"Why don't you move back into your own house," his father wanted to know.

"Dad, I've got a good tenant in there. Besides, it's not in very good shape. I'd rather sell it than invest more money in it. And there are so many places on the market, I can rent something better. Even after a big drop in prices it is still cheaper to rent than it is to buy something."

There are probably millions of homeowners who would like to sell - if they could. This hidden inventory of unsold houses will depress housing prices for a long time.

But there's a crisis coming in commercial real estate too.

"An extreme amount of commercial debt is to mature over the coming years," writes real estate investor George Karahalios in Marc Faber's Gloom, Doom and Boom Report. "And unlike the residential market, there is no safety net (Fannie Mae) for commercial loans. Instead investors must rely on financing through commercial banks, a few insurance companies, and other private lenders who now demand much higher interest rates and more equity for the risk associated with these investments. Thus, not even the Fed's printing presses can save commercial property prices, and I am expecting certain locations to crash, perhaps falling as much as 50-80% from the peak."

So you see, dear reader, there is bad news ahead - a lot of it. Stocks will go down. Gold will go down too - most likely - when people realize that the economy faces a long, deflationary depression...not a period of inflationary growth.

But while stocks are fair weather friends, gold sticks by you in foul weather too. Right now, gold is rising on good news. Eventually, it will soar when the news turns bad. (Though...not necessarily right away...)

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• The Housing Slump Has Fattened the Inventory of Unsold Homes
• Commercial Real Estate May Be the Next to Fall
• Trends Make Investors Less Afraid of Risk
• Ireland Going Through Same De-leveraging Process as the US
• Housing Prices Follow GDP Growth and Inflation

Now, to the markets. You may remember that yesterday we asked chartist Gabriel Andre to confirm or deny the claim by Chart Partners Group that the S&P ASX/200 could rise by another one percent-and then fall by 19%. It turns out Lord Swarm had published his own forecast yesterday in our sister letter, Money Morning.

"What is the target then for this current rally," he asked. " Well, as we anticipated a few months ago (see Money Morning dated May 14), it is likely that the next significant objective will be around 4,550 points. That is 300 points ahead, or 7% higher [than yesterday's open]. The Bollinger bands are widening, the volatility is up. The target could be reached soon.

"Two key points argue for an exhaust at this level of 4,550 points. First, the Relative Strength Index (RSI) clearly shows that the index is already overbought. You may know that a stock or index or any other asset can remain overbought (or oversold) for some time. However a high valued RSI usually means that the countdown has started for the trend in place. Here the RSI is valued at 74, above the overbought level of 70.

"Second, the level of 4,550 points corresponds to the 38.2% Fibonacci retracement ratio of the decline occurred between November 2007 (point A) and March 2009 (point D). It is likely to be a resistance area where investors and traders will take profits."

There you have it. Expect a rally to 4,550 then profit taking. You heard it here first. Or second, if you read Money Morning yesterday.

Sometimes technical analysis sounds like a foreign language. In many ways, it IS a foreign language. It makes the claim that the best way to understand and trade the market is to be fluent in the vocabulary of technical variables and chart patterns. It's a big claim.

Your editor does not pick up foreign languages easily. But just for grins, we asked Gabriel to try his technical speak on the CRB commodities index. It's been up, then way down, then back up. We wondered-all the fundamentals of supply, demand, growth, and recession aside - what the index looks like to trader with an eye for patterns and mind full of oscillators. We showed him the chart below, on to which he put the lines you now see.

Click to enlarge

His commentary was to the point: "23.6% Fibo (the very first retracement level) hit on last June 11 (point C), is likely to be the immediate target, around 265 points. A correction had followed then a rebound on a support level (green horizontal line) valid since last March. I expect the resistance at 265 points to trigger profit-taking. It should hold, as many commodities are a bit overbought on short-term basis."

Speaking of commodity prices, the RBA published its commodity price index yesterday. It was, in the spirit of the season, less bad than expected. The RBA said the index was flat in July after being down 3.8% in June. Coal and wheat were down, but beef, veal, and iron ore were up.

Like all other investable asset classes, commodities are trying to find a natural price floor. That floor would be based on the long-term demand in the real economy for tangible assets. And with commodities, you at least get predictable cycles where overcapacity in production leads to falling prices. Or, as we saw in 1999, years of underinvestment in productive capacity coincided with a surge in demand, creating a huge gap that led to spiking prices.

Now things are levelling off at a higher equilibrium. But what about other asset classes? Specifically, returning to the question we began today's letter with, can asset prices make new highs without new leverage in the system? And exactly who is willing to take on leverage now anyway?

This is the question that we think the markets are working through right now. You get the sense that people feel better about the economy. And they feel like the worse of the financial crisis is over. At the very least, investors feel that systemic risk-the chance of a total meltdown-has been averted. There are still risks, but perhaps not as grave as the risks faced once Lehman Brothers collapsed in September of last year.

One reason investors feel better is that governments have now stepped in and made clear they won't let any systemically important firms collapse. That's been a messy process. But it seems to have reassured people that the worst case scenario is impossible.

