First, Goldman's buy on the banks seemed to buoy the market. The Dow finished up 112 points and is just under 9,600. Meanwhile, Aussie stocks shrugged off that sense of impending doom and rallied 43 points yesterday. The ASX 200 is at 4,622 and thoughts of 5,000 by the end of the year must surely be dancing like sugarplums in the heads of some investors.

Ho! Ho! Ho!

But seriously. The banks? Really? Aren't you the least bit suspicious that Goldman is talking up the banks? Doesn't this mean Goldman is probably already short on the banks?

We have been hanging out at what we now call the "Trading Nebula" in our new offices. Our research department is growing, so we like to drop by and see what the traders think is happening. Often, it seems nebulous to us, given the peculiar vocabulary of indicators and charts the guys are using. Hence the "Trading Nebula."

But Murray Dawes was especially clear this morning when he told us that his screens are producing all sorts of warning signals on the banks. He is obviously running a different trading algorithm than Goldman. But then, he's producing trading leads for our new Slipstream Trader, which is designed to produce long and short ideas on ASX 200 stocks. In our chat this morning he told me that two banks showed up, although neither were part of the big four.

If Murray is suspicious that the banks can lead the market to higher highs, at least he's in good company. Bear heroine and noted financial analyst Meredith Whitney wrote in the Wall Street Journal over the weekend that, "Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting."

You don't say?

"Access to credit is being denied at an accelerating pace," Whitney adds. "Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan...In the U.S., small businesses employ 50 percent of the country's workforce and contribute 38 percent of GDP...Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business."

What then, has the regulatory and policy reaction actually produced? It's propped up large institutions that still have heaps of bad assets and have used the last six months to increase their leverage. But at the regional and local level, real businesses with real customers and real capital needs can't get credit.

To summarise: We have saved the zombie companies with zombie assets at the expense of the living, breathing engine of the free market; the small business. This leads Whitney to conclude, that "We are only in the early stages of the second half of this credit cycle...I expect another $1.5 trillion of credit-card lines to be removed from the system by the end of 2010."

What will happen to the economy then? And what will happen to Australia then? Will it matter? The ability to extend credit to small businesses and households is concentrated in the hands of the Big Four. Does that make us safer? Or does it concentrate the risk in a few major players, jeopardising the whole system of credit?

What's clear is that the supply of commercial credit is more concentrated now than ever before. Will the Big Four shun risk and build a capital cushion by cutting off small business credit? Will they double down on their housing lending in order to support house prices; a scheme which supports the value of the assets the banks carry on their balance sheets?

If we're making it sound like the market and the economy are at a critical inflection point, it's because they are. The complacency of the last six months is giving way to some real questions about what to do with troubled assets that are still troubled and bad debts that are still bad. Can a global economy really grow when the financial system is weighed down by so much debt?

Professor Michael Hudson is coming to Australia and he says "No!" If you're interested in hearing what he has to say in person, check out his schedule here. You can RSVP for the event near you, provided seats are still available. If you can't make it, there's a good You Tube video of his ideas here.

We're not familiar with everything Dr. Hudson has to say. We're planning on catching up for lunch and will report back to you how it goes. In the meantime, he gave an interview with the folks over at Business Spectator and put his views lucidly: "There's a basic mathematical principle; a debt that can't be paid won't be paid."

Talking about the explosion in consumer debt world-wide, including here in Australia, Hudson says, "These debts are beyond people's ability to pay and so we're going to see breaks in the chain of payment and this means that a lot of debts are going to go bad. It means that people are going to hesitate to realise that they can't pay, a kind of cognitive diffidence [sic] that people have about the fact that they really can't pay their debts."

"They're willing to run down their savings, they're willing to sell off their assets and do everything, but in the end they default and this is what breaks the back of an economy. The houses are defaulted on, they're put up for sale, that crashes real estate prices all the more and, again, the commercial real estate is even in more serious condition than residential real estate right now."

Coming back to Barofsky and Goldman then, and if Hudson is right, is this the time to buy the banks? Barofsky's report concluded that not all nine of the banks that received $125 billion in capital infusions from the U.S. government here as "healthy" as Ben Bernanke and Hank Paulson made them out to be.

