A broad consensus has formed in the news media and among government mouthpieces and even some "bearish" investors on the street that "the worst is behind us" in this tortured economy. This view is completely crazy. It will only lead to massive disappointment a few weeks or months from now, and that disappointment might easily transmute to political trouble. One even might call the situation tragic, except a closer look at the sordid spectacle of what American culture has become - a non-stop circus of the seven deadly sins - suggests that we deserve to be punished by history.

The reason behind this mass delusion is not hard to find: it's based on wishing, especially the wish to retain all the comforts, conveniences, luxuries, and leisure that had become normal in American life. These are now ebbing away in big gobs for most of the population - while a tiny fraction of the well-connected pile on ever-larger heaps of swag, enjoying ever more privilege. Those in the broad bottom 95% were content as long as there was a chance that they, too, could become members of the top 5% - by dint of car-dealing, or house-building, or mortgage-selling, or some other venture enabled by easy credit and a smile. Those days and those ways are now gone. The bottom 95% are now left with de-laminating houses they can't make payments on, no prospects for gainful work, repo men hiding in the bushes to snatch the PT Cruiser, cut-off cable service, Kraft mac-and-cheese (if they're lucky), and Larry Summers telling them their troubles are over. (If I were Larry, I'd start thinking about a move to some place like the Canary Islands.)

Too many disastrous things are lined up in the months ahead to insure that we're entering a new phase of history: The Long Emergency.

• Government at every level is worse than broke.
• Our currency, the US dollar, is hemorrhaging legitimacy.
• Inability to service old debt at all levels or incur new debt.
• Bad (toxic) debt lurking off balance sheets everywhere.
• The housing bubble fiasco is far from over.
• Commercial real estate fiasco just getting started.
• Unemployment rising implacably.
• So-called "consumers" unable to consume consumables.
• Crucial energy import supply lines fragile.
• Food supply subject to energy problems and climate abnormalities.
• A world full of other societies who would enjoy watching us fail and suffer.

When The Long Emergency was published in 2005, I said then that the greatest danger this society faced would be its inclination to gear up a campaign to sustain the unsustainable at all costs - rather than face the need to make new arrangements for daily life. That appears to be exactly what has happened, and it didn't happen under the rule of some backward-facing, right-wing, Jesus-haunted crypto-fascist, but rather a "progressive" party led by a dynamically affable young man unburdened by deep cultural allegiance to Wall Street. Barack Obama has been sucked in and suckered. "Change you can believe in" has morphed into "a status quo you will bend heaven and earth to hold onto."

Whatever else you might think or feel about Mr. Obama's performance so far, this strategy on the broader question of where we go as a nation pulses with tragedy. What's remarkable to me, to go a step further, is the absence of comprehensive vision - not just in the president, but in all the supposedly able and intelligent people around him, and even those leaders not in government but in business and education and science and the professions.

History is clearly presenting us with a new set of mandates: get local, get finer, downscale, and get going on it right away. Prepare for it now or nature will whack you upside the head with it not too long from now. Attempting to maintain anything on the gigantic scale will turn out to be a losing proposition, whether it is military control of people in Central Asia, or colossal bureaucracies run in the USA, or huge factory farms, or national chain store retail, or hypertrophied state universities, or global energy supply networks.

These imperatives are so outside-the-box of ordinary experience right now, that to drag them into the arena of politics can only evoke blank stares or nervous giggling. But whether we like it or not, these are the things that will really matter in the years ahead - not whether General Motors can ever make a profit again, or what Target Store's sales figures are next quarter, or whether the latest high-rise condo - and - gambling complex in Las Vegas will be successfully marketed.

Here, in the dog days of summer, it seems to me that the situation in the USA is so fundamentally bad, so unpromising, so booby-trapped for failure, that I wonder if there has ever been a society so badly deluded as ours. We're prisoners of our wishes, living in a strange dream-time, oblivious to the forces gathering at the margins of our vision, lost in a wilderness of our own making.

Anything can happen now. I certainly wouldn't rule out international mischief as we arc around into fall. The air is so full of black swans that the white swan now seems like the exceptional thing. Whatever else happens, it sure will be interesting to see the public's reaction to Wall Street's announcement of Christmas bonuses. The folks at Rockefeller Center better be thinking about getting a fireproof tree.

Regards,

James Howard Kunstler
for The Daily Reckoning Australia

• Feds See Every Emergency as an Opportunity
• Inflation and Deflation Battle is a Long Way from Won
• Emergency Private Pension Plan
• All the World’s Stock Exchanges are Now Officially in Bear Markets
• Gold Standard: The Long-Run Value

There are, I know, politicians and pundits who blame the financial crisis on a "lack of regulation." Frankly, anybody who says that has failed the IQ test, or perhaps the ethics test. For all practical purposes, the American banking system is a branch of the federal government. It has been for decades.