We're not so sure. If anyone has learned anything in the last two years, it's that the improbable is still possible. It only has to happen once, and it only has to happen to you for an event to derail a lifetime of planning. We reckon investors will bear the lessons of the last two years in mind as they approach markets today.

But it sure doesn't look like that's happening now, does it? So what, really, is happening? We reckon one explanation is that the financial system has simply doubled down on itself. Banks and institutions have partly shored up their balance sheets by selling new shares or, increasingly in Australia, bonds. They've taken the rest and made financial bets which generated paper profits and the false dawn of an earnings recovery, which has been priced into stocks.

You wonder though, how much of the liquidity made possible by central bank policies and government fiscal stimulus has simply found its way right back into speculating on higher asset prices. Is this a recovery in asset prices that simply duplicates the speculative excesses of the credit bubble peak last year? Hmmn.

If the entire financial world-institutions and retail investors alike - reverts back to the bubble era thinking, then you can almost guarantee further losses. This is the debt-deflation scenario. But it's a scenario where the losses are taking grudgingly, drip by drip, in the face of furious attempts to releverage the system.

We were going to say that recommitting to the bubble could guarantee a retesting of the 2003 lows on stock markets. But this time, it may be a bit different. Because the monetary authorities will not allow a large firm (or sovereign state?) to fail-and because people believe there are no firms whose failure is big enough to take down the system-you'll get a very different kind of crisis in phase two.

The credit bubble cannot be reflated. But the rate at which asset markets grind lower (in real terms) can be drawn out if there are no catalysts to cause a panic and if liquidity efforts by central banks remain in place. For example, we reckon that Aussie banks and fund are carrying hundreds of billions of dollars in unlisted assets on the balance sheet that are probably worth a lot less. But those assets don't have to be re-valued continuously (marked to market). We reckon there are serious problems with those assets.

For one, there is the composition of them. Are they infrastructure funds? Listed property trusts? Commercial real estate loans? And then, don't forget, there are the listed assets, which also include commercial and residential property.

Our main point is that asset values are probably much lower than investors would like to admit. But because of changes to accounting rules, no one has to realise any losses on these assets which would require more capital or, in some cases, force a firm into solvency once the value of the asset was written down.

So the zombie assets slumber on the corporate balance sheets in the hopes that everything recovers, the bubble is reflated, or excess bank reserves make their way into the economy to inflate asset prices (although in real terms, investors will lose ground).

In any event, you can be sure the "authorities" would like you to believe that a gradual reflation of housing and stock prices means there is nothing to fear any longer. But they may be underestimating one major change in investor psychology over the last two years: fear.

It is all well and good for the financial industry to turn Fed credit into asset price speculation. But at the household level, how are investors going to behave? We reckon most investors who expect to retire in the next ten years cannot afford to have another year like last year. The entire investor class that has seen stock and house prices rise for most of their adult life is counting on those assets to live off of in retirement.

Now they have a choice: stay in the game to make back some of what you lost and benefit from government reflation policies. Or cash out, hope you have enough to get by with, and adjust your expectations for a less lavish retirement than you had hoped for.

No one likes downsizing his expectations, of course. But as was discussed last Friday at our Debt Summit, attitudes towards wealth and debt may also move in cycles. Those cycles are informed by the unique experience of each generation. If you've experienced nothing but prosperity and rising stock and house prices, you're happy to take on debt and you tend to discount risk.

But one good wealth-destroying recession is the kind of thing to temper both your expectations and your attitudes toward risk. We would not be surprised at all to see investors begin with holding liquidity from the stock and property markets. They are eighteen months closer to needing that money than they were when the crisis began. We suspect this will modify some behaviour.

Maybe it's not all that complicated. We'll see. But it could be that a permanent feature of this recession-and of globalisation for that matter-is lower real wages and income for Western workers. For Western workers to become retirees, then asset prices will have to bridge the income gap. However, as Glenn Stevens himself admitted a few weeks ago, the credit bubble created an exaggerated expectation about the rate of return you can expect from stocks and houses.

We reckon those investors who are first to realise this new reality of expectations will profit best. That is, they will modify their asset allocation plans accordingly. They won't liquidate entirely. But they will probably (and prudently) risk much less of their capital, while putting the rest to work buying tangible assets at a good valuation. More on this subject tomorrow!

Dan Denning
for The Daily Reckoning Australia

• CRB Index Correction Likely to Go Further
• S&P/ASX 200 Clears Resistance Line
• U.S. Fed Leaves Rates Unchanged, Morons
• Have the Chinese Stopped Industrial Stockpiling of Raw Materials?
• Aussie Banks Addicted to Foreign Borrowing

We're always wondering: how will we be surprised? What will happen that we don't expect?

It's easy to make money...if there are no surprises. You just put your money in something that is going up and let it go.

But surprises sink ships, marriages, military campaigns and investment portfolios. Things happen that you're not prepared for...

A friend told of what happened to a mutual friend:

"I guess it was the embarrassment that bothered him most. I don't know. He was happily married...or he thought he was. They had three children. They must have been married 10 years. And then, she announced she was a lesbian...and moved in with a woman.

