to be seen again any time soon." So far so good?

"The path to economic health for the major countries of the world will still be a difficult one, because the legacy of the crisis will cast a shadow for some time." Could he mean that the destruction of bank collateral (commercial and residential real estate loan books) is still a problem restricting the availability of credit, or will restrict future lending?

"Major international banks will remain diminished in stature and balance sheet capability, and will be required to devote more capital to their strategies in the future. If global regulators have their way, the world will be characterised by less leverage and more expensive credit, than in the earlier period. We here in Australia have to accept that fact and accommodate it in our thinking."

Bravo! We reckon that means that Aussie bank profitability-indeed the profitability of the whole real estate, finance, and insurance sectors-will never again reach the 2007 highs, or not at least for a very, very long time. And if that's the case, it means that income investors used to counting on dividends from safe bank stocks may need a new game plan.

One other non-housing note from the Governor, this one on debt and the changing nature of global capital markets (due to the massive destruction of global capital). "Government and government-guaranteed debt of one form or another is rapidly increasing globally...Certainly people will worry, longer term, about increases in long-term interest rates potentially 'crowding out' private borrowers. To date, though, long-term rates remain historically low for public borrowers, despite the prospect of very large debt issuance."

The important words in that sentence are "to date." If historically low interest rates do not stay historically low, the cost of government-guaranteed debt is going to rise along with interest rates. And if the government itself maintains and increases its role as middle-man lender in the capital markets, we can't see how government borrowing wouldn't crowd-out borrowing by smaller businesses and even households.

We all know how efficient the government is at spending money and allocating capital to productive enterprise, don't we? This puts Aussie banks in a tough spot. They can use the government-guarantee to borrow. But who are they going to lend to? Households?

"The prominence of household demand driving the expansion from the mid 1990s to the mid 2000s should not be expected to recur in the next upswing," Stevens said. "The rise in household leverage, the much lower rate of saving out of current income, and the rise in asset values we saw since the mid 1990s, are far more likely to have been features of a one-time adjustment, albeit a fairly drawn-out one, than of a permanent trend."

Now that's a bit of a bomb shell. Stevens describes the whole model of getting rich in the Western world for the last twenty years and says it was a one-off, not to be repeated. But if you can't borrow, leverage, and spend your way to wealth as your stocks and houses go up in price, how are you going to get rich and retire?

Stevens says that, "The households of the Western world are currently feeling that they can no longer consume as they did, in part because the earlier spending is now seen to have been based on an unrealistic set of assumptions about long-run income and wealth. To that extent, there is no real way around a period of adjustment involving lower consumption for awhile." What about lower standards of living too? Hmm.

This is remarkably frank talk from a central banker. Stevens paints a picture in which business confidence has recovered. But he also shows that systemic leverage will have to be reduced and that the economy will enter a period where households lower their consumption "for awhile"-even as the government is forced to withdraw its support for "aggregate demand" through cash giveaways s mis-directed stimulus splurges.

All of that leaves us with a question about the Australian economy: who is going to be borrowing and who is going to be spending? What is going to drive the growth? If banks have to repair balance sheets by being more guarded with capital, and if consumers tighten their belts because their real net worth is falling (along with their real wages), why would a business borrow for demand that isn't there, assuming it could even get a loan from a bank reluctant to lend?

Our guess is that Aussie banks don't want to lend to businesses because there's too much risk in that. Besides, Aussie corporations have successfully tapped the equity and bond markets for new capital in last year, leaving the banks out of the loop. But one asset class Aussie banks are keen to lend to is residential housing. Why?

The destruction of bank collateral is what's behind the shrinking of bank profits and balance sheets. The largest part of Aussie bank collateral is in property, especially residential property. If banks don't keep lending to the property market to support demand and prices, prices will fall, damaging bank collateral and forcing the banks to tighten credit (housing finance) which leads to even further house price declines. Vicious circle. Feedback loop. Take your pick.

We were discussing just this subject earlier in the week over lunch with Phillip J. Anderson. Phil is the author of a new book called "The Secret Life of Real Estate." He's also one of our panellists for this Friday night's Debt Summit and the State Library of Victoria. He had some forecasts about the Aussie housing and stock markets that some investor might find...surprising.

Incidentally, if you can't make the Debt Summit, Phil is signing copies of his book tomorrow between noon and 1:30 pm at the Educated Investor Bookshop at 500 Collins Street. We recommend dropping in if you're in the area. It's a great book shop. And Phil's written a book about the real estate cycle that Aussie investors can't afford to miss.

