If that's not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we're wading through. So we'll do our best to clear them up for you. But it's probably going to take two days. Today, we'll look at the case against deflation. Tomorrow, we'll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we'll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He's written about it for years. But for a short course on what he's predicting and why, check out this video.

In the video Prechter says, "The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back....The scramble will be for dollars not for things."

The investment outcome of Prechter's scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, "the chances of default are low." Prechter's argument is based on the idea - which we happen to believe - that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter's reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that's trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren't unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that's not in anyone's model might be the sort of thing that precipitates the next crisis. After all, that's the way these things generally begin.

You could make the argument that it shouldn't really matter to the real economy if a bunch of global institutions find out they can't settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can't we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today's funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are "danger" banks. The reason is that these banks own mostly commercial real estate. It's their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren't going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We're going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It's easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it's hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people's preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We'll assume for the moment the regular banks won't do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit...to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it's monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can't have inflation if there's no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won't this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we're going out on a limb. But what we're arguing is that as the private sector is less able or willing to dole out credit into the economy, we're entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It's done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won't do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it's possible to receive 99 weeks of unemployment benefits. This doesn't mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments...well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it's true for the Euro, the Yen, and the Dollar. It's true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed's ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar...mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you'll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and "jobs" programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it's possible - likely even - that you're going to see across the board falls in stocks, real estate, bonds, and commodities....AND inflation. Whether we got the proper sequence right, we're not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Nationalised Banking System Will Come from Global Market Rout
• Bankers Take Money From the Government and Use it to Speculate
• The Single Best Trade for 2010
• World Economy Faces Hyperinflation or Deflation?

Debt, debt, debt, debt, debt! Everywhere you go, it's waiting for you.

From government, to private lives, it has become the number one facilitator of any given action. For proof, we suggest you resist the urge to channel surf during commercials. Instead, why not endure the financing options that will be spruiked at you by hyperactive dancing sales people. Or, for a less painful option, consider the effect an interest rate rise has on the disposable income of new home owners victims.

Money may make the world go around, but it's debt that dominates the world of money.

Like a giant spinning top, the global economy has relied on the increased economic flow and circulation that debt provides. Eventually it will stop spinning and fall over on its side.

You see, it works like this: Central banks are like the tip of the spinning top - the point upon which our debt based economic system expands from and pivots off. It's a very narrow tip.

The Financial Crisis is an indicator that the world economy has become extremely top heavy with debt and is dangerously wobbling around like a slowing spinning top.

Governments and central banks have managed to engineer some more spin, but only at the expense of piling more debt on top of the already wobbling structure. This only increases the stakes of keeping it spinning.

But have we discovered the point where more debt will not provide more growth - only more instability? Who knows? (Other than these two academics, who reckon they've figured it out.)

The key point is that a roaring economy might be great, as the boom period showed us. But if this boom is at the expense of stability, and only artificial spin is keeping it going, then we are going to pay for it eventually.

National Debt

''Prepare for a very difficult economic time, which you will not be able to escape,'' said the chairman of the Netherlands Authority for Financial Markets at the ASIC summer school.

The Sydney Morning Herald (SMH) explains why Hans Hoogervorst is so 'optimistic':

"Australia is unlikely to avoid an imminent economic downturn caused by excessive government debt".

Hans' timing is excellent. But why stick to government debt?

Dan Denning reports that "...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 is over 60% of GDP."

International debt flows are particularly big on the economic agenda for Australia. Michael Stutchbury, in Tuesday's Australian Newspaper, explains that the traditional measure of trade flows serves another purpose for Australia:

"Today's economic orthodoxy suggests current account deficit simply measures the extent to which domestic savings are not big enough to finance the mining investment boom."

Going back to Dan's commentary:

"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."

With debt running so deeply in the veins of the Australian economy, would it even be possible to have a healthy type of growth emerge? Or would a pickup in economic activity simply be another re-leveraging, doomed to topple the economy at some point in the future?

Austrian economic theory, to which the Daily Reckoning subscribes, would suggest that a period of "creative destruction" must clear out all the malinvestment and excessive leverage before healthy growth can resume. Some of this has occurred, but nowhere near enough, especially in Australia.

Mortgage Debt

Tim Colebatch at the SMH reports that Australia's mortgage debt has "soared" to more than $1 trillion. That's 15 times what it was 20 years ago. The breakdown of the figures since 1990 is fascinating. A 12 fold increase in mortgage debt for people's own homes, as well as a 30 fold increase in mortgage debt for rental investors, while disposable income merely trebled.

"In January 1990, home mortgages ate up just 28 percent of our disposable income. By January 2000, that had ballooned to 66 per cent, and by January this year, it doubled again to 134 per cent.

"Households' willingness to take on greater debt powered much of Australia's economic growth from 1990-2010, but with our households now as indebted as any in the Western world, economists say that will not be repeated."

All this not only inhibits growth, but exacerbates just how sensitive the Australian economy is to interest rates.

Housing

Apparently, a quarter of Sydney homeowners have already experienced the other side to Australia's housing boom. Nick Gardner at The Daily Telegraph writes:

"Despite a broadly rising market, property analyst Residex has revealed 24 per cent of properties bought and sold between January 2005 and January 2010 fetched less than the vendors had paid.

"The average shortfall was more than $54,000 but varied between suburbs.

"The biggest losses were in the affluent Neutral Bay/Spit area, where typical shortfalls topped $275,000.

"But even in Campbelltown, where the median house price is a modest $346,500, 36 per cent of properties sold for less than was paid, with an average shortfall of $31,000."

No matter how wealthy your suburb, you aren't safe from Mr Market.

The real problem faced by people who have lost value in their homes is that the price of the home they are moving to is likely to have risen. Their loss has two sides to it; the nominal loss on their house and the increased price of the new house.

Assuming this is true, it would point out something which has confounded any neutral observer to property markets since the Stone Age. If house prices across the board rise by say 50%, this would be heralded as a success in the property industry. If you realise this gain by selling and moving out, you still have to live somewhere. Your new place would also have increased in price, forcing you to pay more. So, in terms of standards of living, you have got absolutely nowhere.

Any gain is offset by an increase in the price of the house you move to.

Obviously, house prices don't move identically across the board. This means there are opportunities to gain. But spruiking an increase in a nationwide price index doesn't equate to Aussies being better off. It equates to those Aussies who didn't own a home, but want to buy one, being worse off. That means it's even worse than a zero sum game.