"I imagine he was devastated. He didn't seem to have any idea. But just think how you'd feel. You'd think that you were so awful you'd turned her off on the whole male sex. She wanted nothing more to do with any of them..."

Yes, dear reader, you have to watch out for the surprises...

Stocks have been rising since March 9th. Yesterday, the Dow went up another 15 points... The Dow now looks toppy...like it will go down again soon. But the rally may have further to go - maybe all the way to 10,000, as we originally guessed.

And yesterday's rain of news brought forth another green shoot. New houses are selling again - with sales up 11% in June. Maybe it's time to buy a house. Better yet...buy a huge house with a huge, fixed-rate mortgage! Sometime between now and the next 30 years a fixed-rate mortgage is bound to lose its bite. What are the odds that inflation won't rise in the next three decades?

Last week, in Vancouver, we left listeners confused.

"Should I buy gold or not?" was the question one posed.

It's a good question... we'll turn to it in a moment.

First, the background...

Everyone knows that stimulus leads to inflation. And everyone knows that this is the most daring use of stimulus ever attempted. Ergo, it seems likely that we will soon see the most inflation we've ever seen.

But it's not that simple. The story is too easy to tell. It's too obvious. Too logical. Too easy to explain and too easy to understand. Under these circumstances, inflation would be no surprise!

At least...that's been our worry. That too many people understand the inflation threat and are positioning themselves to avoid it. Everybody can't be right. As they say on Wall Street, when everyone is thinking the same thing no one is thinking.

But is it true? Is it true that people fear inflation and that they are taking investment positions to counteract it? Alas, we don't know...but perhaps not. Neither the yield on Treasuries nor the price of gold signals a panic about inflation. Just the contrary; they seem to be telling us that investors are complacent...that they're aware of the inflation threat. They may be even sure that inflation is coming. But they seem to think that they can take action later - after inflation actually shows up. Seems reasonable, doesn't it?

The inflation rate is currently MINUS 1.4%. That is, we're experiencing deflation, not inflation. Why try to protect yourself against something that is such a distant threat?

Our guess is that this is what most investors are thinking: that inflation is coming, but that it isn't here yet. They're watching...they're holding their fire...but they won't be surprised by it.

But what if they're facing the wrong way? While they're keeping an eye on inflation, what could be sneaking up behind them?

Ah...keep reading...

Practically everyone anticipates rising rates of inflation. The adjusted monetary base of the United States has more than doubled in the past year. Deficits are staggering. The price of oil - at $68 - is telling us that inflationary pressures haven't gone away. Gold, too, at $953, seems to be whispering - not shouting - a warning: watch out...

So, what's the prudent thing to do? Shouldn't you keep an eye on inflation, like everyone else...and participate in the stock market rally at least until it shows up? If you failed to join the rally, you missed an opportunity for a gain of 20% to 40%. Though a correction in the rally is probably at hand, wouldn't it make sense to buy stocks...hold them until the rally ends or until inflation appears...and then jump into gold?

Yes...that seems sensible.

But where's the surprise? Here's one possibility: a much deeper and more persistent depression/deflation than people expect. Ben Bernanke told Congress that he had sought to avoid "a second Great Depression." Well...what if he failed?

Roger Lowenstein in The New York Times:

"The US economy is not only shedding jobs at a record rate; it is shedding more jobs than it is supposed to. It's bad enough that the unemployment rate has doubled in only a year and a half and one out of six construction workers is out of work...

"The Federal Reserve now expects unemployment to surpass 10 percent (the postwar high was 10.8 percent in 1982). By almost every other measure, ours is already the worst job environment since the Great Depression...

"In terms of its impact on society, a dearth of hiring is far more troubling than an excess of layoffs. Job losses have to end sooner or later. Even if they persist (as, say, in the auto industry), the government can intervene. But the government cannot force firms to hire."

Job losses result in fewer purchases...which result in fewer sales and earnings...and that leads to more job losses and falling prices. That's what a depression is all about.

Currently, we look at that -1.4% inflation rate as a fluke...an aberration. And most people are sure the feds will stir up the inflation rate soon. But what if the feds are more incompetent than we realize? What if they can't cause inflation? The Japanese couldn't. And they never had deleveraging consumers to contend with. In other words, their households were never so deep in debt that they had to cut back spending in order to pay down debt. But they cut back anyway...and Japanese prices fell.

Nor did the Japanese have an entire world economy that was deleveraging. Instead, they were able to continue supplying goods to eager consumers in the United States...and making profits.

America's economic situation is much more dangerous...and potentially much more deflationary. We could be entering a period of falling prices that will last for many years.

So, should you buy gold or not?

Ten years ago, we suggested a simple Trade of the Decade. Buy gold on dips; sell stocks on rallies.

This was not the best trade you could have done. There were huge run- ups in stocks and in oil, for example. Many investments would have paid off more. Google was probably the biggest hit of the period.