Without government guarantees, backed by taxpayers, Fannie Mae and Freddie Mac could not have attracted the level of investor trust they did. The subprime mortgage and housing bubble wouldn't have been funded. Nor would politicians have had the leverage to pressure banks into offering bad loans. Perhaps most importantly, financial institutions would have had no reason to lavish huge campaign contributions and cushy make-work jobs on the political classes.

The banking crisis, however, is not my primary concern right now. It's happened, despite numerous warnings for years from rational economists and commentators. And it will pass. It is a structural problem, and restructuring is happening even now.

The so-called bailout will delay the emergence of new institutions, but it won't stop it. Alternative institutions are rising that will avoid many of the past mistakes. Some are likely to be offshore. Even Vladimir Putin is talking about metal-backed currencies. It is ironic evidence that others are learning the lessons our political class has forgotten.

My concern at the moment is the federal budget and ongoing deficits. This new expansion of government spending and debt is not some one-time event that markets can repair. According to the Congressional Budget Office, current annual deficits have quadrupled. Independent CBO economists forecast that they will level out in a decade to about triple pre-stimulus levels.

Frankly, I failed to predict the magnitude of these budget increases coming. I expected increases and never believed candidate Obama when he promised to cut net spending. Neither, however, did I imagine he would increase it as much as he has.

It is inevitable, however, that this level of spending will be reduced. It will happen for a variety of reasons. For one, such levels will slow the economic growth Americans are used to. It will stifle productivity and reduce income tax revenues. As it always has before, this will send the political pendulum swinging away from big government.

Incidentally, claims that the spending increases are either a "bailout" or a "stimulus" are bilge. No one has ever seriously tried to explain how spending that does not take place currently can appreciably stimulate the economy in the short run. Still, less than 24% of the stimulus will occur this year. That other 76% stimulates nothing but advocates of government spending.

So today, I want to take the time to deal in some depth with the effects all this will have on breakthrough technologies. I realize, incidentally, that some of my comments may be interpreted as partisan. They shouldn't be. I was a critic of President Bush's spending record as well, though it pales compared with current levels. And for the record, I don't think I've ever registered with either major party, even when I was working with a candidate in the last presidential campaign. He was a Republican, but he understands Federalist principles that would have limited the power of the GOP.

I would gladly vote for the sort of tax-cutting Democrat my father was. Ours was a loyalist Democratic household and my parents revered John F. Kennedy - one of America's great tax cutters. His across-the-board tax cuts were greater proportionately than those passed during the Bush administration. They were enormously successful in promoting spending and economic growth. Give me a Kennedy over a Nixon any day.

Nevertheless, I am prepared for e-mail from those who mistake my criticism of destructively high taxes for partisanship. It's not. Honestly. Economics is called the "dismal science" for a reason. And it often falls to rational economists to play the role of parent, explaining that we just can't afford all those cool toys people want right now.

The term "dismal science," by the way, was coined by a Victorian historian describing the work of Thomas Malthus. Malthus set the standard for doom and gloomers. An Anglican minister and a terrible economist, he predicted the imminent destruction of civilization, if not humanity itself, in the late 1700s. Despite our survival and amazing progress since then, others make similar predictions to this day.

I am, in fact, optimistic about the long run. The economy will not only recover. It will continue to grow exponentially when it does. That doesn't, however, mean that we don't face serious challenges in the short to medium run. This, however, is a unique time historically, with unprecedented opportunities for patient farsighted investors. Rahm Emanuel and Hillary Clinton have both said that you should never let a good crisis be wasted. Though my means of exploiting the crisis are quite different than theirs, I agree with the general sentiment.

There will, however, be delays in technology development. Because so many of the emerging breakthrough technologies today are related to health and longevity, I take those delays personally. While the economy will recover, there are people who will miss out on lifesaving therapies because new technologies are not being funded. This irritates me.

Nevertheless, we need to look at the situation clear-eyed and figure out how to profit from it. And in the process, we may help move some of these revolutionary new technologies forward. There is another Chinese proverb about crises creating opportunity, and this is no exception.

Now, to business.

The most onerous impact of excessive federal spending is the absorption of capital. When finite capital is appropriated through taxation and federal debt creation, this necessarily reduces the level of funding available for research and development.

This simple math is ignored by those who believe it's a good thing to tax the rich, the people who direct most investment capital into emerging technologies. Historically, overall economic well-being is best accomplished through the promotion of new technologies and businesses. Kennedy made that point with his famous statement that "rising tides lift all boats." Right now, the deficit is lowering the tide. Until this sapping of our R&D lifeblood is rectified, transformational technologies will face challenges.

Typically, we know, investors abandon unproven sectors for traditional stability when things get scary. This includes even venture capitalists. New data from PricewaterhouseCoopers, the National Venture Capital Association and Thomson Reuters verify that this is the case.