So, the property spruikers will claim that it's all about picking the right locations. Well, if house prices in Melbourne rise by 50%, while house prices in the rest of Australia stay the same, would Melbournites be better off?

No, unless they wanted to move away from Melbourne...

Sovereign Debt

The 'Ouzo crisis' has entered a critical phase. The Greek people are having to make crippling blows to their public and personal budgets. Worst of all, Elly Koufakis, who "...used to buy special SpongeBob SquarePants toilet paper for her children, [says] she doesn't anymore."

Other devastating accounts include that of Haris Georgatou: "After years of spending $15 a day on coffee, he now makes his own at work."

My own countrymen, ze Germans, have heard their Chancellor rule out a Greek bailout. She stated it in very Deutsche terms:

"There is absolutely no question of it. We have a (European) treaty under which there is no possibility of paying to bail out states in difficulty. Right now we can help Greece by stating clearly that it has to fulfil its duties."

Germany's history isn't great when it comes to treaties.

It would seem that the statements are just a game of terminology anyway. A German bank (rumours are amassing around KfW Bankengruppe) may be backed by the German government in a Greek bailout.

Die Welt put it unambiguously:

"The pressure is growing -- the chancellor knows that. She is still waiting for the right time to justify the billions (in aid) for Greece... But by then the situation in the financial markets could have spun out of control... The billion euro question is now therefore 'when will Merkel move?'"

Apparently investment banking giant JP Morgan considers California (the Vino crisis?) to be a bigger worry than Greece.

Dan Weil explains this is because of the possibility of contagion. Also, JP Morgan hedges its European exposure, so others bear the risk. Those two points appear largely contradictory, but oh well.

Economic Outlook - Look Out

Some nice examples of how government intervention works come from Sean Hyman at Moneynews, with his article titled "Don't Believe What You Hear: It's Not Getting Better".

"Now Fannie Mae says ... that it needs another $15 billion, bringing its total to more than $75 billion. This company is such "crap" that it's had 10 consecutive quarterly losses. Its latest quarterly loss was $16.3 billion.

"AIG lost $8.87 billion in the fourth quarter.

"The FDIC has shut down more banks in Nevada and Washington. That makes 22 bank failures this year (and 140 banks last year and 25 the previous year)."

Then Reuters chimes in with this:

"Some 400,000 jobless Americans could exhaust their unemployment benefits over the next two weeks, the Labor Department said. By the end of March, 500,000 workers could lose the COBRA subsidies that help them pay for health insurance."

And the Washington Times reports the statistic that sums it all up:

"Moreover, for the first time since the Great Depression, Americans took more aid from the government than they paid in taxes."

That is worth reading twice.

If you are wondering what the Reserve Bank of Australia (RBA) is thinking as it continues its rate rises, check out their October 2009 minutes. It seems the RBA is reading up on Austrian economic theory. The ABC even considered it worth quoting this part of the minutes directly:

"Very expansionary policy could result in the build-up of other imbalances in the economy, which would ultimately be detrimental to economic growth."

This revelation should make RAB governor Glenn Stevens very nervous when he looks to his comrades' rates overseas. The nearest rate of a developed nation is 0.5%. That's 1/8th Australia's and "very expansionary".

Retirement advice for Terrorists

The London based Daily Mail reports that the cancer stricken Lockerbie bomber is alive and well, having so far lived twice as long as predicted when he was released from a Scottish prison on compassionate grounds.

Yes, terrorist and compassionate grounds.

Anyway, upon hearing of the luxury and heroic status being enjoyed by the bomber, American blood began to boil. James Taranto of the Wall Street Journal spun the whole thing like a magician to apply to the socialised healthcare debate, which seems to be reaching our own shores:

Great Moments in Socialised Medicine

"In Britain, the government itself runs the hospitals and employs the doctors," claims former Enron adviser Paul Krugman. "We've all heard scare stories about how that works in practice; these stories are false."

"This defence becomes harder to believe when a cancer patient can get better care by going to Libya."

To be fair, James Taranto's comments on a daily compilation of amusing articles are not entirely serious.

Global Warming Casualties

There have been further casualties on the global warming front, with a baby girl surviving a gunshot wound in her family's suicide. The wounded survivor lay among her dead family members for three days. Why did they have to die? The suicide note explained it was their fear of global warming.

Dr Mark Perry of the University of Michigan posted the following on his blog:

"From Al Gore's article We Can't Wish Away Climate Change in today's NY Times:

"It would be an enormous relief if the recent attacks on the science of global warming actually indicated that we do not face an unimaginable calamity."

Dr Perry has degrees from George Mason University, the only university in the world which offers a specialisation in Austrian economics (as far as I know).

Lastly, my apologies for providing a reference to an outdated article on Eastern Europe and thanks to the readers who pointed this out. I was intending to feature Eastern Europe in its own section and did not revise the content that I decided to keep. Considering Eastern Europe still exists, it seems the article's forecast did not eventuate - yet.

Have a great weekend.

Nickolai Hubble.
The Daily Reckoning Week in Review

• Global Illness of Too Much Debt has Been Remedied by More Debt
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• CBA and Their Bad Debt Problem
• China Stepping Up Purchases of U.S. Treasury Debt
• Apparently More Debt is Now Acceptable in Australia

Monday began with jitters over the market's reaction to a raise in the U.S. discount rate. In other words, the Federal Reserve increased the rate at which select banks can borrow from it.

The so called 'discount window', was intended to be an emergency lending facility. The lender of last resort. Instead, it's become the lender of any resort. The increase in the discount rate means it won't be as cheap to borrow money from the Fed.

The relevance to you shouldn't be underestimated. Aussie banks get much of their funding from overseas, so they are affected by what happens in the global interbank market. If the increase in the discount rate is a signal that the broader interest rate is going to be raised as well, then this would affect the availability of funds and their cost.

In a debt drugged, liquidity obsessed world, a change in interest rates can go from affecting profitability to affecting solvency very quickly. And it's not just the banks that are high on cheap credit. Take a look at a listed company's balance sheet. Most of them use leverage to boost their returns.

Low interest rates encourage this.

The reason the western world economy has become particularly interest rate sensitive is because of the way it uses debt. Instead of funding an asset with debt and then paying it off with the increased revenue, more debt is used to pay off the previous borrowings as they come due. This is referred to as rolling over debt.