But the Trade of the Decade looked to us like the safest, surest thing you could do with your money at the turn of the century. Gold was at a record low; stocks were at a record high. What could have been easier?

And it turned out to be a decent trade.

The decade is not finished. So, we'll stick with our trade a bit longer. Our guess is that we'll see some additional profit when the stock market turns down again. But gold's big day still may be a long way in the future.

So, if you are looking for quick profits, gold is probably not a good buy. It's a monetary metal. It is fundamentally a protection against paper money and financial distress, not a real investment...or even a speculation.

Since we rate the risk of financial distress very high, we buy gold - as insurance. But we do not expect a major bull market in gold soon. Later, after deflation and depression have surprised investors and squeezed inflationary expectations out of them, we will buy gold as a speculation. Then, investors will be surprised by how fast inflation comes back.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Contrarian Thinking Secured Me Against Over Optimism in the Boom Years
• A Long Time Before Investors Will Gamble on Housing Debt
• Jim Cramer Says The Depression is Over
• Bankers Take Money From the Government and Use it to Speculate
• It May Be a Depression But it Doesn’t Seem Like One

No, sirree! You can expand the money supply the old-fashioned way, as it can be money made from plain, old, paper-and-ink! Fire up the presses! Monetary inflation the old-fashioned way!

Perhaps that is why Mark J. Lundeen, market analyst, writes that Currency in Circulation (CinC) can also be an inflationary problem, as "The historical period where the US saw double digit CPI inflation occurred from the mid 1970s to about 1982" which was a time when, "CinC's annual increase was pegged at 10% during this period. The CPI Index soon followed." Yikes! Double-digit inflation!

Well, if you are like me, you are wary of references to the '70s and '80s since someone is liable to bring up some of those embarrassing episodes from your past that you had hoped were now forgotten, hopefully forgiven, but past the statute of limitations in either event.

Thankfully, Mr. Lundeen is not referring to any of that, and says, "CinC, after falling for almost 8 years, has just recently jumped up to this same 10% year over year increase line that caused so many inflationary problems 30 years ago." Yikes!

And besides, he says, "How can any economist claim that the Fed is fighting inflation when the US Currency in Circulation has increased 20,000% in the past 95 years?"

Well, already overwhelmed by the terrifying increases in the money supply thanks to the recent insanities of the Federal Reserve and Congress, my Delicate Mogambo System (DMS) cannot take another shock.

So with trembling fingers I quickly verify this, and I see that, as of April 27, 2009, currency in circulation was $903.3 billion, up $90.4 billion from this time last year! He's right! An increase of MORE than 10%!

And if double-digit inflation is not bad enough, the news for the stock market (representing everybody's retirement accounts) is bad, too, as explained when he notes, "capital gains and dividend payouts lagged inflation for 10 years after the surge of CinC inflation of 1971. If this pattern holds for the 2007/09 surge of CinC inflation, stock values, earnings and dividend payouts will be woefully sub-par for a decade or more." Yikes!

Unfortunately, he seems to be being already proved right, as even he notes, "corporate earnings are currently crashing. And," he asks, "without earnings, how long can the DJIA, Barron's 50 and the S&P500 companies continue to pay dividends?" Good point!

Naturally, he figures that he expects to see "big cuts in dividend payouts within a year," and that bond yields will rise "higher than most 'experts' believe possible," which makes perfect sense to me when I see how the 30-year T-bond is priced so high that it now yields about 3 lousy percent, the lowest since the mid 1950s!

And what is the problem with creating excess paper, fiat money? Well, ask the people of Zimbabwe, whose moronic government has been creating so much of it for almost 15 years that, towards the end, inflation in prices could only be poorly estimated, as prices soared to more than a million percent, or a billion percent, or more. Nobody knows. A lot, though!

Well, the final upshot of constantly creating more and more money was provided by Junior Mogambo Ranger (JMR) Arlo S., who made sure I got the news from CommodityOnline.com that "Zimbabwe Declares Its Currency Dead."

The article read, "Super-inflated Zimbabwe declared its currency, the Zimbabwean dollar, a dead one and is no longer being printed." The fiat Zimbabwe dollar is worth zero!

Actually, this was inevitable, as nobody has used Zimbabwe dollars in a long time anyway, and non-governmental commerce was being conducted in foreign currencies and in grains of gold.

Later, we read that even such a catastrophic lesson has not penetrated any thick heads, as "Speaking to reporters here Zimbabwe's Economic Planning Minister Elton Mangoma said the currency could be returned as a different currency or as notes once inflation was under control." Hahahaha!

And what will gold be worth then? And one day, what will you answer when somebody asks you, "What will gold be worth at the end of the American super-inflation?" Hahaha!

I thought so! And that is why we both know that you should be buying gold right now!

Whee! This investing stuff is easy!

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

• Dividend Drop-Off: When Cushions Turn To Rocks
• The Destruction of the Dollar by the Federal Reserve
• Bad News if You Are Afraid of Inflation in Consumer Prices
• Inflation Continuing to Wreak Havoc On Our Economy
• American Taxpayers Up to Their Ears in Debt

We are stuck with houses, dear reader. Chained to them...forced to take care of them... we are their prisoner.