In the first quarter this year, US venture capital investments fell 61%. In the same quarter a year ago, venture investments were $7.74 billion. This year, the total was barely $3 billion. This is the lowest level in 12 years. Acquisitions of venture-backed companies fell by nearly half from last year. There were no venture-backed IPOs. None.

The one notable bright spot in this picture is health care services. Venture capital investment there is actually up somewhat. As I wrote on several occasions while we were waiting for the train wreck, health care is countercyclical. When times gets tough, the last thing consumers cut back on is medical services.

This is one reason that my Breakthrough Technology Alert portfolio is so heavily weighted with medical biotech today. It's not the only reason, however. It is simply true that a huge percentage of the biggest and most profitable technologies on the near horizon are medical. Significantly longer healthy life, i.e. "time," is the product they will deliver.

Economists talk about the "backward-bending demand curve." It refers to the fact that we max out on stuff. Eventually, if we get enough of something, we value additional units less. Demand for life, however, is unlike any other good or service. It is, in effect, infinite.

Regards,

Patrick Cox
for The Daily Reckoning Australia

• Kennedy and Public Service
• U.S. Government Spending $13 trillion to ‘Fix’ Problems
• Debt Backed Securities Face Deepening Trouble
• The Obama Administration’s Impact on Nuclear Energy
• President Barack Obama and Franklin Roosevelt Are Becoming Akin

A.W. (a.k.a. Renter #1)

T.D. (Renter #2)

K.I. (Renter #3)

L.S. (Unwitting Speculator #1)

C.D. (Unwitting Speculator #2)

M.N. (Real Estate Investor)

A.P. (30-Year Fixed Rate New Homeowner)

Chorus: Café patrons and waitresses

TIME and SCENE: Mid spring 2005 A.D., our great nation is in the throes of a tenacious housing bubble. Whole cities have been tantalized, wooed and seduced by this Siren song of easy wealth; entire populations rendered giddy by profits... on paper. Nearly every conversation heard around the dinner table... across the bar... in a cab... is focused on one subject: the housing market.

The scene opens in Café Hon, a locally famous Baltimore eatery in the trendy suburb (sic) of Hampden, where big hair and gaudy make-up are curiously in vogue and admired. Seven colleagues from the Daily Reckoning's HQ are seated around a Formica-topped table.

Lacking an additional 30-yr fixed mortgage holder, the table less-than- fairly represents the breakdown of mortgages nationwide: roughly 60% fixed rate, 40% ARM... 25% of all new mortgage originations in 2004 were real estate investors.

LS (Unwitting Speculator #1) is closing on a house the following day. Mere hours stand between her and the single biggest financial transaction of her young life. Can those stalwart pessimists (Renters #1, #2 and #3) lash her to the mast in time to save her from the Siren's tantalizing tune? We shall see, dear reader... below...

ACT I - A MORTGAGE BROKER'S WET DREAM

Renter #1 : Hey, LS... I'm going to ask you one question. Your answer will determine how much I speak for the rest of this meal. Is your loan... an adjustable-rate mortgage?

Unwitting Speculator #1 : Not at all. It's interest only.

[A gasp is heard. Ominous Lon Chaney-style horror music rises from the background.]

Renter #1 (face wincing): Why... why?! [Screams of horror coming from the kitchen.]

Unwitting Speculator #1 : What?! I was tired of throwing away money on rent every month. I wanted to invest in something real... and build equity. Besides, we're going to sell in five years, anyway. So we're cool.

[Somebody snickers.]

Renter #2 : That doesn't make sense. You are still throwing away money. The only difference now is you pay a finance company instead of a landlord.

Renter #3 : And what if you can't sell in five years... doesn't that make you nervous?

Unwitting Speculator #1 : [muffled unintelligible remarks... something about the location of the house...a leafy street...children on bikes...speed humps... shiny happy people... yada, yada...]

Renter #3: Answer the question. What if you can't sell?

Unwitting Speculator #1: Well... I am a little nervous. [nervous laughter] We're risking a huge amount of money... more money than I've ever known. But hey, you only live once!

Unwitting Speculator #2: Oh come on LS, don't listen to them. I have an interest only mortgage, too. [More gasps of horror. Another burst of Lon Chaney music.] These guys are all gloom and doomers. Remember, they work for The Daily Reckoning.

[Renters' heads snap in unison to glare at Unwitting Speculator #2]

Renter #1: And...what about you, AREN'T YOU nervous?

Unwitting Speculator #2: Nope. I try to take life one day at a time. I don't look that far ahead. I'm doing okay right now... and besides, in 5 years, I hope to be married.

[Unwitting Speculator #2 holds up both hands with her fingers crossed. Smiles.]

All (in unison): Awwww.