The nine institutions combined had over $11 trillion in assets. But Paulson made it sound as if the capital infusion would not only stabilise the banking sector, it would prompt the resumption of credit flows in the economy. That turned out to be...not true.

So what is the truth? Well, as we suggested at the time, the TARP was just a massive delaying tactic. The capital infusions (putting aside that it wasn't really capital but money the Federal government borrowed that must be repaid) were designed to prevent the banks from going insolvent on further asset write downs. But the whole logic of the deal was that asset values would stabilise and even improve, meaning the banks wouldn't have to take losses or raise more capital.

Give it time baby. Time heals all asset values, right?

No. It all goes back to what you mean by "troubled." And this is the real heart of the issue behind our mistrust of the stock market rally. There has been no real improvement in the quality of troubled assets in the last year. In fact, they are more troubled than ever. The financial system remains troubled, and not much in it has really changed.

This leaves the highly-leveraged banks in the same precarious position as they were before, albeit with slightly more confidence from a gullible public. But at the balance sheet level, have things really improved? And more importantly, have the trillions in assets in the financial system related to residential and commercial real estate really become more valuable in the last six months? Or is just a Ponzi Finance pyramid of junk waiting to go up in flames?

In our view, the last year has been a policy and regulatory sham to cover the retreat by bankers. The people heavily invested in the old system of debt-based asset appreciation are stalling for time. They hope that the passage of time will improve earnings for a quarter for two.

And if they are the religious sort, they pray that some other scheme will be established to take the troubled assets of their hands. But time cannot heal troubled asset values. Faith healing doesn't work in financial markets. We'd humbly suggest that the day of reckoning is still out there, hiding somewhere on the calendar, waiting to rise again. Until then...

Dan Denning
for The Daily Reckoning Australia

• Normally Small Businesses Lead the Economy Out of Recession
• Meredith Whitney and the Buy Recommendation on Goldman Sachs
• Rising in Defense of Goldman Sachs
• Warren Buffett is Buying Four Percent of Goldman Sachs
• Is the Macquarie Model Dead?

"Jeepers, creepers...where'd you get those peepers...
"Jeepers, creepers...where'd you get those eyes..."

Thank god for laser eye surgery! Now, the people who were blind to the biggest financial crisis in the history of the world can see clearly again. And what do they see? A recovery!

"Bernanke strikes note of hope on economy," says the headline in today's International Herald Tribune.

"The chairman of the Federal Reserve, Ben S. Bernanke, said Tuesday that the US economy appeared to be stabilizing on many fronts and that a recovery was likely to begin this year."

Is this good news? Or what? 'Or what' is our bet.

Yesterday, the markets seemed to take a breather. Stocks fell slightly. Oil slipped a bit too. The dollar remained where it was...but still on a downward trend. And gold held steady...at $902 an ounce.

Can the feds now fix the trouble they never saw coming? Can the people who ran banks into the ground now run the banks that will help finance the recovery? Can the investors who bought trashy investments with borrowed money now recognize the good investments that are put in front of them?

Neither Ben Bernanke, Tim Geithner, Hank Paulson nor Alan Greenspan could see it - but there was something clearly wrong with the Bubble Economy of 2001-2007. We said so many times.

'Good riddance,' we celebrated, when it keeled over

But now they struggle to revive it. Like a brain-dead codger on life support, they are bankrupting the next generation trying to keep it alive.

"We expect that the recovery will only gradually gain momentum," Ben Bernanke forecast, trying to manage expectations, "and that the economic slack will diminish slowly."

Really? Oh, the wonders of modern medicine. Now, with 20/20 vision, the Fed chief can look ahead and tell us what will happen next. If only he'd gone to the doctor two years ago!

Stocks are rallying all over the world. Economists are putting on their spectacles and looking to the future. Bankers are cashing their checks and laughing all the way home from work.

"That sense of unremitting free fall we had a month or two ago is not present today," says White House economic advisor Larry Summers.

Barron's Big Money Poll shows professional portfolio managers are bullish again. They're looking for the Dow to gain 7% this year...and 17% by the middle of next year.

(This is good news for us. We were beginning to look around and notice that that too many stupid people agreed with us. But now that we see the pros are in the opposite camp...we can sleep more soundly.)