So we asked our gardener, Damien, to come on the weekend so we could work together. There were trees to cut...wood to split and stack...trees to trim...debris to burn...and weeds to pull.

Damien is the best worker we've ever seen. He gets up early...he gets onto the job...and he doesn't stop.

At 7:30AM we were still having our coffee and a croissant, but out the window we saw Damien. He'd already gotten out the tractor and was loading up the firewood cut the previous day.

It was a wet day. A drizzle came down...making the logs slippery and hard to handle. We picked up only the light wood...we'd come back later with the log splitter for the heavy pieces. After several trips, we had loaded up all the wood we could pick up. Then, we attached the log splitter.

What a marvelous device! Rural people all over the world must have welcomed the hydraulic log-splitter like a rich uncle. If Abe Lincoln had had such a thing, he probably would have stayed in Kentucky...and spared the nation a disastrous war. It makes splitting wood so much faster and easier than doing it with axes, hammers and wedges. You just set up the logs...and the hydraulic-driven wedge comes down and splits it. The hard work for us was maneuvering the huge logs onto the splitter. Many of them were so heavy, it took both of us to get them in place.

After a few hours, your editor was beginning to get tired. Damien never takes a break. Not even to talk. He just grabs a cigarette and smokes as he works. We stopped for a quick lunch...and then right back on the job.

By the evening, your editor was beginning to move more slowly. He was keeping up...but barely. All that bending and lifting - he wasn't used to it.

We had ricked up a huge pile of branches, about the size of the Great Pyramid of Cheops in the center of the park. Damien had parked the wagon with a can of gasoline and some old newspapers off to the side.

"Aren't you afraid that the wagon is too close to the fire," we asked him.

"No."

He then took the tractor and, using the front forks, raised up a side of the pile as if peeking under a woman's skirt. With the pile lifted up, he put under it a rubber tire, filled it partially with gasoline, and set it aflame. The flames shot up as Damien raced to the tractor to move it out of the way. Within a few minutes, the whole pile was blazing hot.

It was about 8 in the evening. We continued throwing branches onto the fire and enjoying the heat. We hadn't noticed that the sparks were being carried by the wind over to where the wagon sat. One of them must have fallen onto a little gasoline. All of a sudden, we saw the wagon blaze up.

"Don't worry about it...it will go out," said Damien. He was right. The old wooden wagon had been soaked by the slow rain. The gasoline burned off quickly...and the fire went out.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Experiencing Hard Work
• The French Can’t Understand Shakespeare…
• A Nice House With No Mortgage
• The Family Office
• What a Summer

Yesterday, the stock market was quiet. The Dow ended up 36 points.

Oil held at $50. Gold too...it stayed right where it was, at $820 an ounce.

But the slaughterhouses and gold mints worked overtime.

"You can understand how fraudulent most economic analysis is," Nassim explained, "just by looking the life of the turkey. The animal is fed for 1000 days...and then it is killed. So, if you plotted out the turkey's life on a chart, it would look great for 1,000 days...each day, the food arrived reliably, and each day, the turkey gained weight. The turkeys would look around and say they were enjoying growth and a bull market. Momentum investors would see it as an opportunity. The quants would run linear regressions on the data and prove that the risk was minimal. "

Ben Bernanke would describe the turkey's life - with no setbacks - as the product of a "great moderation." Turkey stockbrokers would assure their clients that nothing had ever gone wrong in the turkey's life. Turkey econometricians and theorists would come up with explanations for why the turkeys' growth would continue forever and they'd pat each other on the back for having finally mastered the "turkey cycle." Turkey politicians would run for re-election on the grounds that they had helped create a better world. And turkey economists would project further weight gains...until the turkey was the size of a hippopotamus.

Then, come Thanksgiving, and all of a sudden, something goes wrong. Alas, all the turkeys' theories, models, and conceits were for the birds.

"Rare events can't be modeled," Nassim continued. "Because they are too rare. You can't get a statistically reliable sample. Alan Greenspan recently explained that he 'had never seen anything like this before.' Well, of course he had never seen it before. It never happened before.

"Because these events are so rare, they are also completely unpredictable...and usually much worse than you can expect. Like Thanksgiving Day for the turkey."

The turkeys are getting the axe...but they're having some revenge: Americans are getting the axe too.

Unemployment is rising sharply...and tomorrow, when Americans sit down to their turkey dinners, they will be dining in houses worth about 18% less than they were worth a year ago. Not only are their houses worth less...their values are falling faster and faster.

There's no sign of a bottom to the housing market. In some areas - Los Angeles, Miami, San Diego, and San Francisco - the loss in housing wealth already exceeds 26% from a year earlier.

But don't worry, dear reader. Houses are not dot.coms. And they're not turkeys. They won't go to zero. And they won't disappear.

Besides, they were never financial assets in the first place. They're just places to live. If you're happy with your house...you don't care what its price is.