Unwitting Speculator #1: Don't you know it's bad luck to cross your fingers with BOTH hands?

ACT II - UNSEEMLY PROFITS

Real Estate Investor: What about you Addison, why do you rent?

Renter #1 : Well, we live down by the water... in the neighborhood we want to live in... and to tell you the truth, I just don't understand the market anymore. Let me give you an example.

When we lived in the same neighborhood before moving to Paris back in 2000, the house across the street went on the market for $97,000. The price was so high, everyone thought the owners were nuts. It was a different time. A friend finally bought the place for $87k, gutted it and started renting to college students.

We moved to Paris for four years. Last year, when we were moving back, we looked for a place to buy in Fell's Point... low and behold, we saw the same property on the market. Guess how much?

All (in unison): How much... tell us!

Renter #1: $357,000. [Renter #1 moves his hands to his hips in disgust. Nods around the table.] A four-fold increase in just as many years!? Tell me, what market - any market - can sustain that kind of growth?

Real Estate Investor: Hey, a lot of people I know would say that's still cheap. Besides, it sounds like you were a damn fool to move to Paris. You should have held on for the ride. Still, I think you're right. The market is getting frothy... that's why I just sold my Baltimore properties.

[Puzzled looks of intrigue.]

Renter #1: Yeah, that's probably a good move. You bought in nice and early, and now you've sold near the top. Then you put the proceeds into a resort property in West Virginia... everyone knows that's an undervalued market.

[Fiddle-heavy blue grass music wafts from the kitchen. More nods of agreement around the table.]

Real Estate Investor: Yup. The price is up already. We only put ten percent down, but by the time of closing we had accumulated enough equity, the bank said they weren't going to require mortgage insurance. We'd already amassed an additional 10% of equity!

30-Year Fixed: Hell yeah! We made over $30,000 on our house before we'd even slept there!

Unwitting Speculator #2: Yeah... same here... my house is way up already, so I have a good margin of safety. And when I get married...

All (in unison): Awwww.

Renter #1: Hey, 30-year fixed, I know you've already made money on your house, but what do you see in the future?

30-Year Fixed: I have a response, but first I'd like to make a comment...

There are some neighborhoods that will always hold value. [muffled remarks... something about the location of the house...a leafy street...children on bikes...speed humps... shiny happy people... yada, yada...]

Renter #1 (with much enthusiasm): Au Contraire! (after all, that is THE motto of The Daily Reckoning...)

Baltimore is a case study of good neighborhoods gone bad. Look at Druid Hill... beautiful row homes. Back in the '20s F. Scott Fitzgerald and Gertrude Stein held garden parties and entertained European royalty up there. Now look at it. Hell might offer better refuge for a family of four.

On the other hand, in the '70s respectable folk wouldn't let their children go down to Fell's Point unchaperoned. It was a haven to bikers, ne'er-do-wells and urchins of the night. Today, they're building spec homes on the water that start at a million plus...

Renter #3: Too bad the harbor smells so bad...

All (sighing): Yeah...

[Pregnant pause. A moment of quiet reflection.]

Chorus: At this point, it's not clear what conclusion, if any, can be drawn from the play.

When will the housing bubble burst?

Is it a bubble at all?

Or... will prices keep rising for five years, handing the interest- onlys the last laugh; leaving the renters, humbled once again with egg on their faces... and feeling like chumps? Well, dear reader, this is what makes a market.

Still, the renters bumble on...

ACT III - THE INTERVENTION

Unwitting Speculator #1 (jolted with excitement turning to Renter #1): Oh, that reminds me, can I have the day off tomorrow? I'm closing on my house. [Turns to the table.] Should I wear a suit?

30-year Fixed: Nah...you don't have to wear a suit for those yahoos.

[Snickers]

Renter #1: Sure, you can have a day off. But I forbid you to use one of these.

[Renter #1 holds up a pen. Renter #2 and Renter #3 smile at each other.]

Renter #3 (smugly): Ahhh... No pens, no signing.

Renter #2 (smug and grinning): Yeah... no pens.

30-year Fixed (Gesticulating expansively, raises his voice): Ah, don't listen to THEM... (mutters to himself) for crissakes.

[Check arrives. Curtain falls.]

Regards,

Addison Wiggin
for The Daily Reckoning Australia

DISCLAIMER: Any and all events in this dramatic reenactment are purely non-fictional. Any resemblance to real life is intentional; not at all coincidental. Some liberty may have been taken with the facts, but we swear it was in good faith. We may have been embellished a tad for dramatic effect.

AUTEUR'S NOTE: It goes without saying, if this reality play had been written in 1999, the object of desire would have been tech stocks instead of houses.