Glenn Stevens says now is the perfect time to build more houses in Australia and hopes that the "ready availability and low cost of housing finance is translated into more dwellings, not just higher prices." He seems to be arguing that the Aussie property market could be in strife if someone doesn't start building more homes ASAP.

"If all we end up with is higher prices and not many more dwellings-then it will be very disappointing, indeed quite disturbing. Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track."

Dan Denning
for The Daily Reckoning Australia

• IMF Report Concludes Aussie Banks are “Very Sound”…
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• RBA Rate Cut Does Little to Unlock Credit Market
• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit

Energy is a great long-term investment theme. As we've mentioned before, the collapse in capital spending in 2008 almost guaranteed that any resumption in demand growth would trigger higher prices because of much lower supply growth. Everyone's been focused on inventories and the global recession. But it's supply that you should keep your eye on.

Of course Goldman is just talking its own book. Everyone is talking his own book, come to think of it. But in this case, we like the book. And more importantly, we think a carefully selected portfolio of energy shares (conventional, unconventional, and alternative) is big part of making money as an investor over the next five years.

Switching gears, did you see what RBA governor Glenn Stevens said yesterday? He said the RBA would be willing to cut rates again if it needed to. But he also said, "It would be counterproductive, though, if further reductions in interest rates induced a large number of marginal borrowers into debts they could service only at unusually low interest rates."

Wow. What's gotten into these central bankers lately? First Ben Bernanke puts on his serious face and tells the U.S. Congress that large deficits threaten financial stability. And now we have Mr. Stevens pointing out the dirty little secret of lower rates. They encourage debt bombs that become debt bombs.

Shhh though. Don't tell anyone else. It would be bad for confidence.

Do you think maybe Dr. Bernanke is just trying to talk his book too? After all, the U.S. Treasury has heaps of debt to sell this year (gross issuance over $3.25 trillion according to Goldman). If Dr. Bernanke makes adult sounds come out of his mouth, it might give people the impression the U.S. is returning to sobriety and fiscal sensibility.

And on due, ten-year bond yields did in fact fall in Thursday trading in New York. Ten-year yields on U.S. notes now stand at 3.54%. Remember that after the Fed said it would be buying U.S. bonds, yields plunged to 2.04% in November of last year. But by May 28th-as the true scope of America's debt bonanza became apparent to global investors-yields soared to 3.75%.

We still think bond yields are the prime mover in this market, but not for the reason that you'll read in the paper. Investors aren't selling bonds because the economic recovery is sound and stocks hold better value. You're seeing a bear market in sovereign bonds because many governments are running into a fiscal and demographic brick wall.

Bond yields also hold the key to explaining how a higher Aussie gold price is possible given the Aussie dollar's recent strength against the greenback. With the Aussie chugging along against the USD, it's been an uphill climb for gold prices in Australian terms. But just you wait.

The yield on Aussie ten-year notes was 4.88% in mid-May. It's now 5.67%. That's a 16% rise in three weeks. Granted, it's not the huge spike you've seen in U.S. yields. But it does tell you something.

It tells you that the Australian Office of Financial Management has its work cut out for it in selling the $1.4 billion in debt a day to finance the country's growing federal deficit. You borrows the money and you pays the higher interest rates. Or, your central bank-like the Fed-does its part if necessary to buy your debt.

Inflation on the way with real interest rates negative

Source: Reserve Bank of Australia

That sort of debt monetisation isn't on the cards yet in Australia. For now, there should be plenty of domestic and foreign investors willing to add a little high-yield government debt to their portfolios. But given the chart above that shows-by the RBA's own admission-that real interest rates are already negative, there are plenty of monetary forces already in the mix in Australia that will lead to expansion of the money supply.

That sort of monetary expansion, along with deficit spending and higher yields, is just the sort of thing that's going to power Aussie gold and precious metals prices higher. If it doesn't, we'll eat every single hat here at the Old Hat Factory.

Dan Denning
for The Daily Reckoning Australia

• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis
• What Inflation Means to Central Bankers, Investors and the Consumer
• Government Debt Bubble is What Directly Precedes Inflation
• How U.S. Mortgage Rates Affect Aussie Stocks
• Now in Post-bubble Era as Financial Industry Bombs Out

For now, at least for this week, it sure does look like the appetite for risk is back. The U.S. dollar and Japanese Yen are weak, while commodity currencies like the Australian, New Zealand, and Canadian dollars are up. Bond prices are down, stocks are trending up, and even oil is creeping back over $50, looking to make a breakout. All of this confirms that we may have a "second wave rebound" from the March lows.