By doing this, a company (or government) is able to sustain a high level of leverage over time. The debt is never truly repaid.

But, if interest rates rise, then the cost of borrowing goes up. Traditionally, this would have decreased the amount of borrowing. In our modern economy more must be borrowed in order to pay off the old debt. That means companies have no choice but to accept a change in rates.

The financial market reaction to a potential increase in the more important Fed Funds Rate would not have been pleasant. However, this unpleasantness didn't eventuate, indicating that financial markets expect rates to sit tight for some time to come. Based on this, Dan Denning is a step closer to declaring victory over our Money Morning editor Kris Sayce, with several beers at stake.

Neither editor is being suspicious enough in their analysis. Let's take a trip down memory lane with a former Federal Reserve economist, Michael Belongia. What happened in the past when the discount rate was changed?

In this podcast, Mr Belongia talks about how a change in the discount rate can lead to a change in the actual interest rate without FOMC approval, or much media attention. Going behind the back of the FOMC, which is supposed to set the interest rate, is scandalous. That didn't stop it from happening regularly, according the Belongia.

He explains that the spread between the discount rate and fed funds rate should be kept constant according to Fed policy. So, if the Fed's Board changes the discount rate, then the Fed Chairman can march down to the Fed's trading desk and instruct the traders to change the Fed Funds rate to maintain the spread. This conveniently avoids the often less complicit FOMC.

Belongia's accounts are shocking to anyone who believes in the integrity of that particular institution and sickening to the sensible people who don't.

As mentioned, governments around the world are also exposed to the problem of having to roll over debt. To Senator Joyce's delight, the lucky country is no exception. Dan Denning points out that "... according to 2008 data, over $400.1 billion dollars of Aussie foreign debt - or 35.4% of the total - matures in 90-days or less. Nearly half the debt total - $514 billion - matures in one year or less."

That's a lot of debt to refinance on such a regular basis, so any change in interest rates will be felt quickly.

The press often refers to the shortening maturity of government debts. This implies governments will have to roll over debt more often. Such shortening has occurred in the U.S. and is now a major concern. Former Federal Reserve Chairman Alan Greenspan has referred to it as the "critical Achilles heel".

The "greatest financial crisis globally ever"

On Tuesday, Bloomberg reported the confession of Kingpin Alan Greenspan. At least, we consider it a confession. Low interest rates have largely been blamed for the financial crisis by those who warned of its imminence. Greenspan set those rates artificially low. Often in a cunningly deceptive way, according to Mr Belongia. Anyway, here is how Greenspan's conscience was finally cleared on Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said the financial crisis was "by far" the worst in history and called the recovery from the global recession "extremely unbalanced."

The world economy has undergone "by far the greatest financial crisis globally ever."

Greenspan said that while the economy was in worse shape in the Great Depression, the recent financial crisis was potentially more harmful than that in the 1930s because "never had short-term credit literally withdrawn."

Greenspan also said "fiscal affairs are threatening this outlook" for recovery, as Congress and the White House face difficulty raising taxes or cutting spending."

So, not only is his reconciliation late, but his diagnosis is too.

Speaking of confessions, our other 'favourite' economist, former Enron adviser and Nobel Laureate Paul Krugman, has declared his ignorance publicly:

"I'm craving the chance to do some deep thinking, and I haven't been doing a lot of that."

While this fact is familiar to most, it does not excuse Krugman's behaviour. Having consistently advocated the inflation of economic bubbles, to the devastation of homeowners, employees and shareholders around the world, he now advocates a level of government debt that would make Senator Joyce faint, or pop, whichever comes first.

But best of all is this part of Krugman's article:

"I guess doing the really creative academic work does require a state of mind that's hard to maintain throughout your whole life."

Creativity! Economics and creativity? Economics is about understanding timeless principles. Perhaps this is where he went wrong - too much creativity. We have seen the results of Krugman's creative solutions, indicating he doesn't understand the economy, or wishes to indebt future generations beyond help.

Resources Comeback

RBA governor Rick Battelino explained that the resources boom has overcome an interruption known as the GFC:

... now that has passed, the underlying dynamics of the resource boom are starting to reappear...

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.

It certainly is big. But so are China's resource reserves.

In an article on oilprice.com, Dave Forest of the e-letter Pierce Points, warns of the potential price reaction should China decide to begin using those reserves, or even selling them. In fact, they may have already started, with vast steel exports going to Europe.

The effect a short term fall in commodity prices could have on Aussie resource investment and development could be pivotal to the future of the Australian economy.

China itself is of course an economic basket case, as cleverly shown in this business spectator slideshow.

Nevertheless, it seems a BRIC barbeque is roasting the PIIGS and may provide demand for resources to fuel their fire. (Thanks to Daily Reckoning reader Wayne for the inspiration on that one!)

Confidence

Confidence indicators took a hit in the U.S. and Germany, while U.S. new home sales dropped to a record low. This is particularly striking, as central banks often tout these two factors as their primary focus. "Restoring confidence in the market" and "supporting house prices" are phrases that echo through the halls of the central banks on a continuous basis.

Meanwhile, the US unemployment figures are proving disastrous, let alone the unemployment itself. The American Bureau of Labour Statistics has its own numbers in such a mess that the pollster Gallup has decided to help out.

The Poll informed the BLS that "nearly 20 percent [of the 20,000 adults in the work force polled] were working part time in January because they couldn't find a full-time job or had no work at all, and that they are having trouble affording basic necessities like food, shelter and health care."

This tells a different story from the BLS estimates of below 10% unemployment.

U.S. banks continue their slide into oblivion, with 4 of the 161 bank failures since 2009 recorded last week. The outlook isn't much better. Bloomberg reports that "hundreds of banks may face insolvency as losses mount on commercial real-estate loans, according to a Feb. 10 report by the panel appointed by Congress to oversee the U.S. bailout program."

Meanwhile The Telegraph uses some spectacular phrases in an article titled "Failure to save East Europe will lead to worldwide meltdown". It even breaks the language barrier with the following: "...set off round two of our financial Götterdämmerung." Götterdämmerung roughly translates to Godly twilight, implying an age of saviourless darkness.

Next up it suggests a "Monetary Stalingrad" and Eastern Europe "blowing up right now." A more surgical approach was taken by Latvia's central bank governor, who declared the Latvian economy "clinically dead", while protesters "trashed the treasury and stormed parliament."