The proximate cause of all this optimism is the vigor with which the people who didn't see the problem coming have gone about fighting it. Mr. Market may taketh away...but Mr. Federal Official putteth back. At least, that's the logic of it. So far, in the U.S.A. alone, they've earmarked a sum nearly three times the cost of fighting World War II. Not all of that are direct cash outlays. Much of it is in the form of financial 'guarantees' and 'investments' (such as buying up Wall Street's smelly derivatives). Still, it's a lot of money.

Normally, in a correction, the supply of money - M1 - falls. Asset values are destroyed...borrowers default...money disappears into vaults and mattresses. But this time, so vigorous has been the authorities' response that M-1 is actually increasing at about a 14% annual rate. The money's got to go somewhere...

Here in London, the government has taken a similarly energetic line. The Bank of England has fallen in line with the government and boosted its balance sheet by more than two times in the last 12 months. Banks have been shored up with easy cash. Rates have been cut. Stimulus budgets have been passed. And yesterday, the government bailed out LDV, a maker of industrial vans.

Naturally, the bailout comes with some strings attached. The government stressed that this was just a 'short term' solution, pending a rescue by a Malaysian group. And hey...wait a minute...the company also had to promise not to move its production out of the United Kingdom. Who needs Smoot and Hawley when you can protect your markets using central bank cash?

Bill Bonner
for The Daily Reckoning Australia

• Feds Can’t Cause a Genuine Recovery Simply by Throwing Money into Economy
• Where, Exactly, is this Economy Headed?
• Ben Bernanke Averts a Second Great Depression
• Stocks, Bonds and Economy All Bounce
• US Economy Still on Runway as Recovery Won’t Fly

But there was no container large enough to hold the subprime losses. Each time one was set out, it quickly overflowed. The latest reports tell us that the bilge is now 500 times deeper than the Fed head forecast...and still rising. And this comes after $11.7 trillion has been committed in the US alone to pumping it out. Whether the plumbers are plain idiots or clever rogues, we can't say, but it should be obvious after two years of watching them, their pumps don't work.

It is not often that we are called upon to advise the world's government. In fact, we can't remember a single time. But we can't resist a lost cause. So, we offer the Daily Reckoning Plan to Save the World, or DRPtStW for short.

We begin with a brief rehearsal of what went wrong: The economy as it was before the spring of 2007 was too wonderful for words; whenever you tried to describe it, it sounded ridiculous. For example: "The richest get richer and richer by borrowing from the poorest."

"We think; they sweat," said one analyst, explaining how Americans could live beyond their means year after year. The West was just recycling the East's "savings glut," added Bernanke. Meanwhile, derivatives - based on mortgage debt from people who couldn't pay - "helped to make the banking and overall financial system more resilient," said the IMF in 2006.

Each sentence must have made the gods choke...groan...and then laugh. But beginning in 2007, came a correction. Suddenly, the big spenders saw their houses fall in value. Lenders watched their collateral collapse. The end was nigh. Two years later, $50 trillion has been lost, according to an estimate from the Asian Development Bank. After a slap in the face like that, you'd expect a little clarity. Instead, the public seems to have acquired a taste for bamboozle; now they can't get enough of it.

Just read the Financial Times. This week it has a windy series on the "Future of Capitalism," inviting readers to imagine how the decaying old creed might be reformed. Alas, for capitalism, it's out of the frying pan, into the toilet. Larry Summers, Obama's number one financial advisor, voiced the prevailing view: "This notion that the economy is self-stabilizing is usually right, but it is wrong a few times a century. And this is one of those times...there's a need for extraordinary public action at those times."

The gist of his program can be expressed in another wistful absurdity: The consumer economy died because of too much spending; now we will revive it by spending more. "Give me your cunning bankers, your hopeless CEOs, your huddled masses of chiselers, spendthrifts and boondogglers," says the Obama team, "and we'll give them other peoples' money!"