We have grave doubts about the durability of this rebound, given the state of the economy (unemployment, debt, and rising deficits). However we're not going to bother with any of that today. If you traded the rebound for profits, good on ya! We are using this moment of relative tranquillity to ponder what's just around the corner.

One object bearing down on the Aussie economy is a 'temporary' deficit that may last until 2016. Liberals, Labor, Republicans, Democrats...they all know how to spend money they don't have. All political parties appear to support big government these days. It's so trendy.

But you wonder if the Australian is starting to worry that the current government is writing checks the future will have to cash. Today's Australian Financial Review reports that next year's Federal budget deficit will be at least $70 billion. It says that Treasurer Wayne Swan has told his state counterparts that, "tax collections would fall by $200 billion over four years, worse than a $115 billion write-down in February."

"There is no doubt that the deficit will last longer, the temporary deficit will be longer, as a consequence of the revenue downgrades imposed on this country by the rest of the world," the Treasurer said. The AFR says the government plans to return the budget to surplus...by 2016.

Here's a stupid question: is something really temporary if it lasts for seven years?

However long it lasts and however big it gets, the deficit (and growing debt) mean Australia will be borrowing more to support its current lifestyle. This is an alarming trend. Temporary government spending and revenue programs almost always become permanent. And that's what would worry us about this deficit: it's the beginning of Australia's long road to debtor status.

But hey! Judging from the hate mail in the mail bag, people are tired of hearing about the long-term consequences of making promises you can't keep. It is not fun to think about the transfer of national income that occurs when you rack up debts to bond holders. And it's not fun to think about what happens when the government is unable to fulfil the promises it's made. So let's not think about that, shall we not?

Instead, let's go straight to the mail bag. Lots of good stuff. And finally, some contempt!

--Hi team,

Your comment "Copper rises on Chinese buy prospects" is interesting except that Chinese are buying copper ASSETS and will no doubt dictate the future price they pay from their owned Australian producers (refer Oz minerals buyout and others).

JHM

--Actually, we were quoting a headline from an article in The Australian, but your point is well taken. China is doing both. It's stockpiling raw commodities. And it's buying shares in publicly listed commodity producers. However, there's a big difference between a customer of an Aussie resource producer buying the producer, and another producer buying the producer. If the customer is buying the producer (iron ore), then it's conceivable the Aussie firm will be run not to maximise shareholder value but to give the consumer (who owns a sizeable chunk of equity) bargain basement prices. When a producer buys a producer, the interests of the two parties (getting the highest price of the commodity produced) seem more aligned.

--Dear DR,

I'm still curious as to how can we have hyperinflation and a property market crash at the same time. While I understand the logic, I still can't wrap my head around how the also heralded hyperinflation will come into this. Please end my suffering by addressing this in your next issue as this enigma just keeps me wondering.

Kind regards,

Susanna

--Ah. Two good questions. A real hyperinflation destroys wealth and puts a premium on real goods that are tradable (liquid). A house is not tradeable. So while the value of mortgage might quickly be inflated away in the early stages of a hyperinflationary scenario, we would not recommend it as a way to get rich. With prices so surreal, the value of large assets in hyperinflation becomes volatile. We'd suggest this makes for an illiquid market, and doesn't help you at all with respect to day-to-day economic activity (where you can barter liquid tangible goods for other goods or services). Try bargaining your rumpus room.

On the other hand, at least you have a roof over your head. It's a subject we need to more research into. But to be as clear as possible, we don't believe buying a house is a real hedge against hyperinflation. Not much is.

The other question you had is how it all begins, this hyperinflation. We would argue that the expansion of the global monetary base has been so large that it's going to be nearly impossible to reverse. So far, the huge expansion by the Fed and other central banks has not made its way into the real economy. Its being held as "excess reserves" at those central banks rather than loaned out into the economy where the multiplier effect would quickly lead to inflation.

The Fed thinks it can soak up these excess reserves before the banks loan them out. After all, the banks would only do so once they thought the economy was safe enough to lend into again, as my colleague Gary North points out. The Fed can try and prevent this increase in the money supply by raising reserve requirements (effectively forcing the banks to keep the cash parked). But if it does so, it risks derailing the so-called recovery. The whole point of the Fed's balance sheet expansion was to create a recovery anyway.

The Fed is hoping that it can reduce bank reserves before they hit the economy. It thinks that the demand for its short-term lending programs will go away as the economy recovers. It also says it can conduct "reverse repurchase agreements." This essentially means the Fed will be SHRINKING the money supply as the economy recovers.