Needless to say, an excellent article.

Strangely enough, stock markets remain comparatively buoyant and Australia seems to be trundling along happily. Whether Mr Market has sucked in enough suckers before another crash is unclear. Daily Reckoning editors would probably be more concerned if the media was more optimistic, as this indicates complacency.

The Economic Climate

Former IMF economist Jeffrey Sachs provided some creativity of his own in a recent article:

Climate change science is a wondrous intellectual activity. Great scientific minds have learned over the course of many decades to "read" the Earth's history, in order to understand how the climate system works. They have deployed brilliant physics, biology, and instrumentation (such as satellites reading detailed features of the Earth's systems) in order to advance our understanding.

The Guardian, points out otherwise:

Scientists have been forced to withdraw a study on projected sea level rise due to global warming after finding mistakes that undermined the findings.

This article was previously put forward as proof of claims made in the infamous IPCC report. The official withdrawal included the statement that "... it's one of those things that happens. People make mistakes and mistakes happen in science."

While we are in agreement that mistakes happen, we do not agree that government policy should be based on anything quite so mistaken. This is especially so, as government policy is more often than not an inherent mistake as well.

In keeping with brilliantly balanced and fair journalism, the Guardian published the article of Jeffrey Sachs two days before the article about the withdrawal of the study. I wonder what readers think of that.

In the name of financial stability!

Dan Denning also reported on the latest government scheme to support its funding aspirations:

Yesterday's Financial Review even mentioned the possibility that a shrinking government bond market would be a problem for Australian banks. That's because a new regulation proposed by the Australian Prudential Regulatory Authority (APRA) would require a certain percentage of bank assets to be made up of high credit quality bonds. And MBS.

MBSs are Mortgage Backed Securities, those things that have a habit of blowing up when house prices fall.

Acropolis Now

According to Porter Stansberry, the publisher of Stansberry and Associates Investment Research, the Greeks have pulled off a feat that would make Sun Tzu jealous. Greek military spending has been excluded from the annual budget, because it is a "state secret". So, according to Stansberry, about 30% of the Greek governments' spending isn't even declared.

Nickolai Hubble
The Daily Reckoning Week in Review

• Hike in Fed Funds Rate Would Cause Damage to Collateral on Books of America’s Banks
• Gold Standard Doubles as the Greenspan Fed Makes Real Interest Rates Negative
• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• Alan Greenspan’s “Smallish” Injections
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If the market wanted to crash, it would have plenty of reasons to do so. China is tightening bank lending rules. Here in the US, there is the aforementioned Fed discount rate increase. In Europe, Greece is going back to the marketplace to raise more money. And in the Mideast, today's news tells us that many Kuwaiti could be wiped out by the latest downturn in their multi-billion dollar investment industry.

Many things could go wrong; something will.

If no panic comes it is because the market is just not ready to panic. Still, we leave our "Crash Alert" flag flying...and stand clear. There is just more downside to this market than upside. Markets are always discovering what things are worth. We don't want to be holding a lot of stocks when the market discovers that they're worth only half what we paid for them. So, the flag stays up...until prices come down.

Gradually, people are coming to two contradictory realizations. On the one hand, there really does seem to be a kind of economic renaissance going on...or, at least that is what you might think if you read the business and investment news. On the other hand, people are also coming to realize that we're in a depression.

We'll leave it to the mainstream press to describe the rebound, such as it is. We'll focus on the depression.

"Millions of Unemployed Face Years Without Jobs," says The New York Times.

Readers may wonder what kind of economic renaissance fails to produce jobs. Answer: a depression.

As we've opined many times in the past, a depression is not just a time when people stand in line to get bowls of soup or sell apples on street corners. It's a time of adjustment...when mistakes of the previous boom are corrected...and a new economic model is found for going forward. This doesn't happen overnight, no matter how much federal money is put to work helping it. In fact, the government money just gets in the way...distorting the picture and delaying the necessary changes.

Those black-and-white depression days of the '30s are gone. Now, we have a depression in full Technicolor...with plenty of shades of gray, too.

More people today get food handouts than ever got them in the '30s. We call our soup lines the Food Stamp Program. More people are out of work too....

...but here you have to look carefully at the figures to understand it. In the '30s, there was no public safety net. No unemployment compensation...no severance packages...and no government welfare. People didn't give up looking for a job; they had no alternative. They kept looking until they found something. Either you were working...or you were jobless. If we reported the numbers the same way they did in the '30s...the number would already be up near Great Depression levels...at about 15% to 18% joblessness.

But there's something else. Now, there are more people per household working. Back in the '30s, the man of the house was the one that had a job. Typically, the family relied upon him, and him alone, as the breadwinner.

And guess what? If you look at the men of the house...men 25-54...what you see is that one out of every 5 of them is out of work.

For men...this is clearly a Depression...no, it's worse. Not only are they unemployed. They're going to stay unemployed for a long time. Because it takes times for a depression to do its work. And when it is over - maybe five or ten years...or 20 years ahead - not only won't they find their old jobs again...they may never work again. And they won't have wives or families either.

Men's jobs are disappearing - jobs in manufacturing and building. As the NY Times explains, they probably aren't coming back any time soon. What's more, studies show that the longer a person stays unemployed the harder it is to get back into the workforce. Employers don't like to take a chance on someone who's been out of the job market for a long time. They're afraid they've lost the habit of work...or that there's some other reason why they have been out of work for so long.

Women's jobs...in information and services...are doing relatively well. So, men not only lose their incomes...they lose their places in the family, and in the world. What woman wants to marry a guy without a job and without income? Not many. During the Great Depression, marriage and family were almost automatic. People got married. Then, for better or for worse, they lived in families.

Even before the depression began, marriage had become optional. Women get more college degrees than men. They typically don't like "marrying down." They delay marriage while developing their careers...and then, when they are ready to marry, it's hard to find a suitable man.

Result? Well, we don't know where this leads. But it doesn't look good for the beer-swilling, football loving X chromosome half of the population.

Bill Bonner
for The Daily Reckoning Australia

• How Do You Enjoy a Depression?
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• Feds Say Don’t Worry About the Depression
• US Economy is Some 11 Million Jobs Short of Full Employment

But before we make the conclusion, we should make the case. There is an Australian grouping of evidence. And there is an American grouping of evidence. Let's deal with American evidence first. And let us call to the stand Reserve Bank of Australia assistant Governor Guy Debelle.