"There's no place that should be reducing its contribution to global demand right now," explained Summers. "The world needs more demand." But it was demand that the world recently had too much of. English speakers took on too much debt to create it...and built too many houses and too many shopping malls to satiate it. And despite the ready cash offered by Bush, Bernanke, and Paulson, demand has sunk, because the real problem is not an absence of spending, but a surfeit of debt. In America, for example, total debt went from 150% of GDP in the '80s to 350% in 2007. The financial markets panicked when it became clear that debtors didn't have the cash flow to pay off the debt...and that an entire world economy had been fizzed up to supply products to people who couldn't afford them. Investors have been discounting debt-soaked assets ever since.

The fix is obvious - reduce the level of debt. About $20 trillion worth of debt, in the United States alone, needs to disappear. Then, consumers can go back to doing what they do best - consuming. But how do you reduce the debt level? Former Treasury Secretary Andrew Mellon had the right idea in 1929: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate... It will purge the rottenness out of the system... Values will be adjusted, and enterprising people will pick up the wrecks from less competent people."

What's the cure for a depression? It's a depression. Let willing buyers and sellers mark debt down to what it is really worth. Mellon's plan was not followed by the Hoover or Roosevelt administrations. Instead, they introduced elaborate bailouts, stimulus programs, and boondoggles. That is why the depression is known as the Great Depression, rather than the So-so Depression. By the end of the 30s, the US economy was almost exactly the same size it had been at the beginning. Likewise, in Japan, holding off liquidation brought a "lost decade" in the '90s. Bush followed in Hoover's footsteps. And now, the Obama administration follows in Roosevelt's and Miyazawa's.

Here's our advice: forget it. Let the depression do its work. Let the bad times roll!

Bill Bonner
for The Daily Reckoning Australia

• George Bush Speech Sounded Like an Edition of the Daily Reckoning
• Bailout Bill Leaves Markets in Deep Freeze
• The Bush Administration Has Been the Most Liberal Administration Since Franklin Roosevelt
• AIG to Receive $85 Billion Loan from Fed
• The Chinese Stimulus Plan to Save the World

Yesterday was another bad day on Wall Street. After gaining more than 900 points on Monday, now the Dow has given back nearly all of them. The index fell 733 points on Wednesday.

Sell the rallies in stocks. Buy the dips in gold...

That has been our formula for this entire decade. It still seems to be working. But now the action is on the stock market side of the trade.

What's going on? Hank Paulson is taking desperate measures to save his friends on Wall Street. Worldwide, the rescue effort is expected to cost more than $3 trillion. At least, that was the big number on the front page of the Telegraph yesterday.

How much it will really cost is anyone's guess. Some say the rescuers will actually make a profit. Others say it will be a total washout.

We don't know. We just marvel at the bold bamboozle itself.

The Goldman crew - there are several ex-Goldman executives in the nation's top financial posts - now get to decide the shape of America's financial industry. You won't believe this - we barely did - but Gretchen Morgenson reported in the New York Times that the decision to save AIG was made by a very small group. Not only was a recent Goldman chief in attendance - Hank Paulson - but the current Goldman CEO, Lloyd Blankfein, was there too - the only representative of Wall Street. The report went on to explain that Goldman Sachs had a lot of money at stake in AIG - about $20 billion.

We're not accusing anyone of anything. We don't have to. We take it for granted that the game is rigged. We'd rig it ourselves, if we had the chance.

And with $700,000,000,000 in their main man's checking account - courtesy of the U.S. government - we have no doubt that Goldman and the rest of Wall Street's insiders are working overtime to make sure it ends up where they want it.

But yesterday - and today - it looks like Wall Street was going to get what it deserved anyway. Stocks fell hard, and today fall even more. Crude oil is sitting at its lowest point in 13 moths - below $72 a barrel. Industrial production in the United States fell the most in close to 34 years. J.P. Morgan announced an 84% drop in next income. The feds are supposed to be rigging the game to avoid such massive losses; the fix is in...but the markets won't stay fixed.

Yet, we've rarely seen such unanimous opinion on the subject. Every journal, every television commentator, every newspaper, every economist - all agree: the risk of a meltdown is too great to ignore. The feds had to take action.

"Just as there are no atheists in a foxhole, there are no economic fundamentalists in a crisis like this," says Jared Bernstein, an economic advisor to Obama.

"Governments have at last thrown the world a lifeline," writes Martin Wolf in the Financial Times.