Our guess? The Fed is going to have a devil of a time preventing excess bank reserves from departing the monetary base into the money supply and the real economy. New bank lending and higher interest rates will fuel even higher prices. And down the rabbit hole we go.

--Dan,

There has been a lot said about the problems easy credit has caused. But what is the solution to easy credit? How do you suggest credit is made harder to get? Is there any other ways than just lifting interest rates?

Glenn D

--Taking the power to dictate the price of money away from a cartel of bankers would be a good start. There is a market price for money, or a natural rate of interest required by lenders to make surplus capital available to borrowers. This natural interest rate is what Central Banking is designed to distort.

The government prefers a monopoly on money because two institutions stand to benefit the most from "just a little inflation;" the government and the banking sector. A free market for money would mean that the supply of credit would probably not exceed available savings. At the very least, the collateral required to secure a loan would be more substantial that it has been for the last twenty years.

Is there a cure, then, for credit excesses? The Austrian economists say no. The only cure is prevention. One the disease has been unleashed, you can only deal with the misallocated capital and try to liquidate the losses and begin again. Ludwig Von Mises argued that the government control of the interest rate is what sets off the boom/bust cycle to begin with. With a market rate of interest, these booms and busts would be moderated. But that would destroy the illusion that central banks can carefully manage an economy (price stability and full employment) by manipulating interest rates.

This was the subject line of an e-mail this week: "Stupid remarks from DR"

For example: "This represents a $50 billion deficit. Compare that to last year's $22 billion surplus. Not a good look for K-Rudd's CV."

What a truly mindless buffoon you appear to be.

Doubtless you also supported your erstwhile heroes who sat on an unprecedented minerals boom, passing the surplus out to their mates instead of investing the surplus in Australia's future.

Do you really believe that Rudd caused our current problems? Really? Maybe his solutions will prove inadequate or wrong but unlike you and your cronies he is doing something. And what suggestions have you got to get us out of the problems caused by your like thinking mates??

None, except the greed based "look after yourself and to hell with everyone else".

As I am sure even you have realised by now I am less than impressed by your vacuous political drivel.

Leave comments to those who are at least prepared to try and do something about the situation and stop the cowardly firing at their backs.

Contemptuously yours,

Alex Millar

--We don't support politicians in anything, ever. If more of us looked after ourselves and our neighbour and families instead of looking to government to "do something" the world would be a lot better off. Does this mean you'd like to unsubscribe?

--Dear Sir,

Your newsletter is really up with the best. My question is since most governments are going broke and most banks are broke where is all the money coming from? The Australian banks have $7-$14 trillion of toxic debt, the world supposed to have over $1000 trillion, ten times more than all the GDP of all the world. If this is the case, where is the money coming from? Who or what is holding up the economies of the world? If the money is just being printed which I believe it is there is no way out but a TOTAL collapse.

If you can answer me it would be really appreciated.

Thanks,

Rafael C.

--We're not sure about your toxic debt figures. But you ask a good question. Asset values-as we've found out in the last year-are largely bogus. They are deflating. As for what's holding up the economies of the world? Well, there are real industries and demand for real goods. But if you mean all this deficit spending and bail out money, that either is borrowed (mostly from Japan, China, institutions, and private investors) or its printed out of thin air by central banks.

--Hi,

Thanks for your constantly interesting pieces. My question is - why should we really believe gold has any value? For most of the last 5,000 years, animals were the key mode of long distance transport - they no longer are. Why will gold not go the way of the horse and cart?

I understand the reasons behind why you think the gold price will rise. However I think there is a flaw in your logic. You say that "But just remember, this whole experiment with fiat money is not even one hundred years old. Just because it's all we're used to doesn't negate that for 5,000 years of human history, people have been using gold as money". This always seems to be the argument for gold. The fact that it has always been used as a currency, therefore it is what will keep its value.

For gold to store value, don't people need to agree that gold is valuable? I have never understood why people put a value on gold. I agree it looks nice and is useful in jewellery and fillings, and I think it's also a reasonable conductor of electricity - but that's it.

If tomorrow, someone succeeds at alchemy, or the world just decides that gold isn't it anymore, it will be absolutely worthless - and it will go down the path of the Zimbabwean $. Wouldn't we be much better off storing some real, useful commodities (copper, tin, tarmac, soy, hogs, OJ - of course limited to the practical problem of actually storing these things). It seems to me that to believe gold will increase in price, requires other people to believe it will increase in price and has a real value/use - whereas actually it doesn't.