"While most of the recent jitters have been associated with sovereign concerns," Mr. Debelle said in a recent speech, "I think the risks stemming from the financial sector are still there. A significant risk is that that we are still yet to see the full impact of the weakness in the North Atlantic economies on the loans on the books of financial institutions.

It might seem strange to begin the case for a further write down in bank collateral with an Australian central banker. But the good Mr. Debelle has done our work for us. He told a crowd in Sydney that, "We are now into the phase where weakness in the global macro-economy is feeding back into the financial sector...We are not all that far advanced in the adverse cycle that normally accompanies recessions."

In other words, if we understand those comments correctly, there are more losses to come. It's not just sovereign nations that are feeling the weight of bad debts. It's the banks themselves - even after a year of recapitalisation and profit growth thanks to low interest rates - that could face serious trouble from a second of losses on residential and commercial real estate.

"For the North Atlantic economies," Debelle concludes, "this was a big recession which, combined with large falls in both commercial and housing property prices, should result in large losses." He goes on to point out that the government-guaranteed larger lenders might survive these larger losses. But smaller regional banks might not.

If those regional American banks fail you can expect two results. First, a larger burden the Federal Deposit Insurance Corporation (FDIC), the U.S. (underfunded) entity that insures bank depositors against just this sort of thing (up to US$100,000 per account). The other result would be a second-cousin of what happened when the Fed raised interest rates in the Great Depression: a contraction in credit.

Banks are the engine of money creation in the modern economy. If you have fewer banks, you have fewer engines of credit creation. Meanwhile, national assets and liabilities get concentrated on fewer and fewer but larger and larger balance sheets. It's the collectivisation of finance, which in corporatist style, greatly benefits Wall Street money centre banks.

And this is all at the private and corporate level. In the world of public finances, American deficits are already spiralling out of control. The Federal Reserve, through its System Open Market Account, is taking an increasingly active role in supporting U.S. bond auctions. This is a fancy way of saying that as foreign investors refuse to finance U.S. deficits, the Fed must print money to paper over the gap itself. More details on this operation tomorrow.

Today, let's ask the direct question: so what?

Why should Australians care if the United States has begun to monetises its debts? Well, it's not certain, but you we're pretty sure that U.S. monetary and fiscal policy is going to give rise to inflation, and higher interest rates. It will make credit harder to come by globally, just as it did in 2008 when the investment banks blew up.

This is bad news for Australia on two fronts. At the banking level, something terrible has happened since 2008. Bank collateral has not, in our opinion, materially improved. On the one hand, it still consists of huge chunks of U.S. commercial and residential real estate. Collateral damage!

On the other hand, those same U.S. banks have loaded up on another kind of equally toxic collateral. They replaced something bad with something equally bad, but perhaps less putrid (sovereign debt). U.S. banks, then, face a double collateral whammy this year from falling house prices and falling U.S. government debt prices.

Even if Australian banks don't own U.S. backed real estate (and some do, mind you) and even if Australian financial institutions are not direct holders of U.S. sovereign debt (and some no doubt are), they're still directly exposed to a world of tighter credit. And that world would be an accomplished fact if U.S. banks either ceased to exist or, as a result of more credit write downs, stopped lending globally.

The prosecution for another massive financial deleveraging in America rests. But what about our promised Australian evidence? Won't things just be fine here, especially since China's savers are set to become Australia's creditors?

Well, maybe not. A speech today by RBA Assistant Governor Phil Lowe shows that Australia faces a similar collapse in private demand as in America. In turn, business investment is falling. Government is trying to fill the breach with a larger fiscal deficit. The end result may be economic stagnation and higher public debts and interest rates.

This all goes against the grain of the positive, earnings-driven news about the economy. But remember, the modern economy runs on huge supplies of credit to consumers and businesses. Take away that credit and you take away the fuel of GDP growth. Not even government intervention can offset the massive write downs in asset values required to put the economy on a sounder footing.

But how about the visual evidence. Mr Lowe provides the first chart below which shows falling private demand in the U.S., Europe, and Japan. This doesn't include Australia. But we'd expect Australia to follow these trends if global credit becomes scarcer and asset values fall. Households and businesses will retreat into a more conservative cocoon.

Speaking of cocoons, Lowe's next chart shows's a figure specific to Australia: business credit growth. It's fallen over 7% in the last year. Whether it's because demand for credit is down or because supply is down (the willingness of bank's to lend) is a relevant question. But the chart itself suggests another credit contraction, leading to more shockwaves in financial markets.

This slump in business credit growth has not yet affected access to capital for Aussie companies. Well, it has for companies on the margin of the mining business. But many other companies have turned away from the debt market (only the big banks got government guarantees to borrow). Instead, Aussie firms have tapped the equity markets. The chart below shows that listed companies raised over $85 billion in new share sales last year alone.

With a steady flow of compulsory super annuation money into the system, you could argue that Australian firms are going to have access to equity capital no matter how tight credit gets globally. And that might be true to a certain extent. But even assuming capital is available to listed companies, how will Austrlian firms grow profits in a world smothered by another credit crunch?

Quite clearly, they won't. That, anyway, is the case for how a second round of deleveraging - driving by credit writedowns at American banks - will crush the Aussie market rally. There is, though, one saving grace. Maybe.

That saving grace is that if the sovereign debt risk in America supersedes the banking story, you will see an outright U.S. dollar crisis this year. That ought to benefit higher-yielding currencies like the Aussie dollar, although truth be told no one really knows how other paper currencies would fare in a full-blown dollar crisis.

What we do suspect is that the dollar crisis will be inflationary in nature. The monetisation of U.S. debts (public or private) will lead to a weaker dollar. And all things being equal, that ought to lead to much higher precious metals and oil prices.

Whether than translates into higher prices for precious metals and energy shares is also an open question. Do you want to be in the equity markets during another round of deleveraging? Last time around, resource stocks proved no refuge at all. And commodities themselves were as inflated as anything else. This time around, what is the best refuge?