"We didn't want to do it...but we had to take action," Hank Paulson told the world.

Nobody wants a financial meltdown; everyone agrees that rapid and forceful state intervention is necessary. Once again, here at The Daily Reckoning, we are like a man showing up at a wedding in a coonskin cap. We're not dressed for the occasion.

Meltdown? What's wrong with a meltdown? Why shouldn't bankers fear to lend? Why shouldn't prices go to what willing buyers and sellers will accept? Why should Wall Street be bailed out? Why shouldn't investors take the losses they deserve? Why shouldn't house prices fall rapidly? Why shouldn't the mistakes of the past five years be corrected quickly, in other words?

The financial crisis was caused by too much ready credit (more below on the culprit of these E-Z credit policies). Because of it, people made mistakes. Investment mistakes. Business mistakes. Spending mistakes. Even lifestyle mistakes. Those mistakes need to be corrected. The sooner, the better. Besides, we've never had a real financial meltdown in America. We'd like to see what one looks like.

But everyone is against it... running scared and eager to sell his soul, if he had one, to avoid it. The Democrats, of course, never had any principles. And the Republicans only pretended to have them. And now they're selling out their residual respect for the free-enterprise system. At least, they hope to get a good price. If they go along with Goldman & Co., they are told, they'll be helping to avert a catastrophe. (That they might also get a slice of the $700 billion pie hardly needs to be mentioned. They are all already getting out their knives and forks.)

Our guess is that they will end up short on both ends - at the end of the day they will have nothing left...neither their (mostly) free market system...nor their money.

*** Chris Mayer specializes in finding opportunities to profit in times of economic crisis - not a bad guy to have on your team in times like these.

He passes on an intriguing example of one of the many opportunities out there.

"Although I'm not recommending it to my Capital & Crisis readers - I hardly know anything about the company - this example from Irving Kahn, by way of Barron's over the weekend.

"Kahn is the 102-year old chairman of Kahn Bros., an investment firm in New York. (There's that longevity again among the long-term value set.) As Barron's notes: "Kahn... is one of the few professionals who not only remembers the 1929 market crash, but who sold short prior to that famed downturn." He likes Nam Tai Electronics, which has a market cap of $266 million and cash of $271 million. It seems to have a profitable business and trades for 8 times this year's earnings guess.

"There are a lot of these kinds of opportunities out there now. At least in pockets, we have the kind of true Depression-era valuations that Ben Graham would have recognized."

There are some silver linings in these clouds...you just need to know where to look. Chris has some more of these opportunities up his sleeve...

*** "Next victim of the turmoil: you salary," announces one New York Times headline.

"Grim outlook for profits and jobs," says another.

Comes news this morning that retail sales are down 1.2% in September - the biggest drop in three years. Consumer spending will collapse; you heard it here first.

Every businessman in America is reading the headlines. And everyone is wondering how the financial crisis will affect him and his business. The smart ones are already taking action to reduce costs. They know that revenues will almost certainly fall - maybe substantially.

"Cut out the deadwood," they say to their lieutenants. Even in our own little enterprise, that message is making its way around. 'Don't hire anyone new...we can't afford it,' we advised our associates.

Even old oaks give way to chainsaws. Which poses a particular problem for the over-50 set. They are expensive employees to keep - often costing more in salary and healthcare benefits than younger ones. And they offer nothing for the long term. By the time this slump is over, they could be retired - and living off the company's pension program.

Our guess: this downturn will be worse than most people expect...and it will fall particularly hard on older workers.

*** Yesterday, we went to the Frankfurt Book Fair, where we were honored by a publishing group from Switzerland, called GetAbstract. Every year, the group gives an award to the best business and finance books of the year. Last year, for example, Nassim Taleb's Black Swan was the winner.

But this year, our Mobs, Messiahs and Markets, co-authored by Lila Rajiva, edged out Thomas L. Friedman's and Robert Shiller's books to take the top place.

"We are pleased and honored," we told the crowd in our acceptance remarks. "We thought at first that the 'GetAbstract' award was a category...like children's books or romance novels. We hadn't thought our book was that 'abstract.' After all, it's about very real phenomena - mass delusions, collective hallucinations and the madness of crowds.