On the other hand, if you're not happy with your house, this is the time to start looking around. Our guess is that house prices will go down another 20-30%. Then, you will be able to get houses at very reasonable prices.. Unless you want to live in Detroit - where you'll be able to get a house at a remarkable price.

Meanwhile, the economy itself is sinking too. GDP faded in the 3rd quarter - down 0.5%. Most likely, the U.S. economy will begin walking backwards faster too. Which means...more businesses will fail...more people will be out of work...and those people with any money in their pockets will be very careful about how they spend it...

...which will, of course, make things worse.

All this is a natural, normal response to a credit bubble. It gets bigger and bigger - and then it blows up. Loans are made...and then they are collected. Mistakes are made...and then they are corrected. People do stupid things...and then they pay for them. People go mad on the way up...then, they go mad again on the way down. What could be simpler?

But if you think the feds are going to stand still and let something natural happen, you have not been reading the papers. They're "pulling out all the stops" to try to prevent the correction. More below...

*** So far, the feds' efforts have been futile. But we have little doubt that they will get the hang of it eventually. If there is one thing the feds can do it is inflate the money supply. Ben Bernanke stakes his reputation on it.

And here is Thomas L. Friedman explaining what is needed:

"...a massive stimulus program to improve infrastructure and create jobs, a broad-based homeowner initiative to limit foreclosures and stabilize housing prices, and therefore mortgage assets, more capital for bank balance sheets, and most importantly, a huge injection of optimism and confidence..."

Friedman is the voice of the masses. But the intellectuals agree. Bloomberg reports:

"'You want to do everything you can when you're facing the threat of a deflationary breakdown of the economy,' says Michael Feroli, a former Fed official who is now an economist at JPMorgan Chase & Co. in New York. He sees the central bank cutting the overnight lending rate to zero in January and holding it there throughout the year."

"Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson are being forced to pull out the stops because the extraordinary actions they've taken so far have failed to gain much traction. Credit markets are collapsing, stock prices are plunging and the world economy is sinking into a recession."

"The biggest mistake Obama could make," says Yale economist Jeffrey Garten, "is thinking this problem is smaller than it is. On the other hand, there is far less danger in over-estimating what will be necessary to solve it."

Yeah...go ahead and err on this side now.... Why not? You erred on the other side. That is about the depth and breadth of thinking on the issue - at least from the people who never understood what the problem was...and now offer to solve it.

And it was to one of these same hacks whom Obama has turned for his Secretary of the Treasury - Timothy Geithner. Here is another Hank Paulson. Unlike Hank, he did not work on Wall Street. Instead, he was supposed to be keeping an eye on Wall Street - as head of the New York Fed. "He was in the room," when all the bailouts and busts happened, said one Wall Street pro. AIG, Bear, Lehman, Citigroup - he was in on them all. And he was at least peeping through a keyhole when Wall Street was enjoying its wild party. He saw the deals go down...the leveraged debt...the private equity buyouts...the subprime razzle-dazzle...the quants...the bonuses.

We don't recall a single word of warning. But then, he's a young guy...maybe he's learned something.

But we have a pretty strong hunch he'll be at the Treasury Department not to further his education...but to play his role in the developing tragedy. He's meant to try to stop the correction. Rather than examine his lines carefully to see if they really make sense...he'll speak the speech given him. "Stimulus," he will say. "Protect jobs...save homes...avoid financial meltdown." he has heard them before. He will say them again. And why not? Almost everyone wants to hear them. They all want bailout. Almost everyone wants to be saved. Almost everyone wants to duck the bill collector...and stop the hangman.

We all have to play our roles, dear reader. We are all turkeys...waiting for the axe.

*** The way, for now, to avoid getting flattened by the Big Bang Bailout, soon to be ignited by Mr. Obama, is to buy gold. But how? This week, we got word that that Perth Mint has had to shut it doors.

This, from the Australian:

"FEARS of the unknown long-term effects from the global financial crisis have sparked a new gold rush.

"With retail and wholesale clients around the world stocking up on the precious metal, the Perth Mint has been forced to suspend orders.

"As the World Gold Council reported that the dollar demand for gold reached a quarterly record of $US32 billion ($50.73 billion) in the third quarter, industry insiders said the race to secure physical gold had reached an intensity that had never been witnessed before.

"Perth Mint sales and marketing director Ron Currie said the unprecedented demand had forced the Mint to cease orders until January, with staff working seven days a week, 24-hour days, over three shifts to meet orders.

"He said Europe was leading the demand, with Russia, Ukraine, Middle East and US all buying -- making up 80 per cent of its sales. One European client purchased 30,000 ounces for $33 million.

"We have never seen this before and are working right at capacity. And we are seeing it from clients in the shop buying one ounce, right up to 30,000 ounces from overseas clients," Mr Currie said.

"Robert Jaggard, manager of bullion and rare coins dealer Jaggards, said business had picked up strongly and he expected it to increase further.

"All around the world there has been a heavy run on physical gold and there is a shortage of supply," he said.