Dan Denning
for The Daily Reckoning Australia

• Australia to Borrow as Much as $300 billion
• Bernanke Calls U.S. Economic Recovery “Nascent”
• It All Comes Down to Debt Again for NAB
• Banks Could Face Larger Asset Writedowns and Losses than IMF has Modelled
• Paying Attention to the Risk from Deleveraging in Commercial Real Estate

But instead of atoning in a dank cell, these same economists strut onto the stage to congratulate themselves.

"The Greatest Depression that could so easily have happened in 2009 but did not is the tribute that the world owes to economics." Wrote Arvind Subramanian in The Financial Times.

We were lost from the get-go, trying to interpret the sentence. It is as tangled and puerile as the staggering conceit behind it. Then, Mr. Subramanian sets up the stage props:

"In 2008, as the global financial crisis unfolded, the reputation of economics as a discipline and economists as useful policy practitioners seemed to be irredeemably sunk. Queen Elizabeth captured the mood when she asked pointedly why no one (in particular economists) had spotted the crisis coming. And there is no doubt that, notwithstanding the few Cassandras who had correctly prophesied gloom and doom, the profession had failed colossally..."

He then brushes off the Queen's very sensible question:

"But crises will always happen, and even if there is a depressing periodicity to them as Professors Reinhart and Rogoff have catalogued, their timing, form and provenance will elude prognostication."

Of course, the record doesn't show that the crisis eluded prognostication; any dope could have seen it coming. But the prognosticators who had contributed so mightily to the crisis had blinded themselves with their own claptrap. Still, Mr. Subramanian figures that they "vindicated" the profession in the way they responded to the crisis.

"On monetary policy, Bernanke was true to the word he gave to Milton Friedman on the occasion of his 90th birthday: 'Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.' Bernanke, the pre-eminent student of the Great Depression, found conventional and some very unconventional ways of not doing 'it' again. At the peak of his interventions, the US Fed came to resemble the Soviet Gosbank, more a micro-allocator of credit than a steward of macroeconomic policy."

It probably wasn't the point he intended to make, but the Fed does resemble the Soviet era Gosbank - manipulating, meddling and micro- managing the economy towards destruction. Meanwhile, Congress is doing some Soviet style management too; it is now owner of the nation's largest automobile company and its largest insurance business: "They took their cue from the writings of the academic scribbler of yore - Lord Keynes - and provided massive public demand for goods and services where private demand had collapsed...."

We were still gasping for air when, on the 30th of December, columnist Martin Wolf called upon Keynes ghost again. He too shuddered to think how horrible things would have been if the financial authorities had not taken resolute action:

"We could not in such times, even take the survival of civilization itself for granted. Never before had I felt more strongly the force of John Maynard Keynes's toast 'to the economists - who are the trustees, not of civilization, but of the possibility of civilization.'"

Is there any doubt that Keynes was a scalawag? Civilization flourished for thousands of years before anyone made a living as an economist. Crises came and went. In the 19th century, for example, there were panics followed by depressions in 1819, 1837, 1857, 1873, and 1893. Not one of the depressions seemed worthy of the "great" modifier. Hundreds of banks failed. Civilization didn't seem to care. The rich and powerful took their lumps along with everyone else; most people enjoyed watching them go down. Business went on.

In 1913, on Christmas Eve, Congress passed the Federal Reserve Act, setting up America's central bank. Only then did economists get their hands on the economy's throat. The dollar was worth about the same thing it had been worth 100 years before. Now, almost a hundred years later, it is worth only 3 cents. And only 16 years after economists took their positions at the Federal Reserve came a depression worse than anything the nation had ever seen - at least, it was worst after government economists finished with it.

The Great Depression may have been an accident, but the debasement of the dollar certainly was not. It was a matter of policy. Economists, led by Keynes, had the idea that they could spur the economy forward by creating phantom demand - in the form of additional units of purchasing power. The gold standard stood in the way; it was abandoned like a bad neighborhood. First, temporarily, then partially, then, in 1971, completely. The first consumer credit boom came in the '20s...leading to the Great Depression. By the 1980s, 50 years later, Americans had lost their residual fear of debt. Consumer credit boomed again. Then it bubbled. Economists didn't understand what was going on. They rarely do. But they had created a hundred year flood of consumer debt. Now they congratulate themselves; households sink...but civilization floats.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• David Ricardo is the Dominant British Economist of the Nineteenth Century
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• The Public Still Has Faith in Economists – But Why?
• How Simpleminded Economists Really Can Be
• Why Weren’t Economists On Top of This Thing?

So, let's talk about gold. But first...a note about the little train that couldn't.

The Eurostar connects London and Paris. Last Friday, several trains entered the tunnel and stopped. According to the press reports, the weather was unusually cold in France and unusually warm in the tunnel, causing some sort of malfunction and stranding 2,000 travelers under the dark water and thousands more on both sides of the channel. It was a blow to France's pride; the French consider their train technology to be the best in the world. Yesterday, President Sarkozy called the head of the Eurostar and chewed him out...and this morning, the trains were meant to be running again.

We rose at 5AM to rush to the Gare du Nord, so we could get the 6:43 to London.

"You're going to take the Eurostar," said the taxi driver with a laugh. "Well...good luck..."

When we got there, it was obvious something was wrong. Passengers weren't lining up in an orderly fashion. Instead, hundreds of travelers who had been waiting three days for a train formed a miserable, complaining mob. We were just trying to figure out what was going on when a phalanx of police came down the steps, followed by another group of Eurostar staff members. They wandered around...formed up the passengers into lines...answered questions and then, nothing happened. We waited. We waited.

"This is intolerable," one French passenger yelled at a young woman in uniform. "You people have no respect for your customers. We've been waiting days to get back to our families...and you treat us like cattle. It wasn't our fault the trains didn't run as they were supposed to. It was your fault. And you should have done a better job of dealing with the trouble you caused."

A murmur of approval went up from the crowd. The clerk walked away. We waited. Finally, after half an hour, your editor gave up. His business in London could wait. We walked over to our office, only about 20 minutes away on foot.

Now...back to gold...

The price fell $15 yesterday, to close below $1,100. We expected a correction in the gold market. But we thought it would come along with a correction in the stock market. Stocks rose 85 points on the Dow yesterday.

We take this as a warning: something is going on that we don't understand. That said, there's a lot going on that we don't understand.

But the broad patterns generally make sense. Boom was followed by bust. As dear readers know, the force of a correction is equal and opposite to the deception that preceded it. The deception of the Bubble Era being exceptional, the correction would be exceptional too - even under the best of circumstances.