"Two years ago, we saw a huge delusion forming in the financial markets, so we decided to write a book about the way in which these delusions work and where they come from.

"All delusions, of course, eventually blow up. And we appreciate the timing of this award. This financial madness is blowing up right now.

"But people come to think what they must think when they must think it. So, at the height of the bubble people thought that capitalism would make them rich. Now that the bubble has popped they believe that government must step in to save them from capitalism. Both ideas are equally and oppositely absurd. "

*** The crisis was made in Washington; it is now being made worse by Washington:

Our old friend Jim Davidson sends this comment:

"I think we should underscore the fact that perverse regulation, rather than de-regulation is a root cause of the crisis. Contrary to the myth that the housing bubble and sub-prime lending were driven by greed in a climate of deregulation, the impetus to sub-prime lending came from federal mandates, like the Community Investment Act, which imposed penalties on banks for not lending to underprivileged borrowers.

"We're getting Smoot Hawley Two in the form of the collapse of letters of credit facilities which finance trade. Citibank won't honor letters of credit from PNP Paribas. So goods are piling up at ports not because there are no borrowers but because the credit freeze has spilled over to letters of credit. Thus the well-established mechanism for funding trade is a casualty of the mortgage meltdown. 1929 comes again."

Bill Bonner
for The Daily Reckoning Australia

• Stocks and Gold Are Going In Opposite Directions
• Bailout on Wall Street Has Left the Door Open for Other Industries
• A Financial World Not Yet Recovered From the Bubble Madness of 2002-2007
• Biggest Bankruptcy in Wall Street History
• Mistakes Made By America Are the Same Mistakes That Empires Make

The financial press will report that the big story this weekend is that the Republicans and Democrats finally agreed on the details of a bailout deal to "save" the economy from imminent collapse. But that is not the story at all. In fact, it's pretty nauseating to see the self- congratulatory smiles on the Senators and Congressmen and women who are on board with the Paulson plan. What have these morons wrought?

Well, on the face of it, the bailout deal is pretty much the program Henry Paulson asked for, with a few bells and whistles to make everyone else happy. It gives him some discretion to negotiate warrants on behalf of the U.S. taxpayer. That gives the taxpayers potential equity in financial firms. Just what we needed.

One interesting rider to the legislation is that it gives the Securities and Exchange Commission the discretion to suspend mark-to-market accounting rules. That could come in handy. If firms don't have to mark troubled assets to market for awhile, they can hang on to them and hope for things to improve. It's also possible that the suspension of the mark-to-market accounting standards is just the cover Team Paulson needs to buy the assets at the non-market (much higher) price.

Don't forget what this bailout deal is all about: recapitalising the banks. You can't do that if you pay them twenty cents on the dollar. The politicians will call it many other things. But you can imagine that behind closed doors the choice was pretty clear. Let the banks get dragged into insolvency or borrow from abroad to recapitalise them.

It amounts to both a wealth transfer and a power transfer. The national penalty for wasting all that capital on a fraudulent housing boom is America's increased dependence on foreign borrowers. The remaining financial institutions not forced out of business have had to partner up with non-U.S. investors, who will now own a piece of future U.S. financial earnings.

Let's not get ahead of ourselves either. When a company goes public, it has to stage a road-show and sell itself to investors. Congress may agree to the concept of borrowing US$700 billion for its nifty bailout deal. But now Hank Paulson has to go out and actually raise that money. And who do you think he will be asking? That's right...China, Japan, Saudi Arabia etc.

There's no guarantee the money will be forthcoming. If it can't be raised abroad (which gives non-U.S. investors a call on future U.S. tax revenues via interest), then the Fed will have to create new money for it. Either way, the people in Washington should realise they are selling their nation into indebted-servitude. But then, they've been doing it for years.

Share markets will probably rally on the news of the bailout deal. And it does seem to close out at least one chapter of the credit crisis. Other things will have to happen, of course. Banks will have to lend. Spreads between inter-bank lending rates and the Fed target rate will have to come down. And the markets must dodge further disaster from the Alt-A mortgage sector and, ye gads, commercial real estate. But how much the banks stand to lose from those developments is not on anyone's radar yet.