A lot has changed since 2005. (Addison fell prey to the Siren song of real estate and now owns a home). And, unbeknownst to the cast of characters, the real estate bubble was about to find its pin...starting with the subprime market. As the subprime loans began to reset at higher rates, borrowers found themselves in over their heads, not able to make their mortgage payments. The subsequent defaults shook the lenders to their cores, causing a ripple effect over the rest of the economy...the effects of which, we are still feeling.

We aren't out of the woods yet, unfortunately. Another wave of defaults will soon be upon us when the "Alt-A" and "Option ARMs" reset at higher rates.

• Negative Equity Becoming the Norm in U.S.A.
• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?
• Bye Bye General Motors
• Hidden Inventory of Unsold Houses Will Depress Housing Prices
• Investors Think Things Will Return to the Way They Were in the Bubble Epoque

But before theory, let's look at reality. The reality is that the Federal Reserve in the United States would like everyone to quit gaping at vanishingly small short-term interest rates. The Fed surprised stock buyers and bond traders when it cut the Fed funds rate from one percent to somewhere between zero and 0.25.

The S&P 500 hit a five-week high and the Dow was up over 340 points. The cut was the Fed's ninth in the last fourteen months, on top of $1.4 trillion in new lending. But really, who does Ben Bernanke think he is? MacGyver? Is he going to fashion a miraculous recovery in the world economy using chewing gum, bailing wire, and raw oyster shells?

Maybe! Or maybe Bernanke is channelling Malcolm X. He's going to reflate the housing bubble "by any means necessary." Hot air, funny money, talk therapy...whatever it takes baby.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the Fed said in its statement accompanying the new rate. "In particular," it continued, "the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."

Short-term rates are low and they're going to stay there for awhile. But the big news in the statement is that the Fed is taking the fight to longer-term interest rates as well. It aims to flatten the yield curve with brute force, or at least bucketfuls of cash. It will do this by buying more mortgage-backed assets and even U.S. Treasury bonds.

"As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities."

The benefits of merely mentioning the strategy started showing up right away. Yields were down and prices were up as traders loaded into U.S. bonds. All aboard the Fed's Bond Yield Express! Destination Zero!

You can see below that the current yield curve is more of an on-ramp. And the only reason it looks moderately curvy is the scale on the y-axis. In truth, the curve is being flattened by the Fed's weight-of-money strategy. Throw money at bonds. Crush the curve!

Source: Bloomberg

This policy is bound to have all sorts of unintended consequences. But the main intended consequence is to liberate the household balance sheet by lowering ten-year U.S. bond yields, which are roughly linked with 30-year U.S. mortgage rates. We talked about strategic indirection yesterday. Here you have it.

Forgive us for this digression into bond yields. But we'll get to why it's important in just a moment. Bear with us for just a few more data seconds. If you look here, you'll find that the Fed HAS been effective in reducing yields on short-term notes and bills in December. The yield on the 1-month bill has fallen by 44%, on the 3-month by 42%, on the 6-month by 47%, on the one year by 44%.

By contrast, stubborn ten-year yields have fallen "just" 12.8% while thirty-year yields have gone down 11.1%. This is why the Fed will start buying bonds of longer maturities. In its attempt to reflate U.S. household balance sheets, it has to move ten-year yields down. So it's rolling up its sleeves and getting to work.

But don't think that just because the Fed works hard it will necessarily work well. Generally in life, we believe the quality of your effort counts for more than the results you achieve. Not because results don't matter. They do. But outcomes are generally beyond your control in most things, and often they are just plain random.

But the Fed believes in hard work. So work it will. But as Bloomberg reports today, Japan's central bank kept its main rate at zero from 2001 to 2006 while flooding the banking system with extra cash to encourage lending, spur growth and overcome deflation. The abundant funds failed to prompt lending by commercial banks, which expanded their reserves at the central bank almost nine times by early 2004."

What can you expect to see then? First, look for rising gold prices. Gold was up again in New York trading by twelve bucks to $855. Diggers and Drillers editor Al Robinson has brought together some excellent Aussie gold analyst in his latest report, going out to subscribers later today. If you want to know the forecast for Aussie gold, you'll want to take a look.

What else? Well, the commercial banks the Bloomberg article mentioned will stock pile cash and deposit it at the central bank. In the local market, Commonwealth Bank raised over $2 billion in a share placement to institutional investors. The Financial Review reports the price of the shares were at a 7.3% discount to CBA's market price. Like other Aussie banks, CBA is beefing up its capital base to reassure investors that it's positioned to ride out the crisis.

Need a laugh? Take a look at this. It's an interview with Bernard Madoff at some sort of Wall Street roundtable in 2007. We listened to it this morning and jotted down some of the more ironic highlights.

"How do you make money?," the moderator asks.

"Well today basically, the big money on Wall Street is made by taking risk," Madoff replies. True enough. Wall Street made money trading its own capital. Or, in some cases, using other people's money as collateral for big loans to trade. You can see, though, that taking on risk is not the same thing as entrepreneurial capitalism, especially when it's not your capital at risk.