But these are not the best of circumstances. Because several other things are happening...things that need to be reckoned with, too.

• The US is losing its privileged place in the world. Americans now compete with many other people in many other places for the world's resources - including its savings.
• The international monetary system, an experimental system built of paper dollars, may be falling apart.
• The days of cheap and bountiful energy are over.
• Governments are going broke. State governments. National governments. In Europe. In the Middle East. And in America.
• The engine of economic growth - Americans' willingness to go into debt in order to consume more and more of the world's output - has gone into reverse.
• And, governments are meddling on an unprecedented scale...delaying and avoiding necessary adjustments, possibly turning an ordinary depression into a Great Depression...or even a Much Greater Depression.

These are not small challenges. Any one of them would be a worthy crisis on its own. Put them together and you have the makings of a catastrophe.

What will happen? Don't know. Wish we did.

A series of mini-disasters? Or one big planet-wide blow-up?

Or, are the authorities so smart that they can engineer trouble-free solutions to these challenges?

If you have confidence in Obama...Bernanke...Geithner...Congress...the European Central Bank...the Bank of China...and so forth... Well, you have no business reading The Daily Reckoning! Heck...let them figure it out. Everything will be fine. Go back to the TV...

If, on the other hand, you have a sly suspicion that the authorities are headed for the rocks...you should own some gold. Traditionally, gold is what people buy when they are afraid things might not work out as planned.

As near as we can tell, gold is fairly priced. It will buy about as much as it would have bought 500 years ago...or 2,000 years ago, for that matter. That's what's nice about it. It doesn't make you any money, but it doesn't lose you any money either.

Of course, the price of gold can still vary substantially. In the last bull market in gold - from the trough in '67 to the peak in '80 - gold rose 1550%. That was a good time sell. The next two decades saw the price sawed in half...and then sawed in half again.

Now it is going up again. Most likely, it is merely adjusting to the inflation of the previous three decades. Or perhaps it is anticipating more inflation ahead.

As to the inflation ahead, we're not so sure. There's probably a long, dark, cold period of depression to go through before we get to the heat of hyperinflation. But then...who knows? As those challenges listed above hint, anything could happen.

Here at The Daily Reckoning we are neither bullish nor bearish on gold. We don't know whether it will go up or down. But as to our confidence in human beings, we have no doubt. In our opinion, the world's most popular economists - notably Ben Bernanke and Paul Krugman - would probably make fine bartenders. They are good at providing 'liquidity,' and not much more. They have no idea what is happening in the world of finance...and their idea of what to do about it will almost surely make things worse. Meanwhile, we feel we can count on Congress and the president too. The nation may already have a net worth of MINUS $70 trillion (according to John Williams of ShadowStats)...but they will surely keep spending until the nation goes broke.

Typically, power begets gold...then gold begets power...and then both gold and power are begotten by someone else. The world never stands still, even for someone with a million dollars' worth of Krugerrands in his home safe.

The BRICs - Brazil, Russia, India and China - are begetting power. Their economies are growing much faster than the developed, mature economies of the west. They grew by selling products - often in dollars. This left them with dollars as financial reserves. They have little gold.

For a very long time, dollars were 'as good as gold' - or almost. But now the power equations need to be reworked. The BRICs are gaining power...but find themselves still hostage to America's paper money. Inevitably, they're going to follow India's recent example...as well as the example of practically every nation to gain power throughout history; they're going to add to their supplies of gold.

A rising power acquires gold. A fading gives it up. The US has more than 8,000 tonnes of gold...nearly 80% of its reserves. Meanwhile, China - America's most likely rival for superpower status - has only 600 tonnes of gold. It keeps less than 1% of its reserves in the yellow metal. Put all the BRICs together and you get 1,500 tonnes, less than a quarter of the US hoard. And the BRICs have 10 times as many people.

Official purchases of gold by central banks have been negative for many years. They still are. In the 2nd and 3rd quarters central banks sold more than they bought. Imagine if they suddenly went positive! If the BRICs wanted to bring their reserves up to just half the level of the US, they'd have to buy 2,500 tonnes.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• India Beats China to Walk Away With 200 Tonnes of IMF Gold
• Feds Have Used the Correction to Increase Their Power and Add to Their Wealth
• China is a Key Driving Force in the Gold Market
• IMF Gold to be Used
• Gold: The Ultimate Unlevered Hard Asset

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
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What's he talking about? Agricultural commodities like soybeans, wheat and corn.

We begin our analysis with some simple "big picture" truths. The world's population has more than doubled since 1950 - from about 2.5 billion to 6.7 billion. By 2050, there will be more than 9 billion people on the planet. Almost all of this growth will occur in the emerging markets like China and India. And their populations will all be doing one thing, for sure - eating.

Now, hang on. I know that is a banal insight by itself, but this story has more layers than a tiramisu. After population growth, the second layer is the mix of food eaten, which is important. These undeveloped economies are becoming wealthier. Predictably, as people everywhere have done and continue to do when they have a little more money in their pockets, they change their diets. They spend more on food. The average Chinese person spends 40 cents of every additional dollar earned on food. In India, it's about 70 cents of every additional dollar. What do they buy?

They buy more meat, more fruits and more vegetables. Their calorie intake rises. That's why the UN says we'll need to boost food production by 70% by 2050 - a big task, given increasing restraints on water and quality arable land.

How do we meet that demand? Here the plotlines start to thicken and things get interesting...

Let's look at soybeans specifically. China is the largest importer of soybeans and has been since 2000. China was once the largest exporter of soybeans, but flipped to a net importer in 1995. It may well be impossible for China to meet its demands for soybeans by producing more of its own. Passport Capital, an astute hedge fund, estimates that in order to grow enough soybeans to become self-sufficient, China would need to cultivate an area about the size of Nebraska.

That looks impossible against China's arable land base, which has been in decline since 1988 - this despite the fact that China subsidizes agriculture. Another reason is the low level of water resources in China. (See the nearby chart "Who Has Water... And Who Doesn't.") Soybeans require a lot of water - 1,500 tonnes of water for one tonne of soybeans.

This chart is telling. Who has lots of water? Brazil. So it is no surprise to discover that the increase in demand for soybeans from China has largely been met by increasing soybean acreage planted in Brazil. (Brazil is the second largest exporter of soybeans in the world, behind the US and ahead of Argentina and Paraguay.)