What's happening here in Australia? Well, the share market will probably get some relief this week. Are there any buyers out there? We'll find out soon enough.

But now there are rumblings about the Aussie housing market. "Sydney house prices could fall by as much as 30 per cent in the next two years," reports News.com.au "Morgan Stanley chief equity strategist Gerard Minack said prices could fall by as much as 25-30 per cent in the next two or three years if Australia fell into recession, and by 10 per cent or more if we have a soft economic landing."

Ouch. And it's not just Minack. "The International Monetary Fund recently said Australian property was among the most overvalued in the world. It said at least 25 per cent of the increase in value over the past decade could not be justified, leaving the market ripe for a correction."

A bear market in shares and a bear market in property at the same time? That is not the sort of thing to boost consumer confidence or spending. And with business spending falling off a cliff due to the credit crunch, who does that leave to carry the spending burden?

Well, it could be that the economy doesn't need more spending right now. Perhaps it needs more investing. But the Prime Minister is having none of it. The Daily Telegraph reports that Kevin Rudd has already outlined quite a few "nation building" projects to be financed from the $20 billion "Building Australia" fund.

Australia paid off its government debt in 2006. But maybe Rudd feels left out from the great government debt binges in the U.K. and U.S. For twelve years, the Australian government has been a net creditor, with surpluses exceeding government borrowing. It now appears prepared to borrow again.

You can have an interesting economic argument about whether government should borrow to build national infrastructure assets. But it's no wonder people are so comfortable and used to being in debt. It's a way of life in the Western world.

It wasn't just Wall Street greed that led to the crisis. That is what the politicians want everyone to believe as they draft a. But the very same Washington politicians encouraged Fannie Mae and Freddie Mac to extend the dream of homeownership to as many people as possible, regardless of whether they could afford it. And when warned by regulators that the Government Sponsored Enterprises posed a risk to the financial system, Congress hid behind the idea of home ownership.

Now they want to blame it all on the lenders. There is plenty of blame to go around, although no one seems willing to accept any. Instead, we want to pretend that borrowing doesn't have consequences and that wasted money can be instantly replenished with the bailout deal. It's juvenile thinking.

Perhaps that is why the American government is now in the position of asking for allowance money from China the way a 15-year old asks for extra money on the weekend. Let's hope China says yes. Maybe they'll extend our curfew too.

Dan Denning
The Daily Reckoning Australia

• Australia’s Response to the U.S. Bailout Plan
• Level 3 Assets Growing in All Five U.S. Investment Banks
• China’s Economy is Now Freer and More Competitive than the United States
• Keynesians Believe Governments Have to Manage Economy in Macro-Economic Way
• Obama’s New Stimulus Program

That is not the way it works in modern central banking, though. Today, it's as if Hank Paulson is pointing his "big bazooka" bailout plan at Wall Street and demanding it opens up its wallet so he can fill it with other people's money. The Paulson Gang (or Goldman gang) is lining up for its share of the loot accordingly. But the real robbery is taking place in Washington.

Today's theft is a lot more subtle, mostly because it's taking place right underneath your nose. That is the trouble with the obvious. You become so used to it that you fail to find it unusual. Sadly, it is as business as usual in Washington D.C. this week.

First, the Wall Street Journal reports that the shclubbs in Washington have agreed on the "principles" of the bailout plan. The words "lawmaker" and "principle" probably don't belong in the same sentence. But our job is to investigate the facts, not pass judgment (yet) on the protagonists in our story. So what are the facts?

Surprisingly few! The principals involved all met at the White House and walked out of the room with no real agreement. They did, however, agree to four principles which any future agreement must address. Not exactly Wilson's 14 points. But give them time.

What are the four principles? First, a bailout plan must provide taxpayer protection. Second, it must provide oversight and transparency. Third, it has to preserve home ownership in America (though how it will or even CAN do this is anyone's guess). And fourth, the US$700 billion lump sum sought by the U.S. Treasury will be doled out incrementally, to make sure Hank Paulson doesn't spend it all in one place.

It doesn't sound like much was resolved, does it? Still, stocks appear to be trading exclusively on the idea that a bailout plan will be passed by the Congress and will rescue the banking system from the edge of the abyss. The Dow was up nearly 300 points early in the day. It faltered later, but still closed up almost two percent to 11,022.