Until tomorrow,

Bill Bonner
The Daily Reckoning Australia

• The Price of Gold is Low – But It Won’t Stay There Forever!
• American Investors Are Being Fattened For Slaughter
• Gold and Oil are Acting as Though They Expect Higher Rates of Inflation
• Record Misery Index Sends People Scrambling for Gold
• Fed Vice Donald Kohn Urges Emerging Markets to Drop the Dollar Peg

American GDP contracted by 0.3%, according the U.S. Commerce Department. Not a big surprise, really. But it was, apparently, a better result than the 'experts' were expecting. And so stocks rallied!

Did you see that U.S. government debt grew by $800 billion between September 1st and yesterday? Seriously. Nearly half that is since the first of October alone. There's more on the ongoing expansion of the U.S. balance sheet below. But how about some local market news first?

There as an interesting contrast of positions on the state of the Australian housing market over the last few days. First, RBA Deputy Governor Ric Battellino gave a speech in Sydney earlier this week in which he gave three reasons why the Australian housing market is different than the U.S. market. Don't worry about a crash here, he seemed to be saying.

Battellino says the Aussie housing market actually leads the U.S. by about three years, and doesn't follow it all. The correction in home values has already happened, he says. Why? Well, when the tech boom hit in the U.S. and drove the Nadsaq up, it did not drive Aussie stocks up.

Instead, Battellino says that excess global savings found their way into Australia via the housing market. The banks increased their lending to low-geared conservative households looking to trade up to a bigger home or buy an investment property. Property rose.

The second big difference, he says, is that the response to the lending boom in the U.S. (after rising house prices) was a huge increase in the inventory of new homes being built. Supply exploded in the U.S. as homebuilders over-built. The same, he says, did not happen in Australia.

"The shortage of housing here," he says of Australia," means that there are buyers waiting for better circumstances - e.g. lower interest rates or rising incomes - to facilitate their entry to the market. This latent underlying demand for housing is a factor that will support the market"

Finally, the lending boom in Australia-though much of it came from non-bank lenders who have since been crushed the credit crunch-never extended to the same kind of marginal borrowers it did in the States. Battellino says the lending boom was concentrated on existing home owners who were not nearly as likely to go into default as the sup-prime buyers driving the U.S. boom.

All in all, it is a spirited defence of the Aussie housing market. He does not believe buying a house priced at ten times your annual income is a sure-fire path toward perpetual debt and servitude to the bank. Battellino concludes that the boom is over, but there won't be U.S.-style double-digit correction in house prices. He says, "The Australian housing boom ended because prices rose to levels that severely strained the financial capacity of buyers to pay higher prices, not because too many houses were built, as in the US."

The trouble is, prices still aren't affordable, incomes aren't going to improve much in a recession, and lower interest rates won't power a new boom if banks don't lend (which they seem reluctant to do, unless it's to people who don't need it). So without new buyers entering the market, how will prices rise, or even be supported at current levels? Mark Latham thinks the problem is with inflated household expectations, Fed by cynical government policy.

In a spirited article in yesterday's Financial Review, Latham writs, "Forget Kevin Rudd's populist claptrap about extreme capitalism. The root cause of the crisis is extreme politics." Getting away from politics-which is really just pathology-has improved Latham's thinking.

"Internationally," he writes, "governments have fostered the myth of universal home ownership, offering large subsidies for families that put themselves into mortgage debt beyond their means...In Australia, subsidies and tax expenditures for the property sector exceed $70 billion a year."

"As in the US, these incentives have distorted the market in favour of housing and encouraged an unsustainable base of household debt. The impact of an international recession in Australia will be severe as risk takers in the small business and housing sectors find themselves underemployed and overleveraged."

Latham is spot on in pointing out that the deflation of a financial bubble is nothing new. "The novel aspect of the crisis is its origins in the household sector." The economy, rather than going through the normal booms and busts of the credit cycle, is now being affected by "the household cycle."

"Advanced capitalism has made finance available to consumers on a mass scale. Higher social expectations about material goods have led to highly leveraged balance sheets, in turn creating a new source of economic volatility." In other words, the entire consumption economy hinges on the health of household balance sheets.

Yet the mythologising of housing as socially desirable goal AND a way to get rich has put households in more debt than ever, and put the whole economy (through securitisation and derivatives) at risk. Houses aren't immune from the global crisis. They're at the epicentre of it. And if Nouriel Roubini is right (see below) house prices everywhere are going down.

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• House Prices Down and Aussie Market Enters Second Wave of Rebound Rally
• Total Meltdown of the Aussie Housing Market
• Australian Recession in the Works? Ask the Sharemarket
• U.S. Stocks Concentrate on Present Bond Market Data

Yes, dear reader, we are getting shot to pieces from both directions. Prices are rising. And prices are falling. Mr. Market marks down prices for housing and stocks. Mr. Federal Reserve System pushes up prices for oil and food.

Yesterday brought more hits, more near misses, and more casualties from "friendly fire." But the big story was that after so many weeks of reporting huge gains by inflation, deflation is back in the news with a major counteroffensive. It had begun to look as though inflation was the clear victor. Prices are rising everywhere; everyone came to believe inflation was unbeatable. Analysts had begun talking about oil at $170...even $200.