The easiest way for China to get around its water shortage is to import soybeans. By importing soybeans, Passport calculates that China is effectively importing 14% of its water needs.

It looks likes this trend will continue for quite some time. When you look across the world, arable land per person is in decline. (Arable land simply means land that can be used for farming; it doesn't mean that it is currently used for farming.) But one nation has more potential for converting arable land into producing farmland than anybody else, by a country mile. It's Brazil again.

Brazil has a large tropical savanna known as the cerrado. You can think of it as the world's arable land bank. It's an area of about 250 million acres - about as big an area as all of the arable land in the US. It gets plenty of rainfall and sunshine. The soil is very old and runs deep. But there is a problem: The soil is nutrient poor. You need to add a lot of potash and phosphate - two key nutrients - to grow soybeans there.

According to estimates by SLC Agricola and Morgan Stanley, the average new acre of farmland in the cerrado requires 14 times the amount of phosphate and three times the amount of potash of a typical American acre. This means that it is expensive to grow grains here. You need a high soybean price to make it worth the effort - and there is more to it than just adding the nutrients. There is road and rail access, for instance. Someone would have to build all that out, too.

So now we are in a position to connect some dots on this story. China's increasing population and affluence will drive its soybean imports. These imports will come mainly from Brazil. And Brazil, as it converts more arable land to producing farmland, will need a lot more potash and phosphate.

What is true of soybeans is also true of wheat and corn and rice and other agricultural commodities. All of them face the same challenges for water and land. All of them require lots of fertilizer.

I've not mentioned the biofuel component. But this is another big pull on demand for grains. The US alone aims to produce 15 billion gallons of ethanol by 2015. All over the world, biofuel demand now competes with "dinner plate" demand for supplies of grain.

This is not a gloom-and-doom scenario. It simply means that there is a lot of support for higher prices for agricultural commodities. Inventory levels still remain low worldwide. Grain prices are all well off their highs. After adjusting for inflation, many of them are as cheap as they've been in decades.

This is why Jim Rogers said he likes the agricultural commodities. I couldn't agree more.

I also mentioned how this idea was hard to kill. In the Great Depression, purchases for jewelry and clothing and the like fell by 50%. But purchases for food - even for meat - held steady. We've seen similar patterns in recent busts. In the Asian Crisis of 1998-2001, the demand for food held steady, even while other markets collapsed.

Put it all together and you have a great case for higher grain prices. You also have an environment that is very good for fertilizers - in particular, potash and phosphate.

Regards,

Chris Mayer
for The Daily Reckoning Australia

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But there are some strange and perplexing crumbs to collect from news reports this morning. Yesterday we learned that for the first time in 70 years, yields on 90-day U.S. government securities were briefly negative. Investors - if you can call them that - were happy to loan money to the U.S. government for 90 days - and lose money.

Normally, the only thing that could explain such an unusual preference for liquidity at the expense of return is abject terror of equities. But stocks have been moving on up nicely. The plunge in short-term yields can't be explained in terms of "risk aversion." So what's behind it?

It's a pretty interesting question if you simply phrase it: what kind of investor is happy to lose money over 90 days? Is the move to the short-end of the U.S. yield curve part of a broader shift out of longer-dated maturities (10 year notes and 30-year bonds).

Even the New York Times is starting to freak out about the amount of U.S. debt that must be rolled over in the next four years. The times article points out what we pointed out at the beginning of the month: U.S. debt is far more interest rate sensitive than ever before, which makes it potentially far more expensive to service if interest rates spike.

But that doesn't get us any closer to explaining the near-zero short-term yields. Granted, they were low to begin with. Maybe they are only unusual because they descended from such a low base to begin with. But is there another explanation that sheds light on what's going on in the markets?

One possibility, and we admit we are speculating here, is that banks are beefing up on liquid assets to bolster their capital positions. Whether this action corresponds with the end of the year or some other force, well, we have no idea. But without a corresponding fall in some other asset, the fall in short-term bond yields must represent a preference by institutions for T-bills and notes right now.

Our colleague Kris Sayce thinks institutions might be using T-Bills as collateral for other loans, pyramiding their way up to new balance sheet growth. It's possible. It's also possible that banks are buffering their capital positions in anticipation of...turbulence.

In today's Age, Eric Johnston begins his story with the headline, "Australian banks fail new capital test." Gee, that sounds familiar! "Ratings agency Standard & Poor's has warned that nearly all the world's big banks - including Australia's major lenders - have insufficient funds to cover their lending exposures and risk a ratings downgrade unless they move to bolster their balance sheets over the next 18 months.'

That might sound odd, considering that Aussie banks tapped equity markets for $20 billion in new equity last year. But did the new money actually bolster the balance sheet? Johnston reports that, "While Australian banks benefited from having a large exposure to low-risk residential mortgages, S&P said a narrow geographic and business base counted as a negative. It also noted that the capital raisings by the local banks had been used mainly to fund acquisitions or balance sheet growth."

More home lending baby!

It's probably a stretch - given we have no evidence whatsoever - to suggest that global banks (Australia's included) are bolstering capital by moving into short-term U.S. debt. It's also arguable that U.S. debt - even short-term near cash bills and notes - are a quality asset to be adding to your capital mix. But it's a lead and we're chasing it down.

Why does it matter? Well, the last time yields went negative like this was in 1938. That preceded a collapse in the stock market and the onset of the "Great" part of the U.S. Depression. Of course in 1938 the Fed began tightening up monetary policy again (prematurely, some argue). It won't do that today.

Meanwhile, some other troubling pieces of information from the bond market. Bloomberg reports that Telstra, "scrapped a domestic bond sale plan after it couldn't reach an agreement with investors on the terms of the securities. " Apparently bondholders "wanted the 10-year debt to include assurances compensating them if Telstra's credit rating gets downgraded."

Geez. Creditors are getting pretty choosy these days, aren't they?

There are other stories we'd like to have a closer look at today. For instance, a Brazilian steel-maker has plans to buy 16.5% of coal explorer Riversdale Mining for $190 million. This fits the pattern we described earlier this week of major international companies seeking to buy independent junior miners in order to guarantee resource supply. We'll have to ask Dr. Cowie what he thinks.

Time to board the plane now and cross the Tasman. We'll report tomorrow from the east coast of the North Island. Until then.

Dan Denning
for The Daily Reckoning Australia

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