While Wall Street tries to save its own neck at taxpayer expense, the sell-off in Australian stocks is making the assets of junior miners even cheaper to the parties that are happy to acquire them at any price.

In fact you could argue, as my colleague Al Robinson has in Diggers and Drillers, that one of the prime results of the market volatility is increased merger and acquisition activity in the juniors. Share prices are down. Yet many quality mining projects clearly have the potential to lead to growing earnings for the firms behind them.

There are two possible complications to Al's bullish scenario, though. One is commodity prices. If the equity market volatility turns into a full-fledged collapse, it's hard to see this being too terribly bullish for commodities. A major recession in the U.S. won't kick start commodity prices from their current doldrums.

But if the bailout plan in Washington is perceived as inflationary, but also just enough to prevent a U.S. recession, well then you may have the conditions necessary for a rebound in certain resource prices. High energy and labour costs have already pinched supply in some key markets. The spring is coiling.

The other complication is capital. With Aussie bank lending plummeting and the share market not an ideal place to raise money right now, how will small companies fund their big projects? Are there enough risk-taking investors to make it happen?

One group of investors that don't seem to care about the credit markets or valuations (perhaps because they find them so stunningly attractive) are the Chinese. Today's Australian reports that, "Chinese- controlled Australian Bulk Minerals has agreed to a reverse takeover of Grange Resources in a deal that secures future iron ore pellet production for China's biggest private steelmaker, Shagang, and will lead to the listing of Tasmania's Savage River mine and pellet plant."

If you keep looking for the action in the big blue chips like Rio and BHP, you will probably miss the flurry of action brewing beneath the surface. And it's definitely brewing. This brew, however, is not toxic like the mess in Washington. THAT brew could still poison us all. But we'll have to wait and see what the Paulson Gang cooks up before we know how much lower stock prices are going to go before we can buy. Until Monday...

Dan Denning
The Daily Reckoning Australia

• Bailout Deal Will Expand China’s Influence in U.S. Economy
• Geithner and His Toxic Asset Bailout Plan
• Parasites and Chiselers Who Benefit from the Bailout
• Congress Urged to Approve Bailout By George Bush and Warren Buffett
• Posco’s Production Cuts May Be Bad for Australian Iron Ore

Regulate in New York and finance goes to Toronto. Regulate in London, it goes to Frankfurt or Paris – and since Toronto, Frankfurt and Paris are run by the same nervous bureaucrat-types, we can reckon soon enough that the entire financial markets will be hosted out of Singapore and Shanghai.

There they will accept the risks as well as the rewards, to their very considerable long-term benefit.

You simply cannot enjoy being the financial center of the world but start bleating for government bailout whenever asset prices dip a few percent. As Paulson is demonstrating, the regulatory price for being bailed out is far too high. We must all grow up and take a full measure of punishment. The banks must take theirs.

Let the shareholders and depositors take theirs too. Just like natural organisms the financial system must have death to evolve into a better form.

Paulson's plan is a dressed-up confiscation of the profits of the cautious, and a transfer of those profits straight back to unreconstructed gamblers in the worst offending banks. This is very unwise.

In these difficult times, profit (or more accurately the avoidance of loss) should be benefiting those who troubled to understand the risks in the system, and avoided them. But Paulson's plan is currency creation, and a devaluation of the good quality assets owned by the cautious. He fails to understand that unless the system occasionally rewards caution there is no reason ever to be cautious again.

The market works better without these rescues. Only by appropriate economic reward to the cautious, when they are right and everyone else is wrong, will caution sit well beside risk-taking in the financial system. The real threat to New York's and London's continued dominance of the world's future financial system is government regulation itself.

Mr. Paulson should read Hayek's classic The Road to Serfdom, and he would understand the inevitable failure of his rescue plans. He would see how these top down rules remove society's flexibility until one day we all wake up in a paralyzed "command" economy, where nothing can be done without official sanction.

Instead, he has forgotten what a command economy means. He should study the history of communism's economic successes. It won't take him long.

Paul Tustain
The Daily Reckoning Australia

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