Here's another gem from Madoff: "In today's regulatory environment it's virtually impossible to violate rules...And this is something the public doesn't really understand...It's impossible for a violation to do undetected, certainly not for a considerable period of time."

The more interesting and less ironic part of the discussion is how Madoff describes his firm's use of quantitative models and algorithms to replace human beings. Madoff told the public that using more models and fewer brains made for greater efficiency and reduced regulatory risk.

"Take the human being out of the equation. When you do that, there are two advantages in our industry. You solve your regulatory risk [because a computer can't lie, cheat, or steal]...Because the nature of any human being and certainly anyone on Wall Street is that the better deal for your customers the worse deal for you. Because you're on the other side of the transaction."

Madoff then gave an example of a retailer who sells televisions. If he lowers prices, he said, he lowers profits. What's good for the consumer is bad for the salesman and vice versa, he says.

"As honest as you try and get people to be," he went on, "there's this normal natural pull that you have to deal with." That 'pull,' presumably, is to always act in your own interests when they are not in alignment with the customer's interests. And in Madoff's formulation of business, the businessman's interests are never aligned with the customers, apparently.

"I guess you could also program a computer to violate the regulations, but we haven't gotten there yet," he joked. Maybe someday, when computers have consciousness too. But not yet.

Is Madoff correct? Well he's probably plain wrong about the TV retailer. If the seller cuts prices, he sells more units. What's good for the customer is good for that particular retailer (though perhaps not all retailers in the aggregate.) Just ask Wal-Mart.

But the real question is whether the interests of financial institutions ever really aligned with their customers. He pointed out that the decline in commissions that came in the late 1970s stripped away all the transactional profit on offer to brokers. They had to make money some way. So they traded their own capital and, ahem, leveraged their informational advantages.

But you sense a fundamental and perhaps cynical error in this conception of things. Madoff reveals the error when he says you should "take the human being out of the equation." This reveals the belief that the economy is a machine, or a complex set of variables that are reducible with enough MBAs and quants, to equations.

As hard as hard as it is to figure out the delta in an options trade (the change in the options price for every change in the underlying) try figuring out how to quantify fear and greed. And besides, perfectly rational people are often quite happy to take opposite sides of a trade. Why? They think differently. They base their decisions on different experiences. They have different objectives. Maybe one of them had hot chilli for lunch. Who knows?

But you can never remove human beings from the equation. That is a new kind of fatal conceit of the model makers of the financial world. That everything can be reduced to variables and plugged in the right equation to be both explanatory and predictive. It's really no more useful than financial astrology.

All you can really get from good models are probabilities, not certainties. The only certainties, other than death and taxes of course, are that human beings are enormously flawed and will repeatedly make stupid mistakes out of arrogance, and later, maybe in Madoff's case, out of fear.

It's kind of remarkable to hear a man talk about the virtue of his cutting edge models that take human beings out of the equation. Hardly. The core of his real business model was good old fashioned fraud. And it wasn't a model based on an equation but on the psychology of the con.

Dan Denning
for The Daily Reckoning

• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis
• Between What Bond Investors Stand to Gain in Yield and What They Stand to Lose from Inflation
• U.S. Bond Prices Rose and Yields Fell
• Finding Assets that Out Run Inflation as Bond Yields Move Up
• Madoff Astonished SEC Didn’t Verify His Claims

We are trying to see the big picture, trying to understand what is really going on. We can imagine ourselves like Caesar – watching the action at Alesia from a nearby hill – or like Lee looking at Cemetery Ridge as the Confederates tried to push back the Yankees. Which way is the battle going? Who’s going to sweep the field...who’s going to carry the day? Caesar won at Alesia with a combination of strategy, planning, and discipline. But Lee lost at Gettysburg for lack of resources...bad luck...and bad tactics. And now...General Bernanke is losing too.

Yesterday’s news described another day of deflation. The Dow lost 42 points. Oil fell almost $4, to $121. The commodity index, the CRB, dropped 18 points. And gold lost nearly $10, ending the day at $907.

What to make of it?

Banking has always been a boom and bust business. Bankers tend to act like retail investors who just happen to have a lot of money. They lend to whatever is fashionable...then, when the go-go businesses go bust, the bankers look for the next opportunity to lose money.

The retail investor doesn’t know anything about investing or economics either. Instead, he watches television or reads the papers. Gradually, he forms the opinions that turn him into a chump for Wall Street – ready to buy financial products because he’s heard someone say they make good “investments.”

From 1997 to 2007, the retail lumpenhouseholder developed an extraordinary hallucination; he came to believe that he could make money simply by buying a house and living in it. Of course, the little guys are always susceptible to delusions – especially those that flatter them or offer them something-for-nothing; that’s how democracy works. But what was really remarkable, in the ’97-’07 period, was that sophisticated bankers and brokers came to believe the same thing – that they could get rich by buying and trading the mortgage contracts of people who thought they’d never have to pay back their mortgages.