Thanks,

Samant

--Gold has four physical properties that have made it extremely useful as a medium of exchange over time. It is durable. It's divisible. It's convenient. And it's consistent. That doesn't mean other things haven't or can't be used as a medium of exchange. It just means these physical attributes of gold make it especially useful. That's not a matter of mystical belief. It's a practical benefit.

The fact that you can't "succeed" at alchemy is also what makes gold desirable as a medium of exchange: it's supply is relatively stable because it cannot be counterfeited by governments. The usefulness of any medium of exchange would decline if a person or a small group of people could easily increase the supply. It would make the unit less stable. Gold supply varies with mine production and above ground sales from central banks. But you can't just drop it from helicopters like brand new paper money. Well, you could, but it might hurt.

Does that mean it has intrinsic value? Well, if by intrinsic you mean that its unique physical properties make it useful as a medium of exchange, then yes. But value is only ever determined in an exchange. Gold is useful only as long as people believe it to be a useful medium of exchange. We think more people will realise that in the coming years.

--Dan

Are you an optimist, a pessimist or an economist?

Larry

--We're Catholic.

And one last note on property.

If we are already "smack in the middle of the biggest economic collapse in 80 years", this economic collapse is not that bad after all! In the worst case scenario; today's people living in the industrialized countries are unlikely to go begging for foods, unlikely to go through winter without enough clothing.

This financial collapse is largely on paper (or computer screen); the transfer of assert ownership from someone to someone else.

The world's factories are still standing, infrastructure are still there to facilitate economic activities. Demand is still there, the population in China is a few times that of the United States; with ever improving production technologies, they will not allow their living standard to be substandard for long.

Wherewithal is still there, if someone owe [sic] someone else three trillion dollars, that someone else must be rich, has plenty of money to spend and invest!

Even confidence is still there; for sure the share market will go down after ups, but the surge in the last two weeks indicated refreshingly, more investor [sic] than not don't share the dim view of the Daily Reckoning.

For those unfortunate home owners being foreclosed, many may not be eligible for a home loan in the first place.

I think you are wrong.

David Tam

--We'll drink what you're drinking. But fair enough. If we've learned one thing in the last year, it's that we can be just as wrong as the next guy. That's why we reckon it up every day. Keep thinking!

Dan Denning
for The Daily Reckoning Australia

• World Economy Faces Hyperinflation or Deflation?
• Brazil is a Good Place to Become Rich
• June Producer Price Index Indicates Slower Inflation in Australia
• Now is the Time to Find Out About Gold as Money
• An International Currency Not Just on Paper

The RBA rate cut WAS a full percentage point as we speculated yesterday. And it certainly did make a splash. Economists loved it. The critics praised it. And investors "huzzahed" the ASX 200 up nearly two percent on a day when the rest of the globe quaked in fear.

What has changed? The bank has shifted from being worried about inflation to being worried about recession. A credit crunch? Slowing global demand? Falling commodity prices? All those DO seem to add up to much slower growth.

"The recent deterioration in prospects for global growth," the RBA released in a statement, "together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast."

But is the biggest RBA rate cut in 16 years more symbolic than anything? What will change in the real economy and the credit markets because of what the RBA has done? The big four banks did pass on a rate cut of 80 basis points to consumers. That's a win for the battlers.

Will the RBA rate cut unlock the interbank lending market, though? The RBA board said it took careful note of movements in funding costs in wholesale markets," and that, "an unusually large movement in the cash rate was appropriate in order to bring about a significant reduction in costs to borrowers." So credit is now cheaper. But is anyone selling? Banks might begin lending if they were sure it was safe to lend. But is it?

To the extent that Aussie banks fund domestic lending by borrowing from foreign banks, the lower rates don't help either. The cut DOES help reduce the cost of all that debt Aussie consumer are carrying (160% of disposable income according to Dr. Steve Keen). But it doesn't make the debt go away.

We made an error earlier this week when we said Australia had moved to guarantee bank deposits. That move has been made in the U.S. and Europe, but not yet in Australia. And according to Wayne Swan on Lateline last night, there's probably no need to do so, since Australian banks are well regulated and well capitalised. Hmmmm.

Dan Denning
The Daily Reckoning Australia

• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• RBA Declares ‘Victory’ Over Inflation in Australia
• It’s a Bear Market in Credit
• Aussie Banks Addicted to Foreign Borrowing
• RBA Buys $780 Million in Residential Mortgage-Backed Securities