But Tuesday, while the Dow rose 152 points - a weak bounce after a long streak of losses - both oil and gold fell. Gold dropped back $5, to $923. Oil lost $5 too - slipping down to $135. Commodities, generally, may be in retreat.

More bad news comes from the housing sector too. Yesterday, it was reported that previously owned house sales fell 4.7% in May...more than expected. They're down 14% from the year before.

Also in the housing news was a report that repossessions are up 100% over 2007, while mortgage payment delinquencies are at a record level. Foreclosure filings are running 48% ahead of last year.

With so much deflation in the housing sector, economists are just waiting for more of it to show up in the retail sales...and then spread to the rest of the economy. With no house price gains to spend, consumers will have to cut back. When they do, retail sales will fall...and so will the demand for goods and services all up and down the line. So far, we've seen a big drop in demand for automobiles - especially SUVs. GM shares are down 75%. We've seen a drop in driving too. And unemployment numbers are increasing. But, so far, no big drop in spending. Of course, part of the reason for that is simply that prices have risen so high, consumers need to keep spending every penny - even though they are getting less for their money. But soon, we should see a significant drop in sales, followed by a further drop in economic growth.

Last week, we saw a report telling us that vacancies in retail space were increasing. The United States has ten times more retail space per person than France. When people spend less, much of this space will cease to be commercially viable. Soon, abandoned shopping malls will follow abandoned houses.

"Suburban office space losing occupancy and value," too, adds the Chicago Tribune.

What this represents to Wall Street is a big drop in the value of its collateral...and its clients' ability to service their loans. First, the borrowers can't make the payments. Then, the lenders realize that their collateral is worthless. We've seen big hits taken in the subprime mortgage market. But what about other parts of the mortgage market? And what about credit card lending? Student loans? Commercial loans?

In England, Bradford and Bingley, a big mortgage lender, got whacked yesterday. Its shares fell 18%, to less than $1. And a leading London stockbroker put out a target price for them of "zero."

U.K. mortgage lending is down 44% from last year. "London house price forecast deepens gloom," reports the Financial Times.

Back in America, the Fed says it will extend its PDCF program into next year. The program is simple to understand. It allows Wall Street to borrow from the Fed at 2.25% - or about half the level of consumer price inflation. It should be easy to make money. You just borrow at 2.25% and lend at...say, 5%. The borrower would be paying a real interest rate of only 1% or less. And the lender would be earning 2.75% on someone else's money. What could go wrong?

What could go wrong is what is already going wrong. Lenders put out too much money to too many people who can't pay it back. Now they're reluctant to lend to anyone. And who's eager to borrow? Who wants to build more retail space? Who's building more houses? Who's setting up a new auto plant in the U.S.A.? Who's expanding production of any sort?

Bill Bonner
The Daily Reckoning Australia

• When People Fear Inflation or a Falling Dollar They Find Refuge in Gold
• All Ordinaries Reach 52 Week Low
• New Default Wave Hits Mortgage Industry
• How Much Worse Can the Stock Market Get? A Lot Worse
• A ‘Draw’ in the ’Flationary War

It was bound to happen.

"As the world's largest economy grapples with the worst housing slump in two decades, people with good credit histories are falling behind on house payments, auto loans and credit cards at an accelerating pace," says the article.

"This collapse in housing value is sucking in all borrowers," said economist Mark Zandi at Moody's.

House sales in Southern California are at a 20-year low. And foreclosures are on the rise. This is having the obvious consequence - more houses on the market... sold at distress prices.

In 2007, 17.5% of all the houses sold in Nevada were ones that had been foreclosed. The figure was 15% in Colorado and 11% in California. These foreclosed house sales are pushing prices down further.

As prices go down, more people are tempted to walk away from their mortgages and their homes. Bloomberg provides an estimate: by the end of this year, 15 million U.S. households will be "upside down," meaning, their houses will be worth less than the value of their mortgage loans. Almost half of the people who took out subprime loans over the last two years have no equity in their houses, says Bloomberg. And of the people who bought two years ago, 39% are already upside down.

Over the last five years, trillions of dollars was "taken out" of U.S. housing values. In 2006, for example, owners took out $318 billion by refinancing their houses, and another $142 billion from home equity lines of credit. We predicted that the day would come when they'd have to put back money into their houses. That day is now here.

Of course, how much they'll have to ante up... how many will go into foreclosure... and how many will walk away depends on how far houses go down. Estimates are all over the place - maybe 5% more... maybe 15% more... maybe 50% more. The total value of U.S. housing is $20 trillion. A 10% loss takes $2 trillion of implied wealth out of the economy. Ten percent is no big deal to the fellow who owns his home outright... or has substantial equity. But one of the starry eyed delusions of the bubble era was that Americans were really saving much more than the numbers reported. They were buying houses and the houses were going up in value. This was the equivalent of savings, we were told.

Well, not exactly. Those savings are now disappearing... causing huge problems for the heavily leveraged, marginal housing speculator of the '97-07 period.

Bill Bonner
The Daily Reckoning Australia

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