Of course, the whole thing blew up last year. The marginal homeowner is in trouble – with more mortgage than house. And the marginal banker is in trouble too – he owns the mortgage! So far, houses have fallen about 20%, with another 10% to 30% left to go. And the banks have written off about $476 billion worth of bad credits – according to the Int’l Institute of Finance – with maybe another half a trillion in mortgage-related losses.

So far, the subprime mortgages have been the focus of losses. But now the Alt-A and Prime mortgages are getting into trouble too – with delinquency rates in both categories on the rise.

Nothing astonishing about this picture. A correction is always equal and opposite to the claptrap that preceded it. The housing hallucination was a whopper. So is the correction. The housing bubble caused big increases in nominal GDP, retail spending, and corporate profits (from the financial sector). Now, the GDP is flattening out, retail spending is softening and corporate profits have been crushed.

Taken altogether, guess how much money the Dow stocks are making? These are the companies that form the backbone of American commerce and industry. Guess again. Because if you put them all together, says Barron’s, you’d have a loss of more than $80 billion. The last time there was such a loss in the Dow was 75 years ago – in the Great Depression.

This is an encouraging word to many observers. They note that the last time Dow earnings went negative proved to be a very good time to buy stocks. After ’32, stocks in the United States went up 373%.

But wait, they went up AFTER having lost about 85%. The Dow in ’32 rose from a low of 41...with stocks trading at only 5 to 8 times trailing earnings (in terms of current negative earnings, the P/Es were meaningless). In other words, the stock-market had been crushed before it rose again.

Today’s stock-market has not yet been crushed. In fact, the Dow itself is only a bit lower than its all-time high.

The correction has taken the wind out of Wall Street’s sales. But, so far, it has done very limited damage to U.S. stocks. Most likely, more pain lies ahead...before another upswing.

Hey, don’t take our word for it. No less an authority than Alan Greenspan himself says there is more suffering ahead...and there is no less an authority than Alan Greenspan.

The auto business is being corrected – severely. One of the biggest losers on the Dow was – no surprise – General Motors. It lost $11 a share in the second quarter– which is almost unbelievable, for a share that sells for $10. And Chrysler’s latest attempt to raise money fell $6 billion short. The auto industry will probably go broke – and be nationalized, like housing.

Bill Bonner
for The Daily Reckoning Australia

• A National Mortgage Bubble
• Housing Prices Follow GDP Growth and Inflation
• Politics and Investment Intertwined
• New Default Wave Hits Mortgage Industry
• Housing Market is Becoming More Affordable but That’s Not Necessarily a Good Thing

The debts covered by the Bank of England, however, totaled $309 million on one estimate. They took 10 years to clear from the Bank's balance sheet.

The Swedish government then stepped into the Scandinavian banking crisis of 1992, buying the 13% of Nordbanken shares that it didn't already own at a 10% premium. That defended investors as well as depositors.

Washington even managed to contain the US savings & loan crisis of the late 1980s, protecting savers but letting more than 1,000 finance companies go under.

The direct cost to the US taxpayer was $124.6 billion, according to the General Accounting Office's report - right about the total bank losses in the subprime collapse so far.

All told, the S&L crisis cost "more than the cumulative loss of all US banks during the Great Depression, even after adjusting for inflation," as Jean-Charles Rochet, then a visiting professor at the London School of Economics, put it in a speech on banking crises of 2002.

Whereas, by its end, the current banking crisis will see total mortgage-credit losses of $400 billion according to Goldman Sachs' latest guess-timate. So "let's be clear and honest," as Housing & Urban Development secretary Alphonso Jackson said when launching Project Lifeline this week.

"One action alone will not solve every problem in the housing market," Jackson said as he gave US home-buyers an extra 30 days to try and stall foreclosure. He could just as easily have been talking about the entire banking industry.

One action alone won't solve it - not even if that one action does come from Warren Buffett. Or the White House. Or the Federal Reserve.

But altogether?

And what if we throw in an extra $3.3 trillion of foreign government finance, pouring out of the oil- and export-rich sovereign wealth funds of Arabia and Asia? Might that be enough to wipe the world's greatest-ever credit bubble from history?

"So far, institutions have raised nearly $75bn of capital from sovereign wealth funds and public sources," notes Joseph Mason, associate professor of finance at Drexel University and a senior fellow at the Wharton School, in the latest market note from his private consultancy, Criterion Economics.

"[But] while the seemingly unconstrained supply of capital has, thus far, been a blessing, it is not clear that the flow can continue. Recent events suggest that private capital sources may be reaching their limits, at least with respect to riskier institutions."

Citigroup just managed to raise funds at 5% interest. It is the world's largest bank, after all. But MBIA, the biggest "monoline" bond insurer, was forced to pay 14% on its AA-rated debt as Mason gasps.

"Ambac canceled their most recent recapitalization attempt," he adds, "ostensibly because the cost was even higher."

So step forward Warren Buffett! The stock market initially rallied - and rallied hard - on the idea that the Sage of Omaha might buy up bonds currently insured by bond-insurance giants MBIA, Ambac and FGIC. Yet as Buffett told CNBC, he only wants the municipal bonds these firms insure, and nothing else.

Because - get this - municipal bonds are currently cheaper to buy if they come with insurance than without!

A "classic kind of mispricing" for the Sage of Omaha to exploit, as John Authers notes in the Financial Times, this arbitrage also shows just how horrified the entire investment world has become by the "monoline" insurers, thanks to the very same junk that Warren Buffett will not step in and save.

Clearly, Buffett's offer makes great news for US towns and states wanting to raise fresh capital to fund their core services. With his prime-beek cherry Coke check-book at the ready, there's no need to repeat Sept. 1933 - when 28 American cities went into default - nor the Orange County default of 1995.

Especially not if the Federal government were to stand behind Buffett standing behind the municipals. Right?

Buffett himself, however, was quick to point out that his offer "doesn't do anything" for the subprime bonds, collateralized debt obligations (CDOs) and leveraged debt pushing down on the bond insurer's credit ratings.

Indeed, "I'm not sure anything is going to do much for the CDOs," he said. That doesn't mean state agencies and central banks won't try, however. "Direct government bailouts are gaining in popularity," as Prof. Mason notes for Criterion.

He's not kidding!

Here in London, the British government has told the two remaining bidders for Northern Rock - the top-five mortgage lender, hit by a banking run in Sept. '07 and now supported by �26 billion ($46bn) of tax-funded loans - that it's on the verge of full-scale nationalization.

Northern Rock was moved onto the British state's official balance sheet last week.

Germany's IKB, currently 38% owned by the state, may see the government-run KfW development bank raise its stake to 50% - effectively nationalizing the subprime-hit lender - because private-sector investors are unwilling to back a new capital raising.

In France, the state-controlled postal bank La Poste is rumored to be joining the government-owned Caisse des D�pots in developing a bail-out package for Soci�t� G�n�rale. The country's second-largest bank, SocGen managed to lose $3 billion on subprime investments - a little-known fact given the $7 billion it lost to "rogue trader" Jerome Kerviel.

This week SocGen raised capital by offering new shares at a 39% discount to its stock market price - itself already offering a near 42% discount from this time last year.

And in Switzerland, UBS - due to report its first loss in history on Thursday, worth some 4.4 billion Swiss Francs for 2007 as a whole ($4bn) - may gain financial support from the Swiss government if shareholders reject the capital restructuring proposed by the Singapore government. Along with an un-named Saudi investor, Singapore's Government Investment Council (GIC) has offered to put up 13 billion Swiss Francs ($11.3bn) without demanding a seat on the board.

But the GIC would take a controlling stake, however, since "on average, 30% of shareholders turn up to vote at the AGMs," as one UBS shareholder told FinanceAsia this week.

"Somebody controlling one-third of that" - and the GIC-Saudi investors would hold 10% of the total between them - "effectively controls the company."

Does it matter? Maybe. "The investment arms of foreign governments appear to have saved the day for American financial institutions," says Steven M.Davidoff for Deal Book. They've also piled into the biggest banks in Europe too, saving Western governments some $75 billion so far.

On one day alone last month, some $19 billion was raised by Citigroup and Merrill Lynch tapping the convertible bond markets - and Citi's funding "included investments from sovereign wealth funds in Singapore and Kuwait, alongside Prince Alwaleed bin Talal, the bank's second largest shareholder," reports Financial News US.

Whatever the Asians and Arabs can do, Washington can do better of course, starting with the little guy right at the bottom of the subprime pyramid - the over-indebted home buyer himself.

George Bush might have watched 226 mortgage lenders go kaput since late 2006 (the latest count from ML-Implode.com), but he just signed that $168 billion tax-rebate bill, hoping to stop the current slump in US house prices becoming a genuine depression.

Not enough, grumbles Senate majority leader Harry Reid. The package is "far from a panacea," he says, getting ready for a Democrat White House no doubt.

"Much more should be done. Another stimulus package or two."

Or three. Or four. You just keep writing the checks, Senator - and get the Federal Reserve to keep US interest rates way below inflation.

We'll just keep buying gold outright - with no default risk - and store it in privately-owned, ultra-secure gold vaults, far outside the world's banking system.

Adrian Ash
For The Daily Reckoning Australia

Photo Source: http://www.socalbubble.com

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